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Q&A with FT:Investing in Range-Bound Markets

December 06, 2009
In the bull market that preceded the collapse of Lehman Brothers and the ensuing financial crisis, equity valuations reached some very frothy levels.

The correction that followed only lasted until March, since when, the S&P 500 index has risen more than 60 per cent, while the FTSE Eurofirst 300 has gained a similar amount.

Vitaliy Katsenelson , fund manager at Investment Management Associates in Denver, Colorado, believes that even in spite of the post-Lehman Brothers correction, equity markets have been in a secular rangebound phase since 2000. He is also author of the bookActive Value Investing: Making money in range-bound markets.

Vitaliy answers readers’ questions about these views, which he first outlines in a little more detail, and the best ways of investing in such a trading environment on Monday are appearing below now.

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Vitaliy Katsenelson : Before I answer questions related to range-bound markets, let me lay out my thesis for secular (long-term, longer than five years) market cycles.

Ask an investor what the stock market will do over the next decade, and he’ll tell you what his expectations for the economy and earnings growth are, and that will turn into his projection for the market. However, this kind of thinking looks at half of the equation that explains stock market (and individual stock) returns, while completely ignoring a very important variable that is responsible for a significant part of stock returns: valuation.

Mathematically, stock prices in the long run (not minutes or days, but years) are driven by two factors: earnings growth and (it’s a very important and) changes in valuation (Price/Earnings, or P/E ratios). Once you add a return from dividends, you’ve captured all the variables responsible for total return from stocks.

During the last two centuries, every time we had a long-lasting bull market the market that followed was not a bear but a range-bound, sideways market. (The only notable exception was the decline during the Great Depression.) This happened not because of some hidden, embedded magical pattern; no, there is no practical joke being played on gullible humans, it happens because our emotions get the best of us. Yes, emotions! Secular bull markets started at low, below-average P/Es. A combination of earnings growth and P/E expansion (which in this case is just a plain simple reversion towards the mean) brings spectacular returns to now jubilant investors. Then the investors get overexcited about stocks during the secular bull and drive stock valuations (P/Es) to above-average levels.

The P/E expansion is a powerful tailwind, a significant source of the returns during secular bull markets, but high P/Es can create a headwinds when they start to fall, curtailing returns during secular range-bound markets. As P/Es stop expanding at the very late stages of a secular bull market, investors who were accustomed to above-average returns grow less than thrilled with lower rates of return. The higher the P/Es the more difficult it is for stocks to continue to climb, as earnings growth alone cannot keep the secular bull market going. Returns from stocks decelerate to below the levels investors have learned to expect, and investors gradually migrate from stocks to other asset classes.

Welcome to a range-bound market!

Emotions now shift into reverse. P/E compression is like gravity pulling stocks down, where earnings growth is the force that counteracts its effects. All the benefits from earnings growth are gradually offset by constant P/E compression (the staple of range-bound markets). P/Es mean-revert from above, through average to below-average levels. Stocks go nowhere for a long, long time in the process.

I discuss this topic in great detail with plenty of charts and tables on my Contrarian Edge website.

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Range-bound markets are going sideways. This implies a pretty equal balance of buying and selling. Can you summarise your current view of medium-term factors that might cause global equity markets to break down or break up? Your comments on any specific markets (e.g., US, Europe, emerging markets) would be appreciated.

Alan Hinkley, London

VK:

Dear Alan,

What would cause the US equity markets to break down: In the US, economic performance has not been significantly different during range-bound and bull markets. That is, as long it was not far from its average state we had either range-bound or bull markets. However, when you coupled high (above-average) valuations with long-term economic contraction, you had a secular bear market on your hands. This is exactly what took place during the Great Depression (and has taken place in Japan from the late 1980s until today).

In secular bear markets, economic growth is not there to offset a price/earnings (P/E) mean reversion; in fact declining earnings add fuel to the fire and supersize the decline in P/E and thus causing stock prices to slide over a protracted period of time.

In the last (1982-2000) secular bull market P/Es reached their highest level ever! Today, nine years into a range-bound market, US stocks are still at above-average valuations. If over a few years the US economy doesn’t achieve positive nominal earnings growth, we may slide into a secular bear market.

What would cause the US equity markets to break up: The US Fed is throwing an enormous amount of liquidity into the economy. The Fed has very few tools to deal with deflation (you can make borrowing virtually costless, but borrowers may still not choose to borrow or to spend). The Fed is much better equipped to fight inflation: it can make money very expensive, and expensive money curbs spending. Thus historically the Fed was willing to err on the side on inflation – be it in consumer prices, housing, commodities, or the stock market (“Bubbles-R-Us”). (In fact, in part we are paying today for the Fed’s handling of the 2001 recession: Alan Greenspan took interest rates to a very low level and kept them there for too long, starting a bubble in real estate.)

Current Fed actions may have the unintended consequence of promoting another bubble, in stocks. I believe it will be harder to achieve this on such a broad basis, since the more you stimulate the less effective stimulus becomes, over time; but I can see how a few sectors may (and already have) bubbled up.

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Your book puts a 16- or 17-year length on secular bull markets, and differentiates between what some call subsequent bear markets, while you identify longer-term, range-bound valuations. Could you explain how you identified the differences between the two, and whether you think your observations will continue to play out in the future?

Ian Maitland, London

and

Do you think markets will always conform to the patterns you describe?

