The Coming Decade of Sideways Markets
paraphrase Nassim Taleb, "Giving interviews is the art of repeating
oneself without anyone noticing." With the new book out, I have
and the opportunity to perfect that art. My latest interview, with
friend Bob Huebscher of Adviser Perspectives, is below; and here are
my interviews with John
Mihalijevic of Manual of Ideas (John is
co-organizer of ValueEx; see below), Elliot
Turner of Wall Street Cheat Sheet, and an
audio interview with Jim
Puplava of Financal Sense. I tried
very hard to offer new perspectives in each interview, even when we
the same subjects. I tried.
be attending and briefly speaking at VALUEx Zurich / Klosters
Conference on Feb
2-4. Attendance at this conference is free, and it is a great
opportunity to spend time with other value
investors, not just in the classroom but on the chairlift and while
You can find more information about the conference here.
Right after that, I'll be giving a
presentation for the Center
for Value Investing in Frankfurt
Germany, on February 7th.
#990000;">The Coming Decade of Sideways Markets
January 4, 2010
Vitaliy Katsenelson, CFA, is Chief Investment Officer at Investment
Management Associates, Inc., a Denver-based money management
firm. He is also the author of the highly acclaimed book, The
Little Book of Sideways Markets (Wiley, 2010), which is
available via the link above. His web site is Vitaliy’s
I spoke to Vitaliy on December 29.
Your latest book, The Little Book of Sideways Markets,
was just published. What is a sideways market?
clearly about this. When I talk about markets, I'm talking about
secular markets that last longer than five years, usually decades or
When we think about secular markets or markets in general, we tend
to think of them in binary terms: "bull" markets are going up, "bear"
markets are going down. But over the last 100 years markets spent
half the time in bull and half the time in a “sideways”
phase. Secular bear markets happened a lot less often than we
think. The only secular bear market we had was the
Think about sideways markets this way: The economy has a lot of
small (cyclical) bull and bear markets, but when we are in a sideways
market in the long run it just stagnates. This is similar to what
S&P 500 did over the last 10 years – we had two bear and two
bull markets, and yet the market is still not far from where it was in
To understand why this happens, you have to understand the simple
arithmetic of why stock prices go up in the long run. They are
really driven by two factors: earnings growth and change in
price-to-earnings ratio. If price-to-earnings ratios had not
changed over last 100 years and stayed at 15 (their long-term average),
you would have had no market cycles, and markets would have gone up in
tandem with earnings growth. Earnings in the long run would have
grown in line with GDP, or about 5 or 6% a year, so stocks would have
gone up gradually over time as the economy expanded.
But investors get overexcited about stocks, and they take
price-to-earnings ratios from below-average to above-average
levels. That is when you have secular bull markets. And
then investors take price-to-earnings from above-average levels to
below-average levels, which is when you have sideways markets.
This happened consistently over the last hundred-plus years.
In sideways markets, earnings growth is offset by price-to-earnings
decline, and markets go nowhere.
In bull markets, you have earnings growth and you have
price-to-earnings expansion. That is why the returns are so
good. This is a very important point: Over last hundred years or
so, economic growth was not that much different during sideways and
What stage is the US market in now?
We are in the middle of a sideways market, and we still have another
decade to go.
How do I know this? The principle is that P/Es go from above
average to average to below average, and they stay at the below-average
level for some time. If you look at the last sideways market,
which was from 1966-1982, price-to-earnings did not just go from above
average and briefly touched below average level before we had a bull
market. No. Price-to-earnings spent half of the time at
below-average ratios before the next bull market (1982-2000) started.
Though the stock market briefly visited below-average P/E levels during
the Great Recession, that dip was not likely the end of the current
With regard to price-earnings ratios, are you using
normalized P/E ratios?
Yes. This is a very important question, because the
“E” in one-year P/E ratios is heavily affected by the
cyclicality of the economy. Profit margins play a very
significant role in what one year (trailing or forward) earnings are at
any given moment of time.
Profit margins today are very high, and they rarely stay above their
average for long. Therefore, if you look at stocks based on
forward earnings, they don't look that expensive, but those earnings
anticipate continuation of very high margins that are not sustainable.
P/E computed on ten-year trailing earnings more accurately describes
how cheap or expensive the market is, as earnings averaged over ten
periods capture the complete economic cycle (high and low
margins). Historically, the average P/E ratio based on 10-year
earnings was about 18, slightly higher than the 12-month trailing
P/E. Today the normalized P/E is close to 25 times
Stocks in general are still not cheap.
Can the difference between 18 and 25 be justified by the
fact that interest rates are so low?
