I
By vitaliy Katsenelson
Investing
Investing in range -Bound Markets
O
ver the last decade, the stock
market has earned the title of Lost
Decade. The next decade will
not be much different from the last: The
U.S. stock market will set record highs
and multi-year lows, but index investors
and buy-and-hold stock collectors will
find themselves not far from where they
started in 2000. We are in a Cowardly
Lion market, whose occasional bursts of
bravery are ultimately overrun by fear that
leads to a subsequent descent.
Every long-lasting bull market, except
one, over last two centuries (including
the supersized one from 1982 to 2000)
was followed by a range-bound market
that lasted about 15 years. The Great
Depression was the only exception.
Despite common perception, secular
markets spent a lot more time in bull or
range-bound phases, roughly half in each.
They only visited a bear cage on very rare
occasions.
Graph 1
22 Napfa advIsor aprIl 2010
This doesn’t happen because stock
market gods want to play a practical
joke on gullible humans, but because, as
the daily noise subsides, stock prices in
the long run are driven by two factors:
earnings growth (or decline) and price-
to-earnings expansion (or contraction).
Though economic fluctuations have
been responsible for short-term market
volatility, long-term market cycles were
either bull or range-bound if the economy
was growing close to the average rate (see
Graph 1).
This distinction between bear and
range-bound markets is seldom made,
but it’s extremely important. One should
invest very differently in each market—
more on this later.
Prolonged bull markets started
with below-average P/Es and ended
with above-average P/Es. This vibrant
combination of P/E expansion and
earnings growth (the latter of which
doesn’t have to be spectacular, just more
or less average), brings terrific returns to
jubilant investors. Range-bound markets
follow bull markets. As clean-up guys,
they rid us of the high P/Es caused by bull
markets, reverting them down towards and
actually below the mean. P/E compression
(a staple of range-bound markets) works
against any earnings growth that occurs,
resulting in zero or near-zero price
appreciation plus dividends. These results
come with plenty of cyclical volatility
along the way.
The 1982-2000 bull market ended at
the highest P/Es ever. Thus, it will take
longer than usual for earnings growth to
deflate them. Though continued economic
growth appears to be a wildly optimistic
assumption, given what is taking place
in the economy, it is not particularly
unrealistic to assume that we will see
nominal economic growth over the next
decade. The Fed and our government are
working very hard to achieve that, at any
cost.
Bear markets are range-bound
markets’ cousins; they share half of their
DNA in high starting valuations. However,
where in range-bound markets economic
growth helps to soften the blow caused
by P/E compression, during secular bear
markets the economy is not helping
either. Economic blues result in declining
earnings, which throw water on an already
dying fire (the compression of high
starting P/Es), and this combination brings
devastating results to investors.
A true, long-lasting bear market
has not really taken place in the U.S.,
but it did occur in Japan, where stocks
declined gradually, and not so gradually,
at times. Japanese stocks have fallen
over 80 percent from the late 1980s until
today. If the U.S. economy fails to stage
a comeback with at least some nominal
earnings growth over the next decade,
Continued on page 24
I
Investing
Continued from page 22
what started as a range-bound market in
2000 will turn into a bear market, given
the high valuations that are in place.
Let’s try to figure out the earnings
power of the S&P 500. The current 2010
estimates of its operating earnings are
$75. I am skeptical of this number for
several reasons.
First, it is nearly double the reported
2010 earnings estimates of $45. The
percentage difference between reported
and operating numbers is the second-
highest since 1988 (2008 holds the
record). During the 2001-2003 recession,
the difference was about 50 percent. “One-
time” write-offs are responsible for the
difference. It is very likely that these “one-
time” charges are not really “one-time”;
thus, operating estimates overstate the true
earnings power of the market.
Second, 2010 estimates are only
slightly below the all-time high earnings
the S&P achieved in 2007, when our
economy was under the influence of
several bubbles which severely inflated
corporate profit margins to unprecedented
levels. Also, the bulk of excesses in
margins in 2007 came from the financial,
materials, energy, and industrial sectors—
the ones that are struggling today and will
continue to do so for a long time.
24 Napfa Advisor April 2010
Finally, if earnings were to be as
projected, we’d be following the last
