A Sideways View of the World
back from Europe.
VALUEx was a terrific event, 50 or
so value investors from around the
world got together and shared ideas in a TED/Wikipedia-like environment.
I had a chance to see some old friends, made
some new ones, and learned a lot. Here
pictures from the event (I am
still learning how to use my new P7000
Nikon, so the pictures
are so-so). My brother Alex and I
travelled from Klosters (on the other side of the mountain from Davos)
Frankfurt, where I gave a seminar to 40 value investors. We
had so much fun, and the questions were so
good that the half-day seminar turned into almost a full-day one.
On the way to Frankfurt we stopped by Munich,
which is a beautiful city. We were in
the Marienplatz (the center of Munich) and walked into a church, which
looks like almost any other church in Europe. However, we
were lucky and walked in during a recital.
I was blown away by the quality of the acoustics – just one
voice sounded like
a choir. (I
captured it on video).
Here are some pictures
from Munich, a few of them from
the BMW museum.
value investor you look for cheap stocks (the ones with a
margin of safety), and I have found that this attitude spills into
life – I don’t like to pay for things above their
fair value. As an American, over the last ten years I got
used to being ripped off when I traveled to Europe (especially London),
things often cost twice as much there as in the US (especially if you
Denver). However, due to Swiss franc
appreciation, Zurich (and Switzerland in general) is insanely
expensive. The Starbucks coffee that I pay $1.50 for in
Denver, and maybe $2 in NYC, is $7 in Zurich.
Switzerland is one of the least
indebted nations in the Europe, with
debt-to-GDP of 40% (Luxembourg has even less
debt, at 16%), and the currency reflects that, dearly. But it
is not just the Swiss Franc;
Switzerland is expensive, period. I’ve
heard stories that many Swiss will drive an hour to stores in Germany
grocery shopping, and save half or more.
be speaking at Johns Hopkins Applied Physics Lab in
Arlington, VA on March 28, on China/Japan.
The event is open to the general public – you
can sign up here. I’ll
be going there
with my 9-year-old son, Jonah. We’ll
spend the weekend in DC, embracing history, visiting museums (after
movie Night at
the Museum: Battle of the Smithsonian,
he really wants to visit!).
Mauldin, who wrote a wonderful foreword to my Little
Book of Sideways Markets,
published an excerpt from the Little Book in
his latest newsletter, so here it is:
A Sideways View of the World
Today’s OTB features
an excerpt from my
friend Vitaliy Katsenelson’s recently published The
Little Book of Sideways Markets.
CIO at Investment Management Associates, a value investment firm in
he is a prolific and engaging writer (you can find and subscribe to his
I had the pleasure of writing the foreword to Vitaliy’s book,
here is a brief excerpt:
“Markets go from long
appreciation to long periods of stagnation. These cycles last on
years. If you bought an index in the United States in 1966, it was 1982
you saw a new high – that was the last secular sideways
market in the
United States (until the current one). Investing in that market was
to say the least. But buying in the beginning of the next secular bull
in 1982 and holding until 1999 saw an almost 13 times return. Investing
simple, and the rising markets made geniuses out of many investors and
2000, markets in much of the developed world have basically been down
Once again, we are in a difficult period. Genius is in short supply.
am often asked. Why don’t markets just continue to go up, as
so many pundits
say that “over the long term” they do? I agree that
over the very long term
markets do go up. And therein is the problem: Most people are not in
for that long – 40 to 90 years. Maybe it’s the
human desire to live
forever that has many focused on that super-long-term market
looks so good.
meantime, we are in a market environment where investors have to be
actively engaged in their investments than before during a bull market
rising tide lifted all ships. The Little Book of Sideways Markets is a
preserver that will help you navigate these perilous waters. Wear it
In the excerpt
that follows, Vitaliy explains the whys and wherefores of bull, bear,
Outside the Box
A Sideways View of the World
What Happens in a Sideways
MOST PEOPLE (MYSELF INCLUDED)
discussions about stock markets a bit esoteric; for us, it is a lot
relate to individual stocks. Since a stock market is just a collection
individual stocks, let’s take a look at a very typical
sideways stock first:
Wal-Mart. It will give us insight into what takes place in a sideways
(see Exhibit 2.1).
Exhibit 2.1 Wal-Mart, Typical
Sideways Market Stock
Though its shareholders
experienced plenty of
volatility over the past 10 years, the stock has gone nowhere
– it fell
prey to a cowardly lion. Over the last decade Wal-Mart’s
tripled from $1.25 per share to $3.42, growing at an impressive rate of
percent a year. This doesn’t look like a stagnant, failing
company; in fact,
it’s quite an impressive performance for a company whose
sales are approaching
half a trillion dollars. However, its stock chart led you to believe
The culprit responsible for this unexciting performance was valuation
the P/E – which declined from 45 to 13.7, or about 12.4
percent a year.
