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Cyclical or Secular Web

Cyclical or Secular Web

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Published by CanadianValue
Cyclical or Secular Web
Cyclical or Secular Web

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Published by: CanadianValue on Jul 24, 2013
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09/18/2013

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Cyclical or Secular? That is the Question
In my judgment, the burning question for any client-centered investment manager is whether the bull marketin financial assets that began in the spring of 2009 is cyclical or secular.If it is secular (meaning of very long-term duration), the markets in equity securities should continue theirupward slope for years, with periodic shorter-term cyclical bear markets to wring out excesses that inevitably develop during extended periods of rising prices. One should largely be fully invested either throughindexing or active management in a secular equity bull market, taking occasional setbacks without alarm likeriding the ups and downs of waves within the ever rising tide. By their actions, the vast majority of professional investors appear to believe this aptly characterizes the current investment environment. The graph shown here, prepared by  well-regarded Hong Kong-based globalresearch firm GaveKal,
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expounds themajority case in some fashion. Co-founder Anatole Karletsky argues that when the markets “break out,” ashappened recently, from long sidewaysor darker phases (which, according toKarletsky, represented half of markethistory since 1900), they do so becausesomething has fundamentally changed,and for reasons that are not apparent atthe time. Karletsky believes that theU. S. capital markets’ recent break-outinto new high ground might suggest thatthe period of grim economic conditions, which has lasted almost five years sinceLehman (or actually since early 2000), is coming to an end.On the other hand, if the upturn is cyclical, as I have argued for several years, a value investor’s strategy mustdiffer from that of the secular-bull-market-thesis majority; and that is particularly true for purists who believethat absolute rather than relative value is what really matters. From that perspective, the remarkable advancein stock prices since 2009 has occurred
within the context of a longer-term secular bear market 
that began at the tailend of the 1990s when the greatest sustained rise in equity prices in modern history fell prey to its ownexcesses.Oh, what a joyride that was from 1982 to 1999, though, remember? The S&P 500 soared from 100 to 1400during the unprecedented 17-year episode. Nominal S&P 500 reported earnings rose from roughly $15 to$50, while a 10-year moving average of reported earnings tracked comparably in percentage terms, from $10to $30. As market prices and therefore the denominator rose, dividend yields virtually disappeared from 6%to 1%. Long-term U.S. Treasury bond yields fell from 14% to roughly 4.5% by 1999. Total non-financialdebt grew from 150% of GDP to 200% (and, subsequently, has spiked to 285%). And perhaps the most
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GaveKal 's published investment record dates only from 2009 so we have no insight as to how effectively they puttheir thoughts into action.
 
 
telling indicator of the secular bull market’s peak: The number of U.S. families invested in mutual fundsjumped from 5 million in 1990 to 50 million by the end of the decade. It was so good and lasted so long,most people forgot that nothing lasts forever.Unlike Mr. Karletsky and the majority he more or less represents, there is a minority, including me and thethree preeminent money managers also mentioned below, who believe that macro policy interventioneffectively preempted and thus postponed the inevitable purging of the now institutionalized excesses wrought by the great bull market. Moreover, we believe that the longer central bankers apply experimentaland almost certainly reckless macro policy as a palliative, the more dire the eventual consequences. Theaccommodative policies now engaged are having the perverse and overarching opposite effect of fanning the very flames of speculative excess that must be quenched before any hope of a sustainable recovery can berationally expected. Tragically, erstwhile investors have become speculators not by dint of greed and avaricebut out of desperation for a modicum of return that had always been available in safe harbors – that is, until adesperate Fed began robbing the frugal Peter to pay for the mistakes of the feckless Paul.Please study the next four graphs insequence. The parameters are identical, butadditional information is overlaid on eachsuccessive illustration. The first graphdisplays the nominal S&P 500 index from1928 to date on logarithmic scale
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withparallel lines creating a trend channel drawnas narrowly as possible to capture almost allof the fluctuations in the index over time.Since the upward sloping trend of the indexis dependent on the growth in earnings of the companies of which it is composed, thesecond graph includes annual reported earnings. As you can see, over the very long-term, the index andearnings are well correlated. Reported earnings are understandably volatile, however, as the residual after allexpenses are deducted from revenues. They bounce around, but notably, almost always within the confinesof the value channel. The markets reflect asimilarly erratic tendency, given theiroccasionally manic-depressive moodswings. The index trendline is anything butstraight as a string. Moreover, even if onelooks closely, it is difficult to discern muchof a cause-and-effect relationship betweenearnings and index values in, say, 1-5 yearperiods, especially during periods of high orlow interest (discount) rates.
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 To fully appreciate the series of charts, a brief mathematical explanation may be helpful. Notice the uneven spacing of the numbers on the right and left sides of the chart. On the right, the spacing between 10 and 100 is identical to thatbetween 100 and 1000. The scale is log (logarithmic) as compared to the more commonly used arithmetic scale, wherethe space between numbers, say, 100, 200, and 300 is the same. The log scale is appropriate when the data being examined covers many years with our wide range of data. For example, with log scale one gets a true sense of themagnitude of difference between the Crash of 1929-32 and the financial crisis of 2008-09. On arithmetic scale, theCrash but hardly be noticeable. Equally important, in log scale, a straight line represents a constant rate of percentagechange.
 
