Sideways Market Moves

Over the next several years, stocks will generally fall in valuation as gold rises, though you’ll have to endure some episodes like the current one, when the market ratchets back up after falling. US stocks are at 29 times earnings, yielding less than 2%, a horrible deal.

Between bull markets, which is where we are right now, stocks go sideways, up and down. As the market moves up and down over the next several years, the overall valuation will fall lower on average. This has happened between every bull episode since 1900. Stocks go up and get overvalued over a period of 15 years or so. That’s the bull phase. After that, they go sideways, up and down, getting overvalued then undervalued, for several years. At the beginning of a sideways market (the end of a bull), stocks are overvalued and everyone loves them, paying more than 22 times earnings at bull market peaks over the last 100 years. At the end of the sideways market (beginning of the next bull), after years of frustrating ups and downs, stocks become very undervalued, generally selling for 10 times earnings or less.

The last bull market started in the 1982, with stocks at right around 10 times earnings. The bull ended, and the current sideways market started in 2000, when the S&P 500 was in the stratosphere, over 40 times earnings, its highest valuation ever (based on 10-year average PE ratios). I expect the current sideways episode will end with the big indexes at the bottom of the troposphere (on the ground). I expect that the corresponding bottom in valuation at the end of this sideways market will be as irrationally low as 2000 was irrationally high. So instead of 7-10 times earnings at the bottom, maybe we’ll see 4-5 times earnings.

That’ll be a great time to buy stocks. I just turned 48 a couple weeks ago. I hope it happens before I turn 60, but I’m not holding my breath. My only caveat is that all this is based on historical observations, and anything can happen. I don’t have a crystal ball. But I’m pretty sure human nature never changes and man’s predictable irrationality will continue to show up in securities prices more or less as it generally has in the past.

To get through this difficult period, I’ve raised the bar for myself and Extreme Value readers, and will only buy what is very, very cheap and very, very safe. I recommended IMS Health (RX) in August, because it was below 5 times free cash flow and owns a one-of-a-kind database big pharma companies can’t live without. The stock was $13 then. It’s now being bought out for $22 (up 70%). I figured a 20+% free cash flow yield was very, very cheap for a one-of-a-kind asset that took 50 years to build, and which tracks 90% of all the prescription drug transactions in the US.

Stock picking will frustrate the herd from here on out, and Extreme Value-style investing will make a lot of people look smart over the next several years.