The stock has not gone anywhere, as all the benefits from earnings
canceled out by a declining P/E. Even though revenues more than doubled
almost tripled, all of the return for shareholders of this terrific
came from dividends, which did not amount to much.
This is exactly what we see in
the broader stock market, which is
comprised of a large number of companies whose stock prices have gone
go nowhere in a sideways market.
Let’s zero in on the
last sideways market the United States saw, from
1966 to 1982. Earnings grew about 6.6 percent a year, while P/Es
percent; thus stock prices went up roughly 2.2 percent a year. As you
in Exhibit 2.2, a secular sideways market is full of little (cyclical)
bear markets. The 1966–1982 market had five cyclical bull and
cyclical bear markets.
This is what happens in
sideways markets: Two forces work against each
other. The benefits of earnings growth are wiped out by P/E compression
staple of sideways markets); stocks don’t go anywhere for a
long time, with
plenty of (cyclical) volatility, while you patiently collect your
which are meager in today’s environment.
A quick glimpse at the current
market shows a similar picture: P/Es declined from 30 to 19, a rate of
percent a year, while earnings grew 2.4 percent. This explains why we
pretty much where we were in 2000.
Bulls, Bears, and Cowardly
Lions – Oh My
Exhibit 2.3 describes economic
conditions and starting P/Es required for each market cycle.
earnings growth, though it fluctuated in the short term, was very
the growth of the economy (GDP), averaging about 5 percent a year. If
the market’s P/E did not change and always remained at its
average of 15,
then we would not have bull or sideways market cycles –
we’ d have no
secular market cycles, period! Stock prices would go up with earnings
growth, which would fluctuate due to normal economic cyclicality but
average about 5 percent, and investors would collect an additional
approximately 4 percent in dividends. That is what would happen in a
world where people are completely rational and unemotional. But as Yoda
have put it, the utopian world is not, and people rational are not.
Exhibit 2.3 Economic Growth +
Starting P/E =
The P/E journey from one
extreme to the other is completely
responsible for sideways and bull markets: P/E ascent from low to high
bull markets, and P/E descent from high to low is responsible for the
ride of sideways markets.
Bear markets happened when you
had two conditions in place, a high
starting P/E and prolonged economic distress; together they are a
combination. High P/Es reflect high investor expectations for the
Economic blues such as runaway inflation, severe deflation, declining
stagnating earnings, or a combination of these things sour these high
Instead of an above-average economy, investors wake up to an economy
below average. Presto, a bear market has started.
Let’s examine the
only secular bear market in the twentieth century in
the United States: the period of the Great Depression. P/Es declined
from 19 to
9, at a rate of about 12.5 percent a year, and earnings growth was not
soften the blow, since earnings declined 28.1 percent a year. Thus
declined by 37.5 percent a year!
Ironically – and this
really tells you how subjective is this
whole “science” that we call investing –
the stock market decline from
1929 to 1932 doesn’t fit into a “secular”
definition, since it lasted less than
five years. Traditional, by-the-book, secular markets should last
five years. I still put the Great Depression into the secular category,
changed investor psyches for generations. Also, it was a very
event: stocks declined almost 90 percent, and 80 years later we are
talking about it.
However, a true, by-the-book,
long-term bear market took place in
Japan (take a look at the next chart). Starting in the late 1980s, over
period, Japanese stocks declined 8.2 percent a year. This decline was
a complete collapse of both earnings – which declined 5.3
percent a year –
and P/Es, which declined 3 percent a year. Japanese stocks were in a
market because stocks were expensive, and earnings declined over a long
of time. In bear markets both P/Es and earnings decline.
In sideways markets P/E ratios
decline. They say that payback is a
bitch, and that is what sideways markets are all about: investors pay
declining P/Es for the excess returns of the preceding bull market.
Let’s move to a
slightly cheerier subject: the bull market. We see a
great example of a secular bull market in the 1982–2000
grew about 6.5 percent a year and P/Es rose from very low levels of
to the unprecedented level of 30, adding another 7.7 percent to
growth. Add up the positive numbers and you get super-juicy compounded
returns of 14.7 percent a year. Sprinkle dividends on top and you have
incredible returns of 18.2 percent over almost two decades. No surprise
the stock market became everyone’s favorite pastime in the
The Price of Humanity
Is 100 years of data enough to
arrive at any kind of meaningful
conclusion about the nature of markets? Academics would argue that
thousands of years’ worth of stock market data to come to a
significant conclusion. They would be right, but we don’t
have that luxury. I
am not making an argument that sideways markets follow bull markets
statistical significance; I simply don’t have enough data for
Most of the time common stocks
are subject to irrational and
excessive price fluctuations in both directions as the consequence of
ingrained tendency of most people to speculate or gamble . . . to give
hope, fear and greed.