I talked about this in my book. This is a very important
point. It is not just enough to say interest rates are low and
therefore P/E ratios should be high. You must understand where
interest rates are – in one of three zones: inflation, normal,
Today's interest rates are very low not because the economy is
great, but because it isn’t. The Federal Reserve is afraid
of deflation. Deflation is not good for stocks, because it would
be accompanied by slow economic growth, and you would have higher
corporate bankruptcies and defaults. This means higher
risk. The Federal Reserve is trying to move rates lower, not just
on the short-term side of the curve but also on the long-term side,
because they are afraid we are going to have another recession.
It is not necessarily good for stocks if interest rates are low
because you are afraid of deflation. You want interest rates to
move from the deflation zone to the normal zone. If long-term
rates go up to 5 or 6% and short-term rates go up to 3 or 4%, that
would be good for stocks, because it would mean the economy has
stabilized. That is not what is happening today.
Of course, having very high interest rates is not good for
stocks either. But the point is that just because interest rates
are low, that does not necessarily mean that you should have high
valuations. Today interest rates are low for a very important reason
that is not conducive to higher price-to-earnings.
One last point on this: Japan had very low interest rates for 20
years, and their price-earnings ratios did not expand; they contracted.
Are there signals that will indicate that we are moving out
of this long-term secular sideways market into a bull market stage,
other than interest rates moving up?
A good clue would be the media basically throwing in the towel on
equities and saying that nobody wants to own equities ever again.
I'm so glad that Business Week did not go bankrupt, for many
reasons. I don't want those reporters to lose their jobs, but another
reason is that I am looking for them to be the contrarian indicator
– to write an article on the “death of equities” like
they did in the early 1980s. That would be another sign that we
are out of the sideways market. I don’t see those signs
Right now, sentiment is very, very bullish, and people basically
expect the bull market to continue. So the sideways market is
We did have a fairly substantial move by individual
investors into bond funds for most of this year.
That's right, and now they are trying to get back into stocks.
Part of the rally we had was because individual investors are afraid to
miss the boat. If you look at the AAII [American Association of
Individual Investors] sentiment, it is at a multi-year high.
Within your clients' accounts now, how much cash are you
holding? As a value-oriented investor, what downtrodden and
neglected asset classes do you consider attractively priced?
In the fourth quarter of 2010, our cash balances peaked at 35% as we
were selling stocks that became fully valued. Our cash balances
have declined since to 28%, however, because even though the market was
going up, some stocks declined and became good bargains.
You find value today in an unexpected place. When I look at
the economy today, I’m not necessarily sure that this recovery is
sustainable, or the speed of the recovery is sustainable.
Therefore, we have positioned the portfolio very conservatively for a
very slow recovery. The stocks you want to own in that
environment are high-quality stocks.
Ironically, these are the stocks that are cheap today. Usually
you pay premium prices to hold high-quality stocks. Today, they
are priced at a discount. We see a lot of value in high-quality,
stable stocks in the health care area, priced at seven- to eight-times
earnings, with strong balance sheets and high dividends. They also have
strong pricing power in case we have inflation, and they’ll be
able to maintain prices if deflations pays us a visit.
Let's talk a bit about China, because you have written a lot
about that country. What is your overall outlook for the Chinese
economy? How will it affect the US economy and US investors?
China is extremely important to the global economy. China to
some degree helped to pull the global economy out of recession with its
enormous stimulus. However, I expect China’s economy to get
worse at some point in the not too distant future
The Chinese economy grew at a very fast rate for long period of
time. The Chinese government is extremely concerned that if the
growth rate of its economy slows down it is going to have high
unemployment. Ironically, though, this country that is supposed
to be communist has less socialism than we have in the United
States. The social safety net is absent for the most part in
China. When people lose their jobs, there are no unemployment
benefits and no healthcare provided by the government. The
unemployed are not just temporarily inconvenienced while they are
looking for a job, they go hungry and they cannot afford to pay for
medical bills, so they don’t complain; they riot. The
government is concerned that high unemployment will bring social
instability, which is why they want to maintain full employment and
thus grow at any cost. Once you start looking at what is
happening in China through this lens, the government’s actions
start making more sense.
When the global economy slipped into recession, China resorted to
the mother of all stimuli. Its stimulus package accounted for 14% of
its GDP and was fire-hosed into economy at a very fast rate.
Lending went vertical; it went up about 30% in 2009 and 2010. The
easiest way to maintain employment is to build, so they built.
China already had a lot of overcapacity going into the recession,
but they took that overcapacity even further. You have a lot of
empty cities in China. The most infamous city, Ordos, was built for 1.5
million residents, and it is completely empty. China has second-largest
shopping mall – the South China Mall - and it is empty.
And there are a lot more examples like that in China. Housing
prices went up nationwide. In Beijing, housing prices reached 22 times
average income. In Japan, in the late 80s, at the peak of the housing
bubble, for reference, that ratio peaked at around 9. In the US in 2007
it peaked at 6.4. For China as a whole, that number is now over 8.
