Making Money from Nothing
We are in a Cowardly Lion market, whose occasional bursts of bravery are ultimately overrun by fear that leads to a subsequent decline.
For the US stock market, the past ten years have earned the title “the lost decade.” The next ten years probably will not be much different: The market will likely set record highs and multiyear lows, but index investors and buy-and-hold stock collectors will find themselves not far from where they started.
Every long-lasting bull market of the past two centuries (and we had a supersized one from 1982 to 2000) was followed by a sideways market that lasted about 15 years. The Great Depression was the only exception. Despite common perception, secular markets spend a lot of time in bull or sideways phases, and roughly an equal amount in each. They visit the bear cage only on very rare occasions.
This doesn’t happen because the market gods want to play a practical joke but because stock prices are driven in the long run by two factors: earnings growth (or decline) and price-earnings expansion (or contraction). Though economic fluctuations are responsible for short-term market volatility, long-term market cycles are either bull or sideways if the economy is growing at a close to average rate.
Prolonged bull markets start with below-average P/Es and end with above-average ones. This vibrant combination of P/E expansion and earnings growth – which doesn’t have to be spectacular, just more or less average – brings terrific returns to investors. Sideways markets follow bull markets. As cleanup guys, they rid us of the high P/Es caused by the bulls, taking them down to and actually below the mean. P/E compression – a staple of sideways markets – and earnings growth work against each other, resulting in zero (or near-zero) price appreciation plus dividends, though this is achieved with plenty of cyclical volatility along the way.
Bear markets are the cousins of sideways markets, sharing half of their DNA: high starting valuations. But whereas in sideways markets economic growth softens the blow caused by P/E compression, during secular bear markets the economy is not there to help. The US, however, has never had a true, long-lasting bear market like the one investors have experienced in Japan, where stocks have fallen more than 80 percent from the late 1980s to today. If the US economy fails to stage a comeback with at least some nominal earnings growth over the next decade, what started sideways in 2000 will turn into a bear market, as high valuations are already in place.
I should mention the role interest rates and inflation play in market cycles. They are secondary to psychological drivers, but important. They don’t cause the cycles, but help shape their magnitude and duration. For instance, if interest rates and inflation had not been scraping low single digits in the late ’90s, the bull market would have ended sooner and at lower P/Es. The higher inflation and interest rates that are around the corner will take their toll on the duration and P/E of this market too.
In sideways markets you as an investor need to adjust your strategies:
- Become an active value investor. Traditional buy-and-forget-to-sell investing is not dead but is in a coma waiting for the next secular bull market to return – and it’s still far, far away. Sell discipline needs to be kicked into higher gear.
- Increase your margin of safety. Value investors seek a margin of safety by buying stocks at a significant discount to protect them from overestimating the “E.” In this environment that margin needs to be even more beefed up to account for the impact of constantly declining P/Es.
- Don’t fall into the relative valuation trap. Many stocks will appear cheap based on historical valuations, but past bull market valuations will not be helpful again for a long time. Absolute valuation tools such as discounted cash flow analysis should carry more weight.
- Don’t time the market. Though market timing is alluring, it is very difficult to do well. Instead, value individual stocks, buying them when they are cheap and selling them when they become fairly valued.
- Don’t be afraid of cash. Secular bull markets taught investors not to hold cash, as the opportunity cost of doing so was very high. The opportunity cost of cash is a lot lower during a sideways market. And staying fully invested will force you to own stocks of marginal quality or ones that don’t meet your heightened margin of safety.
What if a sideways market isn’t in the cards? If a bull market develops, active value investing should do at least as well as buy-and-hold strategies or passive indexing. In the case of a bear market, your portfolio should decline a lot less.