|Switzerland and American Airlines|
Are we in a bull, a bear, or
a cowardly lion market? As we will see, the answer can make a huge
difference in your investment portfolio. This week I am at my
Strategic Investment conference in La Jolla. About four times a
year I take a break from writing the letter and bring in a guest
writer. This week Thoughts from the Frontline will have the very
distinguished analyst and author Vitaliy Katsenelson.
In his recent book, Active Value Investing: Making Money in
Range-Bound Markets (Wiley, 2007), he exhorted investors to fasten
their seat belts and lower expectations for the next decade or so. He
also provided a strategy for improving returns in this environment,
what he calls range-bound or cowardly lion markets. Long-time readers
will recognize some themes consistent with my own research, but Vitaliy
adds some very interesting twists that I believe will make you think.
In today's letter, Vitaliy runs through his analysis of what will
happen and provides an overview of how investors can make money in what
will otherwise be an ocean of stagnant returns. Warning: the letter
will print long, but that is because there are a lot of great
Let me also highly recommend Vitaliy's book, Active Value
Investing. I think as you read today's letter, you will get a sense
of why I am so enthusiastic about his work. You can get you copy at
Bull, Bear, and Cowardly Lion Markets
By Vitaliy Katsenelson
For the next dozen years or so the US broad stock markets will be a
wild roller-coaster ride. The Dow Jones Industrial Average and the
S&P 500 index will go up and down (and in the process will set
all-time highs and multiyear lows), stagnate, and trade in a tight
range. At some point during the ride, index investors and buy and hold
stock collectors will realize that their portfolios aren't showing much
of a return.
I know this prediction has a mild sci-fi feel to it. After all, how
could I possibly know what the market will do, especially that far into
the future? Though I'll explain in more detail in just a second why I
have the audacity to make this prediction, let me offer you a little
factoid: over the last 200 years, every full-blown, long-lasting
(secular) 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.
Yes, this happened every time, with the exception of the Great
Depression, over the last two centuries.
Though we tend to think about market cycles in binary terms - bull
(rising) or bear (declining) - in the long run markets spend a lot more
time in bull or range-bound (sideways) states, roughly half in each,
and visit a bear cage a lot less often then we think. This distinction
between bear and range-bound markets is extremely important, as you'd
invest very differently in one versus the other.
Are bull markets driven by superfast economic growth? Are
range-bound markets caused by subpar economic growth? Could the subpar
market performance be related to high or low inflation?
The answer to all these questions is undoubtedly - "no." Though it
is hard to observe in the everyday noise of the stock market, in the
long run stock prices are driven by two factors: earnings growth (or
decline) and/or price-to-earnings expansion (or contraction).
As is apparent from Exhibits 1 & 2, either by a decade at a time
or a market cycle at a time, it is difficult to find a link between
stock performance and the economy (e.g., GDP, corporate earnings
growth, or inflation). The connection does exist, but periods of
disconnect appear to last for decades at a time.
What about interest rates? Exhibit 3 shows P/Es for the
S&P 500 (based on one-year trailing earnings) and inverse long-term
bond yields - the implied P/E - the famous Fed Model. This model,
despite its name, is NOT endorsed by the Fed; it indicates the
existence of a tight relationship between (inverse of) long-term
Treasury bonds and P/Es of the S&P 500.
By taking a look at the last full 1966-2000 range-bound/bull market
cycle (see Exhibit 3), we can see that the Fed Model perfectly
predicted the direction of equities in relation to interest rates
(okay, assuming you could predict interest rates). Long-term interest
rates were rising from 1966 to 1982, while implied and actual P/Es were
falling. Whereas from 1982 to 2000 interest rates were dropping, and
implied and actual P/Es were rising. Intellectually that makes sense,
because stocks and bonds compete for investors' capital, and thus
higher interest rates make equities less attractive and vice versa.
However, it is hard to find ANY relationship between interest rates
and the animal with its name on the secular market if you look at the
first 66 years of the 20th century. None!
It is difficult to dismiss the role interest rates play in stock
valuations, but they seem to be a second fiddle in the orchestra
conducted by economic growth and valuation. If the Fed Model worked
flawlessly, how could we explain declining P/Es of Japanese stocks in
the last decade of the 20th century, when interest rates
declined and were scratching zero levels?