When you try to fire-hose a lot of money into the economy, you are
going to misallocate capital. China has been ranked as one of the
most corrupt countries in the world, and that guarantees that you are
going to have even more misallocated capital. China has a lot of
overcapacity in many different areas.
You cannot have vacant cities, empty shopping malls, and a real
estate bubble and not have a lot of bad debt. But the bad debt is
covered up by growth and will surface when growth slows down or
stops. I hear the argument that China only has 30% debt-to-GDP,
so it is stronger than many other global economies and has a lot less
debt than the United States, for instance. Well, Ireland
had very little debt before the financial crisis. Now it is one
of the "I”s in the PIIGS, because its government had to bail out
the banking system. The difference between Ireland and China is
that Ireland had a choice of whether to bail out its banking system,
whereas China owns its banking system, so it will have to bail it
Why do we care about what happens in China? Several reasons:
It is the second largest economy; it is single-handedly responsible for
the rising prices in most industrial commodities; and, according to a
paper authored by the Reserve Bank of Australia, China is responsible
for two-thirds of the global demand for iron ore, one-third of global
demand for aluminum, and more than 45% of global demand for coal.
Any Chinese decline will tank commodity prices globally. So if
your portfolio is heavily exposed to commodities – an asset class
that worked well as of late – you are exposed to China.
But China’s influence doesn’t stop there. Chinese growth
has benefited a lot from commodity-producing countries like Canada,
Russia, Brazil, Australia and many others. Only a decade ago, for
example, exports to China accounted for 5% of Australian exports, now
that number is pushing 25%. Readjustment in the Chinese economy
will cause a significant readjustment for those countries as well
– so if you have a lot of exposure to these countries, you are
exposed to China. Finally, China has been the largest holder of
US Treasury securities; as its economy weakens, its demand for our fine
paper will decline, which will lead to higher interest rates in the
Could China face a banking crisis if, for example, its
central bank has to raise interest rates in order to stem rising
inflation? Do you see that as a potential threat?
It is very difficult to see exactly what is going to do China
in. It's very difficult to figure out which straw is going to
break China's back. China’s central bank is raising
interest rates because they have significant inflation. When you
inject as much money into the economy as the Chinese government did,
you are going to have inflation. The more leveraged the system,
the more sensitive the economy becomes to higher interest rates.
Here is what puzzles me: Everybody looks at the Chinese government
and thinks that it manages its economy so well, and therefore it will
find the right mix of interest rates and fiscal policy measures.
Americans, however, think that our government has done a horrible job
of managing our economy. I doubt if the Chinese government is any
better at managing its economy than our government is at managing
ours. High interest rates may be what does China in, but who
knows? I think it is more important to identify the bubble than
the prick that will burst it.
I want to wrap up with a fairly specific question: What is
your outlook for the US markets for 2011? What do you think the
return will be on the S&P?
To have an outlook about the market you have to get a couple things
right. You have to get the economy right, and you have to get the
response of the markets to the economy right. I have some doubt
about the sustainability of today's recovery, or more accurately about
the sustainability of the current growth rate. That is number
one. Even if you get economy right, predicting what the market
will do in response to the economy is a crapshoot at best.
In addition, we can't find enough good stocks to buy. That is
why we hold a lot of cash. (Our cash is a byproduct of our inability to
find stocks that meet our criteria and our unwillingness to compromise
on what we own, not our belief that we can time the market. We
cannot.) So I am, naturally, not excited about the market, though I am
excited about specific stocks we own. Despite having written a
book that makes an argument that market will be going sideways for
another decade or so, I really have no idea where it is going to be
next year. It is random.
Where do you think interest rates are headed?
Interest rates are a very interesting subject. The Federal
Reserve is desperately trying to bring down long-term rates through
QE2, and short-term rates are already at zero. So far, in its
latest attempt, the Fed has had little effect on long-term rates,
though the Fed will likely keep trying.
I am conflicted on this topic. On the one hand, higher
interest rates are not good for the economy in the short run
(especially for the housing market, though they are good for savers).
In the longer run, however, interest rates that are set by the free
market, not by 12 guys sitting in cushy chairs in the Fed’s
boardroom, are a big positive. For this recovery to be
sustainable, we need less government interference and more free market.
We don't need a recovery that is orchestrated by the Federal Reserve,
because that won’t work in the long run.
Also, considering that two largest foreign holders of the US debt
are China, which we already discussed, and Japan, which is the most
leveraged first-world country [see Vitaliy’s presentation on
Japan here], I believe we’ll have lower demand for
US debt going forward from overseas. We’ll likely have higher
Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of upcoming The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email, click here.