 
 The rate of slope of the trend channel is 6%. Not coincidentally, that is also both the long-term growth ratein S&P earnings and the S&P index, before dividends are added in determining the total return. To completethe picture for investors, the average dividend yield has been 4% which, along with the 6% annualappreciation in the index, is how the roughly 10% return from common stocks since 1926
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is calculated.So, in the third graph, we’ve included a 10-year moving average of annual reportedearnings to smooth out the alwaystemporary aberrations, and to amelioratethe tendency to get overly excited whenreported annual earnings are getting aheadof themselves or depressed when they arefalling behind. As the graphics make clear,for the last 85 years reported earnings havealways “mean reverted”; i.e., like a jerky pendulum, they fluctuate around amidpoint. Without getting into the math,the eye alone will tell you that the market is more attractive when prices are closer to the bottom trendlinethan the top – both in terms of a lesser likelihood of falling still farther and its enticing corollary, the rising probability that it will rise at a rate faster than the trendline in the future. Think about that sentence carefully. Value investing throws the conventional high-risk/high-return paradigm on its ear. Value investors tilt therisk/return scales in their favor by disciplining themselves to buy only when the price-to-value favors themand not the seller. We call it the “margin of safety.” More importantly, the relationship between the index value and the 10-year moving average earnings – whether the index value is above or below, and by homuch – is an indicator of how much valuation risk (or advantage) to which one is exposed at any point intime.In the final graph of the series, we’veadded the horizontal lines from Mr.Karletsky’s earlier chart and use them now to more closely examine his hypothesis. As for the line from 1929 through 1955, we are at a loss. Surely a rational valueinvestor would have not waited until 1955to invest, when the market finally “brokeout,” 23 years after the lows of 1932. That is unless, like millions of others, it wasn’t just his savings he lost, but his willto venture as well. On the other hand, thecase in the early 1980s is, from ourperspective and as is obvious from the graph, compelling. Being fastidious about detail, we think the lineshould be drawn somewhat lower, right on top of the 100 line found on the right margin. Doing so wouldonly strengthen Karletsky’s argument, but it would also be more consistent with our other writings about 17-year cycles, with the one in question beginning in 1966 and ending in 1982. As for looking forward fromtoday, Karletsky’s thesis that something has changed of which we are not yet aware must ultimately translateto two forces about which we have a low level of conviction: (1) corporate earnings will rise in the future at arate higher than the 6% average of the last 85 years and (2) interest rates will remain well below theirhistorical averages indefinitely. In fact, we would argue that the conditions necessary for (1) to occur for any extended period of time preclude the possibility of (2) coexisting simultaneously.
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Ibbotson Stocks, Bonds, Bills, and Inflation Classic Yearbook
. Roger Ibbotson, Yale University. Published annually bMorningstar (Chicago). ISBN: 978-0-9849500-2-7
 

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