It is valuation! If earnings growth in the long run remains
consistent with the past, P/E is the wild card that is responsible
for future returns. Though continued economic growth appears to be
a wildly optimistic assumption given the meltdown of the housing
industry in particular, and job layoffs, it is not particularly
unrealistic to predict that we will see economic growth overall. With
the exception of the Great Depression (see Exhibits 1 & 2), though
it had its ups and downs, economic growth was fairly stable throughout
the 20th century. Earnings, though more volatile than real
GDP, grew consistently decade after decade, paying no attention to the
animal (bull, bear ... or cowardly lion - my pet name for range-bound
markets, whose bursts of occasional bravery lead to stock appreciation,
but which are ultimately overrun by fear that leads to a subsequent
descent) lending its name to the stock market.
Though economic fluctuations were responsible for short-term
(cyclical) market volatility, as long as economic performance was not
far from the average, long-term market cycles were either bull or
range-bound. Valuation - the change in price to earnings, its expansion
or contraction - was the wild card that was mainly responsible for
markets being in a bull or range-bound state.
Market Cycle Math
So let's examine the stock market math for secular bull,
range-bound, and bear markets. The following Exhibit 4 shows sources of
price appreciation in past bull, range-bound, and bear markets.
During bull markets, a vibrant, peaceful combination of P/E
expansion (a staple of bull markets, a great source of return) and
earnings growth brings outsize returns to jubilant investors.
Prolonged bull markets start with below- and end with above-average
P/Es are some of the most mean-reverting creatures, and range-bound
markets act as clean-up guys: they rid us of the mess (i.e., deflate
high P/Es) caused by bull markets, taking them down towards and
actually below the mean. P/E compression wipes out most if not all
earnings growth, resulting in zero (or nearly) price appreciation plus
Bear markets are range-bound markets' cousins; they share half of
their DNA: high starting valuations. However, where in cowardly lion
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 (runaway inflation, severe deflation, subpar or
negative economic or earnings growth) add oil to the fire (started by
high valuations) and bring devastating returns to investors.
A true secular bear market has not really taken place in the US, but
one has occurred across the pond in Japan. The market decline caused by
the Great Depression, though referred to as the greatest decline in US
stocks in the 20th century, only lasted three years and thus
doesn't really fit the traditional "secular" requirement of lasting
more than five years. Japan's Nikkei 225 suffered (see Exhibit 5)
through a true secular bear market: stock prices declined over 80
percent from their 1989-1991 highs until they bottomed in 2003 (the
market seems to be coming back now). For more than a decade the country
struggled with deflation caused by its banking system coming to a near
halt on the heels of a collapsing real estate market and the bad loans
that came with it. Of course, all this took place on the heels of a
huge bull market, and thus very high valuations.
A unique aspect that contributed to the severity and longevity of
the Japanese deflation was a cultural issue: the Japanese government
intervened and did not allow structurally defunct companies to go
bankrupt, thus tampering with the nucleus of capitalism (and Darwinism
as well), creative destruction. I must admit, it seems that lately
we've been importing a lot more from Japan than their cars and
flat-screen TVs, as the US government steps in to "fix" our troubled
financial firms. (In the following articles I argue against government
bailing out homeowners and against
the Fed bailing out the economy).
Where Are We Today?
Today stocks may appear cheap at first glance, at least if you look
at valuations of the late 1990s. They are not! To minimize the impact
of cyclical profit volatility, let's first take a look at stock market
historical and current valuations, based on 10-year trailing earnings,
as shown in Exhibit 6. This way we capture a full economic cycle.
The conclusions we can draw are:
- Secular bull markets end at P/Es much above average. The
1982-2000 bull market ended at the highest valuations ever!
- Secular range-bound markets ended when P/Es were below
- Markets spent very little time at what is known to be a "fairly
valued" state of 15 times 12-month trailing earnings. Historically,
stocks only saw average valuations on the way from one extreme to the
other. From 1900 to 2006 the S&P 500 spent less than 27% of the
time between P/Es of 13 and 17.
- Today, after eight years of plentiful volatility and no returns,
what the WSJ called a "lost decade," stocks are not cheap. If you
look at ten-year trailing earnings, they are still at levels where
previous range-bound markets started. In other words, based on
10-year trailing earnings, stocks are still at 64% above their
average stated valuations.
