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Making Money When Markets Go Nowhere
We
are in a Cowardly Lion market, whose occasional bursts of bravery are
ultimately overrun by fear that leads to a subsequent decline.
(full image at http://ActiveValueInvesting.com)
For the US stock market, the past ten years have earned the title
“the lost decade.” The next ten years probably will not be much
different: The market will likely set record highs and multiyear lows,
but index investors and buy-and-hold stock collectors will find
themselves not far from where they started.
Every long-lasting bull market of the past two centuries (and we had a
supersized one from 1982 to 2000) was followed by a sideways market
that lasted about 15 years. The Great Depression was the only exception.
Despite common perception, secular markets spend a lot of time in bull
or sideways phases, and roughly an equal amount in each. They visit the
bear cage only on very rare occasions.
This doesn’t happen because the market gods want to play a practical
joke but because stock prices are driven in the long run by two factors:
earnings growth (or decline) and price-earnings expansion (or
contraction). Though economic fluctuations are responsible for
short-term market volatility, long-term market cycles are either bull or
sideways if the economy is growing at a close to average rate.
Prolonged bull markets start with below-average P/Es and end with
above-average ones. This vibrant combination of P/E expansion and
earnings growth – which doesn’t have to be spectacular, just more or
less average – brings terrific returns to investors. Sideways markets
follow bull markets. As cleanup guys, they rid us of the high P/Es
caused by the bulls, taking them down to and actually below the mean.
P/E compression – a staple of sideways markets – and earnings growth
work against each other, resulting in zero (or near-zero) price
appreciation plus dividends, though this is achieved with plenty of
cyclical volatility along the way.
Bear markets are the cousins of sideways markets, sharing half of
their DNA: high starting valuations. But whereas in sideways markets
economic growth softens the blow caused by P/E compression, during
secular bear markets the economy is not there to help. The US, however,
has never had a true, long-lasting bear market like the one investors
have experienced in Japan, where stocks have fallen more than 80 percent
from the late 1980s to today. If the US economy fails to stage a
comeback with at least some nominal earnings growth over the next
decade, what started sideways in 2000 will turn into a bear market, as
high valuations are already in place.
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 shape their magnitude and
duration. For instance, if interest rates and inflation had not been
scraping low single digits in the late ’90s, 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 P/E
of this market too.
In sideways markets you as an investor need to adjust your strategies:
- Become an active value investor. Traditional buy-and-forget-to-sell
investing 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 discipline needs
to be kicked into higher gear.
- Increase your margin of safety. Value investors seek a margin of
safety by buying stocks at a significant discount to protect them from
overestimating the “E.” In this environment that margin needs to be even
more beefed up to account for the impact of constantly declining P/Es.
- Don’t fall into the relative valuation trap. Many stocks will appear
cheap based on historical valuations, but past bull market valuations
will not be helpful again for a long time. Absolute valuation tools such
as discounted cash flow analysis should carry more weight.
- Don’t time the market. Though market timing is alluring, it is very
difficult to do well. Instead, value individual stocks, buying them when
they are cheap and selling them when they become fairly valued.
- Don’t be afraid of cash. Secular bull markets taught investors not
to hold cash, as the opportunity cost of doing so was very high. The
opportunity cost of cash is a lot lower during a sideways market. And
staying fully invested will force you to own stocks of marginal quality
or ones that don’t meet your heightened margin of safety.
What if a sideways market isn’t in the cards? If a bull market
develops, active value investing should do at least as well as
buy-and-hold strategies or passive indexing. In the case of a bear
market, your portfolio should decline a lot less.
Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email, click here.
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I'm looking at a co-plot of $dxy (us $ index) vs SPY (s&p500) over the last decade. $ is down 30%, SPY is down around 3%. Even at 2007 peak, the $ was down 30% and spy was up 20%, so you equities still weren't a debasement hedge. That's the role gold plays as we all know. Article was very naive not to correct SPY for inflation. Well, I guess investors should be glad we've just got back to the levels of 1998 in constant $. That's sideways alright!
a) I wonder how that would look adjusted for inflation (including the real inflation of food and energy, not the Fed's fake inflation)
b) I wonder how that would look without the adjustments to the Dow that they create when they take weak companies out and put stronger companies into the Dow. (they change the rules after the fact)... yeah they make it tough by creating ever more useless and unproductive mergers and acquisitions.
c) I wonder how the investment money intake of the big banks compares to the average investor in the market.
It seems to me that the stock market is a rigged crooked casino designed to fleece people and hide it under the cover of inflation created by the Federal Reserve Bank.
My best trades are when I am feeling the most irreverent
and synical. Never marry a stock. They are to be traded!
Best regards.
"sideways"? are you ed jones talking to my grandmother? What a jack-ass post. Can I get a new savings account book. Mine has been stamped every week for 12 years and I need a new one.
Well, sideways and down; would have been a bit more accurate; but then, it's up to you. Silver bullion will continue to offer relief from the paper scama-rama-ding-dong.
I think you will see more of the situation "V" found itself in this past week. Thursday, the "Fed" proposed a deep cut in fees. Late Friday afternoon "Barney" thought that was a little extreme. Expect Visa to pop Monday.
Look at Thursday's Visa's price. Note how it popped a little before it was driven down big. Friday was just a lot of churning as the weak hands were shook out. A reasonable amount of time after the markets closed on Friday, our man Friday comes out and says he doesn't agree with the Fed's recommendation. It's too bad he couldn't have come out and said that Thursday. Maybe the pension funds and mutual funds wouldn't have dumped their shares into waiting hands.
Oh well, what's a multi-billion dollar hit to a company's equity when that deficit will be erased over the next few months. It's too bad new hands are riding the shares higher.
Oh well, that's business...
Just think how much money you could have made if you knew ahead of time that the Fed was going to recommend a big cut in fees; knowing that Barney was going to come to the rescue after the markets closed Friday.
Monday should be interesting.
Tell everyone anything you want,make a % everytime they buy and a % everytime they sell.As long as they trade who gives a f**k.Ah the respectability of our established banks,the bedrock of our civilization,respite of the untried criminal.
"We are in a Cowardly Lion market"
The Masters of Financial Innovation have destroyed the markets. The Cowardly Lions watched, yawned and farted.
Some good advice there. Thanks.
I like the part about avoiding the use of recent bull market valuations for current conditions.
So true, and I see it done everyday by the "smart people" on TV.
Only 3 years of bear markets in the last 110 years! I would like some of what this guy is smoking.
Ahh. 2000 - 2010 sideways?!? Up 60% down 40% up 100% down 60% and now up 70%. If that's sideways well whatever. Maybe if it wasn't a log chart even you could see it
now is the time to buy into oil and mining stocks. food processing is a good choice also.
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