Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo. He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).
The stock market’s performance over the next decade will be very similar to the one since 2000: the WSJ appropriately named it “the lost decade.” Stocks will go up and down (setting all-time highs and multiyear lows), stagnate, and trade in a tight range. At the end of this wild ride, when the excitement subsides and the dust settles, index investors and buy-and-hold stock collectors will find themselves not far from where they started in 2000.
Welcome to secular (long-lasting) range-bound markets or, in the tradition of giving pet names to market cycles, what I call the Cowardly Lion market, whose occasional bursts of bravery lead to stock appreciation, but are ultimately overrun by fear that leads to a subsequent descent.
Over the last 200 years, every long-lasting bull market (and we just had a supersized one from 1982 to 2000) was followed by a range-bound market that lasted about 15 years or so (the only exception was the Great Depression). Despite common perception, secular markets spent a lot more time in bull or range-bound phases, roughly half in each, and only visited a bear cage on very rare occasions. This distinction between bear and range-bound markets is seldom made but extremely important, as you’d invest very differently in one versus the other.
Let me explain why this takes place. Though it is hard to observe in the everyday noise, in the long run stock prices are driven by two factors: earnings growth (or decline) and/or price-to-earnings expansion (or contraction). Take a careful look at the two tables and you’ll be hard pressed to find an economic metric that was responsible for a stock market cycle. Though economic fluctuations were responsible for short-term (cyclical) market volatility, as long as longer-term economic performance was not far from the average, secular market cycles were either bull or range-bound. Valuation – the change in price to earnings, its expansion or contraction – was mainly responsible for markets being in a bull or range-bound phase.
Prolonged bull markets started with below- and ended with above-average P/Es. This vibrant combination of P/E expansion (a staple of bull markets, a great source of returns) and earnings growth, which doesn’t have to be spectacular, just more or less average, brings terrific returns to jubilant investors.
Range-bound markets follow bull markets. As clean-up guys, they rid us of the high P/Es caused by bull markets, taking (reverting) them down towards and actually below the mean. P/E compression (a staple of range-bound markets) and earnings growth work against each other, resulting in zero (or nearly) price appreciation plus dividends, though this is achieved with plenty of cyclical volatility along the way.
The 1982-2000 the bull market ended at the highest P/Es ever! Thus it will take longer for earnings growth to deflate them. Though continued economic growth appears to be a wildly optimistic assumption, given what is taking place in the economy, it is not particularly unrealistic to assume that we will see nominal economic growth over the next decade. The Fed and our government are working very hard to achieve that, at any cost.
Bear markets are range-bound markets’ cousins; they share half of their DNA: high starting valuations. However, where in range-bound markets economic growth helps to soften the blow caused by P/E compression, during secular bear markets the economy is not there to help. Economic blues (earnings decline) throw water on an already dying fire (the compression of high starting P/Es) and bring devastating results to investors.
A true, long-lasting bear market has not really taken place in the US, but occurred across the pond in Japan, where stocks declined gradually, and not so gradually at times, falling over 80% from the late 1980s until today. If the US economy fails to stage a comeback with at least some nominal earnings growth over the next decade, what started as a range-bound market in 2000 will turn into a bear market, as high valuations are already in place.
Let’s try to figure out the earnings power of the S&P 500. The current 2010 estimates of its operating earnings are $75. I am skeptical of these numbers for several reasons:
First, they are double those of reported 2010 earnings estimates of $45. The percentage difference between reported and operating numbers is the second highest since 1988. (2008 holds the record. During the 2001-2003 recession the difference was about 50%. “One time” write-offs are responsible for the difference. It is very likely that these “one-time” charges are not really “one-time;” thus operating estimates overstate the true earnings power of the market.
Second, 2010 estimates are only slightly below the all-time high earnings the S&P achieved in 2007, when our economy was under the influence of several bubbles, which at the time severely inflated corporate profit margins, to unprecedented levels (I’ve written about this in Barron’s). Also, the bulk of excesses in margins came from the financial, materials, energy, and industrial sectors – the ones that are struggling today and will continue to do so for a long time.
