Nature abhors a vacuum, but she must love cycles. Stand at the shore and watch the waves. Each has its own inflection, duration, intensity, but the process that generates waves is relentlessly repetitive. Individual waves combine in groups that surfers call “sets” and these change location and intensity with the global wave that makes the tides.
Markets are defined by a variety of cycles of differing duration that overlap, diverge and converge to create broad moves identified as “bull” or “bear”. At this writing (mid-February 2011) the S&P 500 has risen 100% from its ‘09 bottom, yet the patient investor who bought this index ten years ago has been rewarded with a return less than 2%. Between 1982 and 2000 that same patience would have been rewarded with 18% average annual returns for almost two decades. What defines the difference between these two cycles? Part of the difference lies in general economic conditions – growth rates and employment – but not nearly enough to explain the divergence in returns. A technological catalyst helps – the PC and Internet revolutions of the ’82 to ’00 bull market improved the productivity of virtually every job in our economy. But by far the greatest impact comes from valuations. A strong, sustainable bull market needs low but expanding earnings multiples as a starting point. In 1982 the price earnings multiple of the S&P 500 was hovering around 7. In other words investors were paying about $7 for every $1 of annual earnings. By the peak of the dot-com bubble investors were paying six times as much for an identical dollar of earnings. Expanding valuations are the rocket fuel that turns expanding earnings into a major bull run. A sideways market, like the one we have experienced for the last ten years is characterized by expanding earnings that are offset by a flat or falling valuation of those earnings. Over
the last ten years Wal-Mart’s earnings tripled from $1.25 per share to $3.42, but its valuation – its P/E – has declined from 45 to 14. The end result? The stock has only appreciated by 7.5% in ten years, with plenty of excitement (volatility) in the meantime.
Another factor that both describes and motivates the cyclical moves of markets is “mean reversion” or the tendency displayed by market measures to reverse once they reach extremes. An extreme multiple of 40 times earnings will eventually revert in the direction of an average of 15 times earnings if it is not supported by extraordinary growth. Simplistically, “what goes up must come down.” But there is more at play than statistical distributions. On both sides of each trade that makes up a market are human beings, and a lot of computers programmed by humans to anticipate human behavior. So rather than simply returning to a historic average, markets consistently overshoot in both directions. Fear and greed, exacerbated by a frantic 24/7 financial media, ensure that markets spend little time at a level that approximates fair value and a lot of time swinging and missing.
So where are we now? Still in the middle of a sideways market capable of moves that halve or double its values over a period of less than two years. What would cause a break to a new, extended bull market? Either a washout event that takes us back to compelling valuations (no fun), or a technological development that changes productive capacities over a broad number of industries (great fun), or the former, followed by the latter. Breakthrough events are very difficult to anticipate but areas ripe for transformative developments include energy, biomedicine and cloud computing.
What are the best strategies for a sideways market? First, don’t let me or anyone else talk you out of participating in a healthy rally. Second, remember that a story is a story, but the true value of an enterprise is the present value of a recurring stream of income. In a frothy market some of the best values belong to boring names that happen to represent global brands, strong balance sheets and real cash flow. Third, don’t undervalue a real, reliable source of income, whether it is in the form of dividends, tax-exempt interest, rent, or your job. Fourth, dollar-cost averaging and periodic rebalancing can deliver results that market timing can only hope for. Fifth, holding on to what you’ve earned ought to be a part of every investment strategy regardless of market conditions.
Thank you for your support and best wishes for a successful 2011.
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