The rough guide to surviving market cycles
There are a few books that I turn to time and again which I find extremely useful, and a surprising number of them come from the 'Little Books, Big Profits' series published by Wiley. The reason I'm a fan of the series is that the format forces the often very smart authors to distil their thoughts into less than 150 pages. Such a format does away with the verbosity and in-the-know jargon that fills larger tomes leaving the author to focus on storytelling and ideas. One that's useful to read at difficult times like these is the Little Book of Sideways Markets. In the book the author, Vitaliy Katsenelson, describes at length how stock markets have a tendency to move in long wave cycles from extreme overvaluation to undervaluation and describes especially the strategies required to prosper during downwaves.
Redefining markets as bears, bulls and 'cowardly lions'
The real value that Katsenelsen adds in this short book is in providing a mental model to help investors think about what really drives the market over the long term. He makes the distinction between secular movements in the market which last from 5 to 15 years and cyclical movements which last from several months to several years. These cyclical bull and bear moves may be the prime focus of the media, but really they are just shorter term waves within broader secular trends.
Katsenelsen notes that these secular trends have tended to be long term bull and 'sideways' markets rather than bear markets. He describes sideways markets as 'cowardly lions' given that every brave cyclical rally within them tends to turn and decline. As shown in the graphic below, the last 100 years have seen 4 main bull markets, 4 sideways markets (each lasting 13 to 18 years) and one short secular bear market in the Great Depression - our current predicament is that of a Sideways market with a long way still to run.
PE ratios drive these trends
A simple equation to understand a stock's return is as follows: Stock Return = EPS Growth + Change in P/E + Yield . Historically during bull and sideways market periods the level of EPS Growth and dividends haven't been much different - so the entire reason for the long drift upwards or sideways in price has been a result of the P/E multiple expanding and contracting.
During the long bull market from 1982 to 2000 the P/E ratio based on reported year earnings of the S&P 500 expanded enormously from 10x to 30x earnings, while the P/E based on 10 year average earnings (known as the CAPE or cyclically adjusted PE ratio) grew from 12x to 48x! At peaks such as this there's only one way for the P/E ratio to go - down.
Katsenelsen uses Walmart as an example showing how from 1999 to 2010 earnings almost tripled from $1.25 to $3.42 per share (EPS Growth of 12% per annum) but the share price literally went nowhere. The P/E ratio during that period declined from 45 to 13.7x wiping out all the gains. So what happens in sideways markets is that the twin forces of EPS Growth and P/E ratio contraction work against each other. Positive EPS Growth is wiped out by the falling P/E ratios, which is precisely what we've seen happen in the market 2000, and the trend looks like it may have a long way to go.
Where are we now?
If you look at the series of historic peaks and troughs in P/E ratios it sets quite a sobering scene. Using reported earnings the P/E lows that were reached at the beginning of each bull market in the last 100 years have been 11x, 9x, 7x and 10x. Considering the US stock market is still valued at over 15x reported earnings we may still have a way to go until this sideways market has fully bottomed. Using 10 year average earnings it's even more sobering, the P/E lows reached at market bottoms have been at 11x, 4x, 13x and 12x compared to a current CAPE of 21x. Anyone wanting to verify these extremes can look at the charts on this excellent website. Katsenelsen shows that even if earnings were to grow 5% per year we'd still have around 10 years until the CAPE falls to reach a typical historic low.
Of course Katsenelsen's book has a big US bias and his view may be overly pessimistic. The situation in Europe may be far worse economically, but in terms of valuations we are far closer to the lows. A recent paper by Albert Edwards at Soc Gen showed that the CAPE for eurozone stocks has almost reached the pitiful lows in the early 1980s, but while that may provide a value opportunity for contrarians, the experience in the late 1970s was that valuations remained at these lows for a good 5 years. More ominously the chart shows how far US valuations could fall in a worst case scenario. Is Ben Bernanke pushing on an asset price string?
Ultimately secular bull markets feed on growing investor confidence which in turn is driven by consistently rising prices. Rising price trends ride on the back of P/E multiples that have the capacity to expand gradually over the course of many years bringing more investors to the market. The perfect set up for this to occur is when valuations start from an extremely low base, which historically has occurred when the CAPE has been driven down to extreme lows. There has never been a long term secular bull market started from a CAPE as high as it is in the US today which again ought to be extremely sobering for stock investors.
Dividends to the rescue?
Katsenelsen isn't entirely pessimistic about the outlook for stocks in such an environment. He prescribes a buy and sell strategy in the book that focuses on good value high quality growth stocks. But the most fascinating statistic that Katsenelsen cites is that while during secular bull markets dividends make up only 19% of total stock returns, insecular sideways marketes they make up 90% of the return! This statistic alone has hugely piqued my interest in dividend stocks. There are many who have been hurt badly by the broken promise of small cap growth, mining and energy stocks over the past 12 years, but solid high quality dividend paying stocks have massively outperformed. The Soc Gen Quality Income index I wrote about last week has tripled in value since 2000. There are many who are calling dividend stocks a 'bubble' at the moment due to this outperformance, but it may be that during this great sweeping sideways market that we are currently enduring, dividends may be all that investors have to look forward to. Given that this cowardly lion market may have many years to run it's worth exploring the performance of dividend stocks in a bit more detail which is a theme I'll be following up on next.