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We're on day 3 here in Vancouver, British Columbia, at the Agora Financial Investment Symposium put on by the folks of The Daily Reckoning newsletter.
Today's speaker was Vitaliy Katsenelson, author of the book Active Value Investing, director of research at IMA, and professor at the University of Colorado, Denver. If his name sounds familiar, Vitaliy also used to write for The Motley Fool. "I invest, I educate, I write and I could not dream of doing anything else," he said. Below is a partial transcript of Vitaliy's speech, "Making Money in a Range-Bound Market," edited for clarity.
On market cycles: People think of markets in terms of either bull markets or bear markets -- one or the other. The problem is that we've gone nowhere for the past 10 years. It's been range-bound, and I think it will stay range-bound for another seven-10 years.
There was a secular bear market during the Great Depression. It doesn't fit the secular definition, but I arbitrarily put it into the secular category because 80 years later, we are still talking about it. Other than that, stocks trade between secular bull markets, cyclical bull markets, cyclical bear markets, and sideways markets. We don't focus enough on sideways markets. We think they don't happen very often, but they do. It's part of the normal cycle.
I set out to try and find what causes these cycles. In general, we think market cycles are caused by 1) the economy, 2) earnings growth, 3) interest rates, and 4) inflation. Recent history shows this to be the case. If you look back at the last 50 years of market data, there's a tight negative correlation between interest rates and market returns. But if you take the data out over the past 110 years, the correlation breaks down. There's a much more important factor that determines market returns: starting valuations.
Take Wal-Mart (NYSE: WMT ) as an example. In 2000, it earned $1.30 per share. In 2010, it earned $3.60 per share. So it had very solid earnings growth. Interest rates also fell over the last 10 years. But what happened to Wal-Mart's stock? It dropped from $57 to $53. The reason is because its P/E ratio fell from 45 in 2000 to 14 today. You'll find the same thing for a company like Johnson & Johnson (NYSE: JNJ ) : earnings growth of 12%-15% per year, but P/E ratios contracting by the same amount. That's what creates a sideways market. Investors love to focus on earnings growth. They think that's all that matters. But the most important part is the starting valuation.
On range-bound markets: The last range-bound market lasted from 1966-1982. During this time, earnings growth was 6% per year -- not that bad. But P/E multiples contracted by the same amount, 6% per year. Investors' capital ended up at the same place they started 16 years before. That's what a range-bound market looks like.
Interestingly, earnings growth isn't that different during bull markets. In the last bull market (1982-2000), earnings growth wasn't that spectacular. But P/E multiples expanded by 7.7% per year. Add the two together, and you get really great returns.
The difference between these two market periods was the starting valuation. In 1966, you were starting with really high valuations, and that cycle ended in 1982 with low valuations. Vice versa for the last bull market. When it ended in 2000, valuations were at an all-time high.
Why does this happen? People are very emotional. We get excited about stocks and depressed about stocks, depending on recent past returns. When P/E multiples are expanding, we get above-average returns, and people start pulling money out of bonds, out of gold, whatever, and dumping it into stocks. Stocks become their hobby, and investors come to expect above-average returns.
But at some point, P/E multiple expansion must stop. It can't hit the stars. Then it starts falling. So investors get disenchanted with stocks. They go to bonds. They go to gold. Then P/E multiples contract.
What's important to know is that P/E multiples have to stay below average for a while before a new cycle can begin. Valuations usually stay below average for eight years in a sideways cycle.
On where we're going: So where are we today? If you look at trailing 10-year earnings over the past 100 years, the average P/E multiple is about 18. Today, we're still about 20% above that. That's why I expect a range-bound market to continue for some time.
On what to do about it: In a range-bound market, stocks barely beat Treasury bonds. So average market returns are not good enough. You need to be in the right stocks. Stock selection matters a lot. If you invest in index funds, your returns will not be exciting.
Buy and hold is not dead, but it's in a coma waiting for new bull market to begin. Today, you have to be a buy-and-sell investor. It's sort of like being a closet trader. I buy stocks when they're undervalued, and sell when they're fairly valued. You don't need to do that in bull market, because valuations go above average, so you can just buy and hold. That's not the case in a range-bound market. If I can't find undervalued stocks, then I have a much higher cash position. The opportunity cost of being in cash in this environment is very low.
So what kind of companies should you invest in during a range-bound market? First, think of stimulus. It seems like the economy is getting better. GDP is growing. But it's not sustainable. Once you take the stimulus away, you go back to where we were. It's temporary, and it can distort how healthy things really are.
Think of earnings the same way. You have to ask whether earnings are sustainable. Look for companies whose earning power will remain intact if stimulus is taken away. The stocks I own are not geared for recovery. They're defensive. If there is a strong recovery, my stocks will lag, but that's ok. The goal should be to not lose money.
Investors should also favor stocks with high dividends. In the past, 95% of market returns came in the form of dividends. We tend to forget that. Don't just reach for any dividends; they have to be good, high-quality companies. Not like financial stocks. You know how that story played out.
Investors should also look abroad. And not just to diversify. I don't really buy the diversification argument. They should look abroad for opportunity. There are cheap stocks overseas. I'm looking at Europe right now.
You also want to own stocks that will do well with either inflation or deflation. I don't know which one we'll have, so I prepare for both. I like companies that can maintain pricing power in any environment. When I lived in Russia, I smoked. At one point, the price of cigarettes went from one ruble to five rubles. And guess what? I didn't stop smoking. That's the kind of company you want to own. [Altria (NYSE: MO ) and Philip Morris International (NYSE: PM ) are great examples].
You should also look for companies with very strong, conservative balance sheets. Now, high inflation is actually good for companies with lots of debt. It bails them out. But what about deflation? They'll tank. It's terrible. I err on the side of caution. That's what you should do in range-bound market. Look for companies with lots of cash and little or no debt.
I'll have more from Vancouver each day this week.