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Vitaliy N.

Katsenelson, CFA
Chief Investment Officer

Investment Management Associates, Inc.

Active Value Investing Net of Fees performance is after the deduction of management fees, after reinvestment of dividends, interest and other earnings (recorded on accrual basis), and after the deduction of broker fees and commissions.

S&P 500 market average includes reinvestment of dividends but are not adjusted for any transaction costs.
Past performance is not necessarily indicative of future results and is only one of several factors which should be used in evaluating a professional investment organization.

We are used to thinking about secular (longer than 5 years) markets in binary terms:


There is another type of long-term market Cowardly Lion or Sideways

bursts of occasional bravery lead to stock appreciation, but are ultimately overrun by fear that leads to a subsequent descent
Active Value Investing: Making Money in Range-Bound Markets

Dow Jones Industrial Average 100+ Years

The bear markets were actually sideways markets

and happened the time

Dow Jones Industrial Average 2000 - 2010

So far markets have gone sideways hell of a ride, but still sideways

Secular Bull and Sideways Market Cycles Were Not Caused by:

Economy Earnings growth

Interest rates Inflation They Were Caused by: Valuation

As Long As: Inflation Remained Reasonable / Deflation Was Absent / GDP And Earnings Growth Remained Positive Market Was Either Bull Or Sideways.

10 Note: Real GDP growth was extremely stable throughout all secular markets

Stock Market Math

Price + Dividends = Total Return from Stock(s)

Earnings Growth + P/E

Earnings Growth + P/E + Dividends = Total Return from Stock(s)


Sources of Return Practical Example:


Wal-Mart -- A Typical Sideways Market Stock

2001 - 2010


Sources of Return: Secular Sideways and Bear Markets (S&P 500)


Sideways Markets: P/E Contraction + Earnings Growth = Low Returns Bear Markets: P/E Contraction + Earnings Decline = Negative Returns


By the Book Bear Market Japan


Sources of Return: Secular Bull Markets

Bull Markets: P/E Expansion + Earnings Growth = Super Returns




Bull Markets Start at Below-Average and End At Above-Average Valuations. Range-Bound Markets Start at Above-Average and End at Below-Average Valuations.


Bull, Bear and Sideways Markets Happen


Bull Range-Bound Bear

Economic Growth
Good (Average) Good (Average) Bad

Starting Valuation (P/E)

Low High High


In a perfect world where humans have no emotions stock market appreciation = economic growth = earnings growth = 5-6%


The Effects of Psychology on Market Cycles

End of Bull Market

New average expectations are NOT met P/E stopped expanding

P/E + EPS = 0% + 6% 6%

Sideways Market
Returns are NOT new average, not average, but below average:

P/E + EPS = -6% + 6% 0%


Interest rates and inflation are very important but they take a second seat to market psychology. They ultimately determine the length and the extremes of market cycles.
Interest Rates Move from Zone 1 Zone 2 1982 If interest rates /inflation were higher, secular range-bound may have ended sooner at higher valuation Zone 3 Zone 2 Zone 2 Zone 3 Zone 2 Zone 1

Good/Bad for P/Es


Reason Move to normalcy Risk of inflation Move to normalcy Risk of deflation


If interest rates /inflation were not that low, secular bull may have ended sooner at lower valuation


Still in the Sideways Market?

Valuations are still high (above average).

Valuations need to stay below average for a while (see next slide).
Real earnings growth will be lower in the future due to higher future taxes, higher interest rates (caused by government borrowing), consumer deleveraging sideways market may last longer than we expect. High inflation will shorten sideways market duration, but final P/E will be lower as well. If nominal earnings growth doesnt materialize in the future (3,5,10 years), earnings decline we are set for a secular bear market



Brief Summary of Strategy and Analysis for Todays Environment

Be a buy and sell investor. Buy and hold is in a coma (see next chart) . Time (price) stocks through a strict buy and sell process. Buy when undervalued, sell when fairly valued. Time stocks, not the market: Market timing is very difficult. In the short run emotions are in the drivers seat.

Dont buy for the sake of being invested. Dont lose money by making marginal decisions. In the absence of good stocks to buy, be in cash. The opportunity cost of cash is not as high as in a secular bull market.
Increase your margin of safety: Fewer (better) stocks will be in your portfolio. Favor dividend-paying stocks. Dividends were 95% of the return in previous range-bound markets. (Warning: dividends are part of the analytical equation, not the equation.) Look overseas -- increases return without increasing risk.

Bull Markets: Stocks Do Outperform Bonds Hands Down

Throw money at stocks, and youll do much better than in bonds or cash. In general, the fewer decisions you make the better off you are (buy and forget).


Sideways Markets: Stocks Dominance Is Not Significant

Asset allocation is not as important as stock selection.


Conclusion: Stock Selection Matters A Lot!


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Secular Range-Bound Market Is Comprised of Many Cyclical Markets