Finally, if earnings were to be as projected, we’d be following the last recession’s recovery path, which is unlikely. The last recession was corporate, while the current one is riddled with debt-laden consumers. Deleveraging the excesses of the housing bubble, in the face of higher future taxation and likely higher interest rates (both byproducts of large deficits) will be a lengthy process. The recovery will be slower and real earnings growth will be lower than in previous recessions.
It is hard to know the exact earnings power of the S&P 500, but it likely lies somewhere in between operating and reported earnings estimates, and thus closer to $60, putting the P/E of the S&P 500 at about 19.
Since 1900, stocks have spent very little time at what is known as a “fairly valued” P/E of 15, spending less than 27% of the time between P/Es of 13 and 17 (2 points above and below their “average” level). They only saw a P/E of 15 when they went from one extreme to another. Most importantly, they’ve never stopped at the average and gone the other direction: they’ve continued their journey to the other extreme.
During secular bull markets, investor optimism, bundled with constant reinforcement from rising prices, takes stocks to above-average valuations, causing P/Es to expand beyond their long-term average.
P/Es can shoot for the stars, but they don’t get there: at the late stages of the secular bull market P/Es stop expanding. As earnings growth becomes the sole source of returns, disappointed investors start diversifying away from stocks into other asset classes (real estate, bonds, commodities, gold, etc.) – and a range-bound market ensues. As the range-bound market marches on, unmet expectations reinforce disappointment in stocks, and P/Es are compressed to the other extreme.
Keeping this in mind, note that stocks are still not cheap, and thus range-bound markets still lie ahead of us.
I should mention the role interest rates and inflation play in market cycles. They are secondary to psychological drivers, but important. They don’t cause the cycles but help to shape their duration and the valuation extremes stocks achieve. For instance, if at the end of the 1966-1982 range-bound market interest rates and inflation had not been in the mid-teens, the range-bound market would have ended sooner, at higher P/Es. On the other hand, if in the late 1990s interest rates and inflation had not been scraping low single digits, the bull market would have ended sooner and at lower P/Es. The higher inflation and interest rates that are around the corner will take their toll on the duration and final P/E of this market as well.
In range-bound markets, as P/Es compress they turn against investors; thus investment strategy in this very different and difficult environment needs to be adjusted for the new investment reality:
– Become an active value investor. Traditional buy-and-forget-to-sell (hold) strategy is not dead but is in a coma waiting for the next secular bull market to return; and it’s still far, far away. Sell is not just another four-letter word; sell discipline needs to be kicked into higher gear.
– Margin of safety needs to be increased. Typically, value investors seek for margin of safety to protect them from overestimating the “E”. In this environment it needs to be beefed up to accommodate the impact of constantly declining P/Es.
– Don’t fall into the relative valuation trap. Many stocks will appear cheap based on past valuations, but past secular bull market valuations will not be in vogue for a long time, thus absolute valuation tools such as discounted cash-flow analysis should carry more weight.
– Though timing the market is alluring, don’t – it is very difficult to do it consistently. Value individual stocks instead. Buy them when they are undervalued and sell them when they become fairly valued.
– Increased margin of safety and stricter sell discipline will lead one to have a higher cash position at times. Don’t invest for the sake of being invested, because this will force you to own stocks of marginal quality or ones that don’t meet your heightened required margin of safety. Secular bull markets taught investors not to hold cash, as the opportunity cost of doing so was very high. However, the opportunity cost of cash is a lot lower during a range-bound market.
And what if a range-bound market isn’t in the cards? If a bull market develops, active value investing should do at least as well as buy-and-hold investing or passive indexing. In the case of a bear market, your portfolio should decline a lot less.
Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo. He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007). To receive Vitaliy’s future articles my email, click here.
Vitaliy Katsenelson, CFA
Director of Research / portfolio manager
Investment Management Associates, Inc.
7979 E. Tufts Ave, 820 Denver, Colorado 80237
Office Phone: 303.796.8333 Cell: 303.564.6142