We Have Been In The Grip Of A Treacherous Sideways Moving Stock Market

Vitaliy Katsenelson is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of Active Value Investing (Wiley, 2007) and The Little Book of Sideways Markets (Wiley, December 2010). He writes a monthly column for Institutional Investor

I started writing my first book, Active Value Investing: Making Money in Range-Bound Markets, in 2005; finished it in 2007; and published the second, an abridged version of the first (The Little Book of Sideways Markets), in 2010. In both books I made the case that there is a very high probability that we are in the midst of a secular sideways market – a market that goes up and down, with a lot of cyclical volatility, but ends up going nowhere for a long time.

Sideways markets happen not because stock market gods play an unkind joke on gullible humans but because of human emotions. Historically, sideways markets have always followed secular bull markets. At the end of secular bull markets stocks become very expensive – their valuations (P/Es) get very high. Sideways markets are just a payback for all the fun and returns stock investors received during secular bull markets.

In 1999, after 17 years of incredible returns, the mother of all secular bull markets ended at valuations we'd never seen before. For this reason, in my first book I argued that the present sideways market, which started then, might last longer than past ones. In the Little Book I want a step farther with the benefit of hindsight – it was written post-Great Recession. I argued that the economic growth rate going forward will be lower than it was in the past, and thus this sideways market may even last longer than I originally suspected.
Every so often I get an email from a reader with the question, “Are we there yet?” Are we still in the grip of a treacherous sideways market, or we are now entering into a secular bull market? I will try to answer that question as best I can in this writeup.

The Sideways View of The World

In early May I had the pleasure of attending and speaking at the Value Investing Congress in Las Vegas. The last time I spoke there it was May 2008 and the market was just coming off its top. (Here is a PDF of the '08 presentation, and the new presentation is here.) The S&P was at 18x trailing earnings. Profit margins were at a modern-day high. They subsequently collapsed but came back to set an even higher high.

The market was not cheap in 2008. It is not cheap now, either.

Before I dive into my argument I need to introduce you to a very simple calculation that is at the core of my sideways argument:

E + Change in P/E + Dividends = Total Return

Stock price movements are driven by two variables: earnings growth and changes in the price-to-earnings ratio. Add dividends, and you have total stock returns. The dividend yield of an average stock today is 2% – it is all yours to keep, so my discussion here will focus on the direction of “E” and “P/E.”

If you were to normalize profits for high margins and look at 10-year trailing earnings, in 2008 stocks were trading 66% above their historical average. They were at 30 times 10-year trailing earnings (see next chart).

Vitaliy Katsenelson

In all honesty, I could make the same presentation today as I did five years ago (in fact I borrowed and updated a few slides from that presentation – see next chart). Market valuation is not dramatically different now from what it was then. A cyclical bear and a cyclical bull market later, the S&P 500 is still at the same 18 times trailing earnings and 26 times 10-year trailing P/E, or 41% above average. (It was 60% above average in 2008.)

Vitaliy Katsenelson

(See footnote at end for a detailed explanation of the above chart.)

Investors who were on the sidelines over the last few years and who are now pouring money into stocks, expecting that we are in the midst of a secular bull market, will likely be disappointed

The previous sideways market of 1966-1982 had four cyclical bull markets and five cyclical bear markets packed inside it. From 1970 to 1973 the Dow went from 700 to 1,000, just to drop again, this time to 600. Four times, investors thought that a cyclical bull market had turned into a secular (long-term, 1982-1999 type of ) bull market, but their hopes were dashed as they discovered that these were just head fakes toward the next cyclical bear market (see next chart).

Vitaliy Katsenelson

It is when nobody wants to own stocks ever again, when valuations are below their historical average, that a secular sideways market finally dies (actually more like goes into hibernation) and the next secular bull market is born.

View the original article here