Now, if you look at historical valuations where P/Es are computed
based on one-year trailing earnings (see Exhibit 7), the picture is not
that exciting but less grim. At about 18 times trailing earnings, US
stocks don't appear that expensive.
Unfortunately, the cheapness argument falls on its face once you
realize that (pretax) profit margins are hovering at an all-time high
of 11.5%, about 35% above their historical (since 1980) average of
8.5%. Similarly to P/Es, profit margins are extremely mean-reverting.
As companies start to earn above-average economic profits, new
competition waltzes in and competes these excess profits away -
arrivederci fat profit margins. Once this happens, the "E" in
the "P/E" equation will decline as well, and P/Es will rise from 18 to
22. An additional point: as you see in Exhibit 8, margins don't have to
revert and stop at the mean; historically they've gone below the mean -
that is how the mean is created. (In the February 4th, 2008 issue of Barron's I rebuffed common
arguments against profit-margin mean reversion.)
As a side note: The bulk of excesses in overall profit margins,
54.5% to be exact (see Exhibit 9), were in "stuff" stocks (i.e.,
energy, materials, and industrials). Profit margins will deflate when
the global economy slows down. This goes far beyond oil and
commodities. Companies that make "stuff," which historically have been
very cyclical (today is no different) have benefitted from tremendous
operational leverage that contributed to considerable improvement in
margins. However, leverage works both ways: lower sales and high fixed
costs will push margins to the other extreme.
Financials were responsible for 22% of the excess in margins, as
they benefitted from tremendous liquidity hosed down by the Fed over
recent years; now they are drowning in it. Their margins are
compressing at a faster rate than you can read this.
Finally, the "new" economy stocks are responsible for 17% of the
excess. However, I'd argue that these industries have transformed
substantially since 1988, so that higher-margin software and services
now account for a much larger portion of technology and telecom sales.
It is kind of like Microsoft (ironically the "new" economy) vs. IBM in
1988: the hardware company (the old economy) vs. the new. Of course IBM
of today is lot more of a software and service company than the
hardware company it was in the 1980s. Thus the "new" economy stocks
should have higher margins than they did in 1988, but by how much? I
don't know, but they likely will face a lower margin compression than
"stuff" and financials.
The bottom line: Remember those long-term double-digit
returns you were promised by stock market gurus during the last bull
market? Well, an average passive buy-and-hold investor will be lucky to
have very low single-digit returns for the long term. In fact, during
the last 1966-1982 range-bound market, investors received almost zero
real total returns.
Analyze and Strategize
Fairly depressing stuff, and it sounds like the investor is going to
have to eat lower returns. However, there are strategies to improve
portfolio performance so that one can do well, even in a trading range.
Whether you are a buy-and-hold or stalwart value investor, there are
opportunities that don't require you to day trade stocks. You don't
have to change your investment philosophy, but you have to tweak your
stock analysis and strategy a little to adapt it to range-bound
Modify your analysis: To clarify, I created an analytical
framework where stock analysis is broken down into three dimensions:
Quality, Valuation, and Growth.
Quality. Though often it is in the eye of the beholder, in my book I
clarify what constitutes a quality company (i.e., sustainable
competitive advantage, strong balance sheet, great management, high
return on capital, and a lot more). But the lesson here is, you want to
compromise as little as possible on this dimension, because it is very
difficult to recover from significant losses in the range-bound market.
Stick to quality.
Growth. This dimension consists of earnings (cash flows), growth,
and dividends. When you own companies that grow earnings, time is on
your side. Dividends are extremely important in range-bound markets, in
fact 90% of the returns in past range-bound markets came from
dividends, vs. less than 20% in past bull markets. Also, today an
average stock (i.e., S&P 500 index) yields only 1.7%. Do you really
want 1.7% to be 90% of your total return?
Valuation. This dimension requires the most modification: the
valuations that we saw in the 1982-2000 bull market are not coming back
anytime soon, but don't step into what I call the relative valuation
trap. Don't buy stocks based solely on their relative cheapness to
their prices in the past, but rather based on what their future cash
flows will bring. To combat a constant P/E compression, in the
range-bound market increase your required margin of safety.
