Best of the Week
Most Popular
1. The Trump Stock Market Trap May Be Triggered - Barry_M_Ferguson
2.Why are Central Banks Buying Gold and Dumping Dollars? - Richard_Mills
3.US China War - Thucydides Trap and gold - Richard_Mills
4.Gold Price Trend Forcast to End September 2019 - Nadeem_Walayat
5.Money Saving Kids Gardening Growing Giant Sunflowers Summer Fun - Anika_Walayat
6.US Dollar Breakdown Begins, Gold Price to Bolt Higher - Jim_Willie_CB
7.INTEL (INTC) Stock Investing to Profit From AI Machine Learning Boom - Nadeem_Walayat
8.Will Google AI Kill Us? Man vs Machine Intelligence - N_Walayat
9.US Prepares for Currency War with China - Richard_Mills
10.Gold Price Epochal Breakout Will Not Be Negated by a Correction - Clive Maund
Last 7 days
Is This Time Different? Predictive Power of the Yield Curve and Gold - 19th Aug 19
New Dawn for the iGaming Industry in the United States - 19th Aug 19
Gold Set to Correct but Internals Remain Bullish - 19th Aug 19
Stock Market Correction Continues - 19th Aug 19
The Number One Gold Stock Of 2019 - 19th Aug 19
The State of the Financial Union - 18th Aug 19
The Nuts and Bolts: Yield Inversion Says Recession is Coming But it May take 24 months - 18th Aug 19
Markets August 19 Turn Date is Tomorrow – Are You Ready? - 18th Aug 19
JOHNSON AND JOHNSON - JNJ for Life Extension Pharma Stocks Investing - 17th Aug 19
Negative Bond Market Yields Tell A Story Of Shifting Economic Stock Market Leadership - 17th Aug 19
Is Stock Market About to Crash? Three Charts That Suggest It’s Possible - 17th Aug 19
It’s Time For Colombia To Dump The Peso - 17th Aug 19
Gold & Silver Stand Strong amid Stock Volatility & Falling Rates - 16th Aug 19
Gold Mining Stocks Q2’19 Fundamentals - 16th Aug 19
Silver, Transports, and Dow Jones Index At Targets – What Direct Next? - 16th Aug 19
When the US Bond Market Bubble Blows Up! - 16th Aug 19
Dark days are closing in on Apple - 16th Aug 19
Precious Metals Gone Wild! Reaching Initial Targets – Now What’s Next - 16th Aug 19
US Government Is Beholden To The Fed; And Vice-Versa - 15th Aug 19
GBP vs USD Forex Pair Swings Into Focus Amid Brexit Chaos - 15th Aug 19
US Negative Interest Rates Go Mainstream - With Some Glaring Omissions - 15th Aug 19
GOLD BULL RUN TREND ANALYSIS - 15th Aug 19
US Stock Market Could Fall 12% to 25% - 15th Aug 19
A Level Exam Results School Live Reaction Shock 2019! - 15th Aug 19
It's Time to Get Serious about Silver - 15th Aug 19
The EagleFX Beginners Guide – Financial Markets - 15th Aug 19
Central Banks Move To Keep The Global Markets Party Rolling – Part III - 14th Aug 19
You Have to Buy Bonds Even When Interest Rates Are Low - 14th Aug 19
Gold Near Term Risk is Increasing - 14th Aug 19
Installment Loans vs Personal Bank Loans - 14th Aug 19
ROCHE - RHHBY Life Extension Pharma Stocks Investing - 14th Aug 19
Gold Bulls Must Love the Hong Kong Protests - 14th Aug 19
Gold, Markets and Invasive Species - 14th Aug 19
Cannabis Stocks With Millennial Appeal - 14th Aug 19
August 19 (Crazy Ivan) Stock Market Event Only A Few Days Away - 13th Aug 19
This is the real move in gold and silver… it’s going to be multiyear - 13th Aug 19
Global Central Banks Kick Can Down The Road Again - 13th Aug 19
US Dollar Finally the Achillles Heel - 13th Aug 19
Financial Success Formula Failure - 13th Aug 19
How to Test Your Car Alternator with a Multimeter - 13th Aug 19
London Under Attack! Victoria Embankment Gardens Statues and Monuments - 13th Aug 19
More Stock Market Weakness Ahead - 12th Aug 19
Global Central Banks Move To Keep The Party Rolling Onward - 12th Aug 19
All Eyes On Copper - 12th Aug 19
History of Yield Curve Inversions and Gold - 12th Aug 19
Precious Metals Soar on Falling Yields, Currency Turmoil - 12th Aug 19
Why GraphQL? The Benefits Explained - 12th Aug 19
Is the Stock Market Making a V-shaped Recovery? - 11th Aug 19
Precious Metals and Stocks VIX Are About To Pull A “Crazy Ivan” - 11th Aug 19
Social Media Civil War - 11th Aug 19
Gold and the Bond Yield Continuum - 11th Aug 19
Traders: Which Markets Should You Trade? - 11th Aug 19

Market Oracle FREE Newsletter

The No 1 Gold Stock for 2019

Welcome to Another Lost Decade For Stock Market Investors

Stock-Markets / Stock Markets 2010 Jan 11, 2010 - 11:52 AM GMT

By: Vitaliy_Katsenelson

Stock-Markets

Best Financial Markets Analysis ArticleThe 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. 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. (For charts / presentation / speech on this subject visit this page).

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.

© 2010 Copyright Vitaliy Katsenelson - All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules