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Investing in Range-Bound Markets by Vitaliy N. Katsenelson (published in NAPFA Magazine)

Investing in Range-Bound Markets by Vitaliy N. Katsenelson (published in NAPFA Magazine)

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Published by VitaliyKatsenelson
Investing in Range-Bound Markets by Vitaliy Katsenelson
Investing in Range-Bound Markets by Vitaliy Katsenelson

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Published by: VitaliyKatsenelson on May 23, 2010
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Cntinue n ge 24
ver the last decade, the stock market has earned the title of LostDecade. The next decade willnot be much different from the last: TheU.S. stock market will set record highsand multi-year lows, but index investorsand buy-and-hold stock collectors willfind themselves not far from where theystarted in 2000. We are in a CowardlyLion market, whose occasional bursts of  bravery are ultimately overrun by fear thatleads to a subsequent descent.Every long-lasting bull market, exceptone, over last two centuries (includingthe supersized one from 1982 to 2000)was followed by a range-bound marketthat lasted about 15 years. The GreatDepression was the only exception.Despite common perception, secular markets spent a lot more time in bull or range-bound phases, roughly half in each.They only visited a bear cage on very rareoccasions.This doesn’t happen because stock market gods want to play a practical joke on gullible humans, but because, asthe daily noise subsides, stock prices inthe long run are driven by two factors:earnings growth (or decline) and price-to-earnings expansion (or contraction).Though economic fluctuations have been responsible for short-term marketvolatility, long-term market cycles wereeither bull or range-bound if the economywas growing close to the average rate (seeGraph 1).This distinction between bear andrange-bound markets is seldom made, but it’s extremely important. One shouldinvest very differently in each market— more on this later.Prolonged bull markets startedwith below-average P/Es and endedwith above-average P/Es. This vibrantcombination of P/E expansion andearnings growth (the latter of whichdoesn’t have to be spectacular, just moreor less average), brings terrific returns to jubilant investors. Range-bound marketsfollow bull markets. As clean-up guys,they rid us of the high P/Es caused by bullmarkets, reverting them down towards andactually below the mean. P/E compression(a staple of range-bound markets) worksagainst any earnings growth that occurs,resulting in zero or near-zero priceappreciation plus dividends. These resultscome with plenty of cyclical volatilityalong the way.The 1982-2000 bull market ended atthe highest P/Es ever. Thus, it will takelonger than usual for earnings growth todeflate them. Though continued economicgrowth appears to be a wildly optimisticassumption, given what is taking placein the economy, it is not particularlyunrealistic to assume that we will seenominal economic growth over the nextdecade. The Fed and our government areworking very hard to achieve that, at anycost.Bear markets are range-boundmarkets’ cousins; they share half of their DNA in high starting valuations. However,where in range-bound markets economicgrowth helps to soften the blow caused by P/E compression, during secular bear markets the economy is not helpingeither. Economic blues result in decliningearnings, which throw water on an alreadydying fire (the compression of highstarting P/Es), and this combination bringsdevastating results to investors.A true, long-lasting bear markethas not really taken place in the U.S., but it did occur in Japan, where stocksdeclined gradually, and not so gradually,at times. Japanese stocks have fallenover 80 percent from the late 1980s untiltoday. If the U.S. economy fails to stagea comeback with at least some nominalearnings growth over the next decade,
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Cntinue m ge 22
what started as a range-bound market in2000 will turn into a bear market, giventhe high valuations that are in place.Let’s try to figure out the earnings power of the S&P 500. The current 2010estimates of its operating earnings are$75. I am skeptical of this number for several reasons.First, it is nearly double the reported2010 earnings estimates of $45. The percentage difference between reportedand operating numbers is the second-highest since 1988 (2008 holds therecord). During the 2001-2003 recession,the difference was about 50 percent. “One-time” write-offs are responsible for thedifference. It is very likely that these “one-time” charges are not really “one-time”;thus, operating estimates overstate the trueearnings power of the market.Second, 2010 estimates are onlyslightly below the all-time high earningsthe S&P achieved in 2007, when our economy was under the influence of several bubbles which severely inflatedcorporate profit margins to unprecedentedlevels. Also, the bulk of excesses inmargins in 2007 came from the financial,materials, energy, and industrial sectors— the ones that are struggling today and willcontinue to do so for a long time.Finally, if earnings were to be as projected, we’d be following the lastrecession’s recovery path, which is unlikely.The last recession was corporate, whilethe current one is riddled with debt-ladenconsumers. Deleveraging the excesses of the housing bubble, in the face of higher future taxation and likely higher interestrates (both byproducts of large deficits),will be a lengthy process. The recovery will be slower, and real earnings growth will belower than in previous recessions.It is hard to know the exact earnings power of the S&P 500, but it likely liessomewhere in between operating andreported earnings estimates, and thuscloser to $60. This would put the P/E of the S&P 500 today at about 19.Since 1900, stocks have spent verylittle time at what is known as a “fairlyvalued” P/E of 15. In fact, they have spentless than 27 percent of the time between P/Es of 13 and 17. They only saw a P/E of 15 when they went from one extreme toanother. Most importantly, they’ve never stopped at the average and gone the other direction; they’ve continued their journeyto the other extreme.During secular bull markets,investor optimism, bundled with constantreinforcement from rising prices, takesstocks 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 thelate stages of the secular bull market,P/Es stop expanding. As earnings growth becomes the sole source of returns,disappointed investors start diversifyingaway from stocks into other asset classes,and a range-bound market ensues. As therange-bound market marches on, unmetexpectations reinforce disappointment instocks, and P/Es are compressed to theother extreme. Keeping this in mind, notethat stocks are still not cheap, and thusrange-bound markets still lie ahead of us.Interest rates and inflation aresecondary to psychological drivers, butthey’re still important. They don’t causethe cycles, but they do help to shape their duration and the valuation extremes thatstocks achieve. For instance, if, at the endof the 1966-1982 range-bound market,interest rates and inflation had not beenin the mid-teens, the range-bound marketwould have ended sooner, at higher P/Es.On the other hand, if, in the late-1990s,interest rates and inflation had not beenscraping low single-digits, the bull marketwould have ended sooner and at lower P/Es. The higher inflation and interest ratesthat are around the corner will take their tollon the duration and final P/E of this marketas well.
What Investors Should Do
In range-bound markets, as P/Escompress, they turn against investors. Inthis difficult environment, investmentstrategy needs to be adjusted for the newinvestment reality. Here are things thatinvestors can do:Become an active value investor.
Traditional buy-and-forget-to-sell (hold)strategy is not dead, but it’s in a coma,waiting for the next secular bull marketto return, and it’s still far, far away.
 is not just another four-letter word; selldiscipline needs to be kicked into higher gear.Increase your margin of safety.
Typically, value investors seek protectionfrom overestimating the “E,” earnings. Inthis environment, protection needs to be
Napfa advIsor aprIl 201024

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