January 4, 2010
Vitaliy Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates, Inc., a Denver-based money management firm. He is also the author of the highly acclaimed book, The Little Book of Sideways Markets (Wiley, 2010), which is available via the link above. His web site is Vitaliy’s Contrarian Edge.
I spoke to Vitaliy on December 29.
Your latest book, The Little Book of Sideways Markets, was just published. What is a sideways market?
Let's begin with some definitions so we can speak clearly about this. When I talk about markets, I'm talking about secular markets that last longer than five years, usually decades or longer.
When we think about secular markets or markets in general, we tend to think of them in binary terms: "bull" markets are going up, "bear" markets are going down. But over the last 100 years markets spent half the time in bull and half the time in a “sideways” phase. Secular bear markets happened a lot less often than we think. The only secular bear market we had was the Great Depression.
Think about sideways markets this way: The economy has a lot of small (cyclical) bull and bear markets, but when we are in a sideways market in the long run it just stagnates. This is similar to what S&P 500 did over the last 10 years – we had two bear and two bull markets, and yet the market is still not far from where it was in 2000.
To understand why this happens, you have to understand the simple arithmetic of why stock prices go up in the long run. They are really driven by two factors: earnings growth and change in price-to-earnings ratio. If price-to-earnings ratios had not changed over last 100 years and stayed at 15 (their long-term average), you would have had no market cycles, and markets would have gone up in tandem with earnings growth. Earnings in the long run would have grown in line with GDP, or about 5 or 6% a year, so stocks would have gone up gradually over time as the economy expanded.
But investors get overexcited about stocks, and they take price-to-earnings ratios from below-average to above-average levels. That is when you have secular bull markets. And then investors take price-to-earnings from above-average levels to below-average levels, which is when you have sideways markets. This happened consistently over the last hundred-plus years.
In sideways markets, earnings growth is offset by price-to-earnings decline, and markets go nowhere.
In bull markets, you have earnings growth and you have price-to-earnings expansion. That is why the returns are so good. This is a very important point: Over last hundred years or so, economic growth was not that much different during sideways and bull markets.
What stage is the US market in now?
We are in the middle of a sideways market, and we still have another decade to go.
How do I know this? The principle is that P/Es go from above average to average to below average, and they stay at the below-average level for some time. If you look at the last sideways market, which was from 1966-1982, price-to-earnings did not just go from above average and briefly touched below average level before we had a bull market. No. Price-to-earnings spent half of the time at below-average ratios before the next bull market (1982-2000) started.
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