That value (i.e., low P/E stocks) beats growth (high-valuation
stocks that have high expectations built in) has been historically
documented by numerous studies. After doing extensive study of the
1966-1982 range-bound market, I found that value kills growth. Cheaper
stocks had a lower P/E compression and generated bull-market-like
returns, plus they had a natural advantage: their lower P/Es led to
higher dividend yields. Stock selection matters in the range-bound
market. Blindly throwing money at market indices - a strategy that did
wonders in the past bull market - will bring market-like returns, which
likely will not pay for your dream house or fund your retirement.
Strategize: Once you have determined, based on the Quality,
Valuation, and Growth framework, what stocks are to be bought and at
what prices, you can start applying a range-bound market strategy.
A long-lasting secular range-bound market consists of many mini
(months to several years long) cycles. For instance, the last 1966-1982
range-bound market consisted of five mini bull, five bear, and one
range-bound market (See Exhibit 10).
Successful investing is a lonely place, as it requires an
independent thought process that often goes contrary to the herd
mentality. In the range-bound market, a contrarian mindset comes in
especially handy, as you'll be selling when everyone else is buying.
Your stocks will be hitting their fair value, and you'll be buying when
everyone else is selling - during the mini bear markets.
This is not to suggest that you need to be a market timer, not at
all. Market timing only looks easy with the benefit of hindsight, and
it is very difficult to do on a consistent basis. Instead, time
(price) individual stocks, one at a time. Buy when they are undervalued
and sell when they are fairly valued, and repeat the process over and
over again. In other words, instead of focusing on the bowling alley
(the market) focus on the ball (individual stocks).
Selling is looked upon as a four-letter word, and therefore a sin,
in a bull market. A buy-and-hold strategy (which is often just buy and
forget to sell) is rewarded richly in secular bull markets - every time
you made a "don't sell" decision, stocks go higher. And though buy and
hold is not dead but in a coma (waiting for the next bull market), it
takes investors to a place of no returns. Forgive yourself the "sin" of
selling and become a buy-and-sell investor.
The almighty US constitutes 4% of the world population, but its
stock market capitalization represents more than a third of the world's
wealth. It has been comfortable for us to buy US stocks; it felt safe.
However, by solely focusing on US stocks we are insulating ourselves
from a greater pool of stocks to choose from. You don't need to become
an Indiana Jones of international investing by venturing into
fourth-world countries like South Paragama or Liberania (ok, I made
those up, didn't want to offend folks in Turkmenistan
or some other places heading towards the stone age), but there are
plenty of countries that have a stable political regime and the rule of
I could be wrong but I doubt it
What if I am wrong and the range-bound market I describe is not in
the cards? After all, history is prolific about the past but mute about
the future. What if they find life on Venus and our economy starts
growing at double digits and the secular bull market thunders upon us?
Or the current credit market problems spill into a Japanese-like
prolonged recession, causing a bear market? Every strategy should be
evaluated not just on a "benefit of being right" basis, but at least as
importantly on a "cost of being wrong" basis. An active value-investing
strategy has the lowest cost of being wrong in comparison to other
investment strategies, as you'll see in Exhibit 11.
I was one of 300,000 people who had their American Airline flights
cancelled this week. I got to San Diego from Dallas on Southwest with a
mere three stops, and am grateful I could get here, although I did miss
dinner with Richard Russell. Hopefully, things will be back to normal
soon. I must admit to not understanding why the FAA could not have
chosen a more deliberate approach to pulling planes out of the system.
It does not appear to be a real near-term safety issue. A lot of people
were seriously inconvenienced, and I can't even begin to imagine how
much it cost business and consumers, not just in money but in time.
As noted above, I am at my fifth annual Strategic Investment
Conference in La Jolla. It is sold out at about 280 attendees. Somehow,
only two people had to cancel due to American Airline problems. It is
good to see old friends and new ones, and the conversations have been
very stimulating. I am hopeful that we can get some of the
presentations up on the web soon.
I am off to London and then Switzerland this Monday on American. I
am looking forward to being a tourist for a few days in the Interlaken
area of Switzerland, after my speech for Bank Sarasin, and then back
Have a great week!
Your always a believer in value analyst,
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