As the saying goes, the more
things change the more they remain the
same. Whether a trade is submitted by telegram, as was done at the turn
twentieth century, or through the screen of an online broker, as is the
today, it still has a human originating it. And all humans come with
emotional equipment that is, to some degree, predictable. Over the
become more educated, with access to fancier, faster, and better
tools. A myriad of information is accessible at our fingertips, with
abundance that just a decade ago was available to only a privileged few.
Despite all that, we are no
less human than we were 10, 50, or 100
years ago. We behave like humans, no matter how sophisticated we
we completely delegate all our investment decision making to computers,
will still be impacted by human emotions.
The following example
highlights the psychology of bull and cowardly
a bull market stock prices go up because earnings grow and P/Es rise.
So in the
absence of P/E change, stocks would go up by, let’s say, 5
percent a year due
to earnings growth. But remember, in the beginning stages of a bull
are depressed, thus the first phase of P/E increase is normalization, a
towards the mean; and as P/Es rise they juice up stock returns by,
we’ll say, 7
percent a year. So stocks prices go up 12 percent (5 percent due to
growth and 7 percent due to P/E increase), and that is without counting
from dividends. After a while investors become accustomed to their
rising 12 percent a year. At some point, though, the P/E crosses the
and the second phase kicks in: the P/E heads towards the stars. A new
is born: 12-percent price appreciation is the “new
average,” and the phrase “this
time is different” is heard across the land.
or 100 years ago, “new average” returns were
justified by the advancements of
railroads, electricity, telephones, or efficient manufacturing.
mistakenly attributed high stock market returns that came from
to the economy, which despite all the advancements did not turn into a
In the late 1990s, during the
later stages of the 1982–2000 bull market, similar
made, except the names of the game changers were now just-in-time
telecommunications, and the Internet. However, it is rarely different,
different when P/E increase is the single source of the supersized
P/Es rose and went through the average (of 15) and far beyond.
Everybody had to
own stocks. Expectations were that the “new
average” would persist – 12
percent a year became your birthright rate of return.
P/Es can shoot for the stars,
never reach them. In the late stage of a secular bull market P/Es stop
Investors receive “only” a return of 5 percent from
earnings growth – and
they are disappointed. The love affair with stocks is not over, but
diversifying into other asset classes that recently provided better
(real estate, bonds, commodities, gold, etc.).
Suddenly, stocks are not rising
percent a year, not even 5 percent, but closer to zero – P/E
wiping out any benefits from earnings growth of 5 percent and the
(or two) of a sideways market has begun.
This Time Is Not Different
done a few dozen presentations on the sideways markets since 2007.
that people are either very happy or extremely unhappy
with this sideways market argument. The different emotional responses
nothing to do with how I dressed, but they correlated with the
cycle we were in at the time of the presentation.
In 2007, when everyone thought
were in a new leg of the 1982 bull market, I was glad that eggs were
while I presented my sideways thesis, for surely they would have been
me. In late 2008 and early 2009, my sideways market message was a ray
in comparison to the Great Depression II mood of the audience.
Every cyclical bull market
is perceived as the beginning of the next secular bull market, while
cyclical bear market is met with fear that the next Great Depression is
us. Over time stocks become incredibly cheap again and their dividend
finally become attractive. The sideways market ends, and a bull market
Where You Stand Will Determine
How Long You Stand
stock market seems to suffer from some sort of multiple personality
One personality is in a chronic state of extreme happiness, and the
suffers from severe depression. Rarely do the two come to the surface
Usually one dominates the other for long periods of time. Over time,
personalities cancel each other out, so on average the stock market is
fellow. But rarely does the stock market behave in an average manner.
the most important concepts in investing is mean reversion, and
it is often misunderstood. The mean is the average of a series of low
numbers – fairly simple stuff. The confusion arises in the
reversion to the mean concept. Investors often assume that when mean
takes place the figures in question settle at the mean, but it just
Although P/Es may settle at
the mean, that is not what the concept of mean reversion implies;
suggests tendency (direction) of a
movement towards the mean. Add human emotion into the mix and P/Es turn
pendulum – swinging from one extreme to the other (just as
do) while spending very little time in the center. Thus, it is rational
expect that a period of above-average P/Es should be followed by a
below-average P/Es and vice versa.
Since 1900, the S&P 500
traded on average at about 15 times earnings.
But it spent only a quarter of the time between P/Es of 13 and 17
“mean zone,” two points above and below average. In
the majority of cases the
market reached its fair valuation only in passing from one irrational
to the other.
Mean reversion is the Rodney
Dangerfield of investing: it gets no
respect. Mean reversion is as important to investing as the law of
to physics. As long as humans come equipped with the standard emotional
equipment package, market cycles will persist and the pendulum will
swing from one extreme to the other.
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.