recession’s recovery path, which is unlikely.
The last recession was corporate, while
the current one is riddled with debt-laden
consumers. Deleveraging the excesses of
the housing bubble, in the face of higher
future taxation and likely higher interest
rates (both byproducts of large deficits),
will be a lengthy process. The recovery will
be slower, and real earnings growth will be
lower than in previous recessions.
It is hard to know the exact earnings
power of the S&P 500, but it likely lies
somewhere in between operating and
reported earnings estimates, and thus
closer to $60. This would put the P/E of
the S&P 500 today at about 19.
Since 1900, stocks have spent very
little time at what is known as a “fairly
valued” P/E of 15. In fact, they have spent
less than 27 percent of the time between P/
Es of 13 and 17. They only saw a P/E of
15 when they went from one extreme to
another. Most importantly, they’ve never
stopped at the average and gone the other
direction; they’ve continued their journey
to the other extreme.
During secular bull markets,
investor optimism, bundled with constant
reinforcement from rising prices, takes
stocks to above-average valuations,
causing P/Es to expand beyond their
long-term average. P/Es can shoot for
the stars, but they don’t get there—at the
late stages of the secular bull market,
P/Es stop expanding. As earnings growth
becomes the sole source of returns,
disappointed investors start diversifying
away from stocks into other asset classes,
and a range-bound market ensues. As the
range-bound market marches on, unmet
expectations reinforce disappointment in
stocks, and P/Es are compressed to the
other extreme. Keeping this in mind, note
that stocks are still not cheap, and thus
range-bound markets still lie ahead of us.
Interest rates and inflation are
secondary to psychological drivers, but
they’re still important. They don’t cause
the cycles, but they do help to shape their
duration and the valuation extremes that
stocks achieve. For instance, if, at the end
of the 1966-1982 range-bound market,
interest rates and inflation had not been
in the mid-teens, the range-bound market
would have ended sooner, at higher P/Es.
On the other hand, if, in the late-1990s,
interest rates and inflation had not been
scraping low single-digits, 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 final P/E of this market
as well.
What Investors Should Do
In range-bound markets, as P/Es
compress, they turn against investors. In
this difficult environment, investment
strategy needs to be adjusted for the new
investment reality. Here are things that
investors can do:
• Become an active value investor.
Traditional buy-and-forget-to-sell (hold)
strategy is not dead, but it’s in a coma,
waiting for the next secular bull market
to return, and it’s still far, far away. Sell
is not just another four-letter word; sell
discipline needs to be kicked into higher
gear.
• Increase your margin of safety.
Typically, value investors seek protection
from overestimating the “E,” earnings. In
this environment, protection needs to be
Mean Reversion
I Investing
beefed up to accommodate the impact of
constantly declining P/Es.
• Don’t fall into the relative-
valuation trap. Many stocks will appear
cheap based on past valuations, but
past secular bull market valuations
will not be in vogue for a long time.
Thus, absolute-valuation tools such as
discounted cash-flow analysis should
carry more weight.
• Though timing the market is
alluring, don’t try it. Market timing is
very difficult to do consistently. Value
individual stocks instead. Buy them
when they are undervalued, and sell
them when they become fairly valued.
• Increased margin of safety and
stricter selling discipline will lead
investors to have a higher cash position
at times. Don’t invest for the sake of
being invested, because this will force
you to own stocks of marginal quality or
stocks that don’t meet your heightened
required margin of safety. Secular
bull markets taught investors not to
hold cash, as the opportunity cost of
doing so was very high. However, the
opportunity cost of cash is a lot lower
during a range-bound market.
And what if a range-bound market
isn’t in the cards? If a bull market develops,
active value investing should do at least as
well as buy-and-hold investing or passive
indexing. In the case of a bear market, your
portfolio should decline a lot less.

Vitaliy Katsenelson is a director of

research/portfolio manager at Investment
Management Associates, Inc., a value
investment firm based in Denver. He is
the author of Active Value Investing:
Making Money in Range-Bound Markets,
published by Wiley & Sons. His insights
on value investing, as well as on investing
in China, Russia, and Japan, are regularly
featured in major business and investor
publications. For more information, go to
contrarianedge.com.  

APril 2010 Napfa Advisor 25