James Flannery, Leeds

VK: Dear Ian and James,

Ian, I already answered a part of your question above, so I’ll answer the second part here.

Will my observations continue to play out in the future?

In my book Active Value Investing: Making Money in Range-Bound Markets (Wiley, 2007), I inadvertently created a framework that should help one to understand the mechanism behind stock market cycles. As things change over time one thing remains the same: as humans we’ll have emotions, emotions will make us overexcited about stocks, and this will drive stocks to above-average level, thereupon giving us cause to be underexcited (I think I just made up a new word), which will result in treacherous periods of range-bound markets.

If it were not for our emotions, stocks would always hew very close to their value levels (a P/E of 15) and we’d not have secular market cycles. I am oversimplifying; but if it were not for emotions, returns from stocks during short, intermediate, and long-term periods would be identical to their earnings growth.

Human emotions don’t let valuations (P/Es) remain in their average state of 15, and so valuations are driven to extremes, on both sides of the mean. Thus returns from stocks over short (a year) and intermediate terms (5, 10, 15 years) may have a significant disconnect from their earnings growth. And the disconnect between earnings growth and stock market returns may persist for decades, or even longer.

Over, say, thirty years in the US (it takes that long for bull and range-bound markets to cancel out each other), returns from stocks will be in line with economic growth.

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When talking about trading ranges, technical analysis of the charts seems a necessary tool to gauge cycle frequency or possible breakouts from the implied ranges. What are the key indicators that you follow to gauge such factors?

Luke Levine, London

VK: Dear Luke,

About a month after the book came out I regretted its subtitle, “Making money in range-bound markets”. People assume that I know what the range is, and the name also implies that I use technical analysis to conquer this market. “Sideways markets” would have been a more accurate description, but what’s done is done.

Secular market cycles are full of many cyclical bull and bear markets; in fact the last range-bound market, which started in 1966 and ended 1982, had five cyclical-bull and five cyclical-bear markets. It is impossible to make short-term market timing into a process, as you have to get two things right: the short-term economic numbers and the market’s response to them, which in many cases may be irrational.

What I propose in the book (and practice in life) is active value investing. Instead of being a market timer, I’m a buy-and-sell investor, with a focus on valuing individual stocks.

Find stocks that lie within your circle of competence, analyze them as to whether they meet your qualitative criteria (such as competitive advantage, strong balance sheet, high return on capital, shareholder-friendly management. etc.), value them, determine an appropriate margin of safety (discount to fair value, which should be increased in range-bound markets), and you’ll thereby arrive at a price at which you’d want to buy them.

If a stock trades at or below your buy price, buy it; if not, put it on your watch list. When the stock reaches your fair-value level, you don’t hold it, you sell it. Repeat this process over and over again.

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The dollar’s decline since March obviously has given rise to the great carry trade that is reflected in equities and other risky assets. From a purely trading perspective, what indicators would tell us that a dollar rebound is around the corner and thus give the opportunity to play the equity market’s slide?

Nandan, London

VK: Dear Nandan,

It is hard for me to answer your question from the trader’s perspective, as I am not one.

Though problems in the US are well-known, I am not a long-term dollar bear (though, as a hedge, we do own some stocks that would benefit if the dollar continued to decline).

Whenever you are dealing with currencies, you need to ask “against what?”

What currency will the dollar fall or gain against?:

The Japanese yen? Japan has its own, more immediate crisis: its economy has been in recession since the late 1980s, it has one of the oldest populations in the developed world, and its savings rate has declined greatly and is still falling. Japan has been trapped in a zero-interest policy that it may not be able to sustain for much longer. Its debt-to-gross domestic product is second only to Zimbabwe’s, and even a small increase in interest rates will put a significant pressure on its budget. So the yen is not it.

The euro? The euro blankets a collection of 20+ countries with very different interests. As John Mauldin put it, and I agree, the euro was created for prosperity, not adversity. Europe has its own demographic issues, high unemployment, etc. So I am not betting on the euro against the dollar, either.

The Chinese renminbi? The People’s Republic of China is neither the people’s nor is it a republic. Despite its economic progress, China is still a communist country with a totalitarian regime with limited human and property rights. The Chinese government made the choice of growth at any cost even if projects don’t (or barely) cover the return on capital. And also at the cost of undermining purchasing power of its people by manipulating its currency, keeping it significantly undervalued. In addition, and I’ve written a lot about it, significant Chinese economic problems will likely surface down the road.

Though this is slightly off subject, lately I’ve been hearing chatter of “nominating” the Chinese currency to reserve currency status. This is unlikely to happen for the reasons I’ve just mentioned, and also it goes against the Chinese business model. As long as the Chinese model is to be a low-cost producer and exporter to the world, reserve-currency status is off the table. If the rest of the world decides to park their money in the Chinese currency, it will drive the renminbi up and decapitate China’s export industry.

Maybe the Russian ruble? Unfortunately, Russia is a bit of a one-trick petrochemical pony. The natural resources of Russia are more of a curse than a blessing as they detract capital from non-commodity industries and don’t let them develop.

I understand that what’s happening in the US isn’t good for the dollar, but I’m not sure the rest of the world is in a much better position.

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What about emerging markets? Surely there is no restrictive trading range likely to hold back the likes of China and Brazil, and also, possibly, India? Will we see a lot of money moving into these markets; is that likely to be the main investment story of the next century?

Jonathan Davey, Greenwich

VK: Dear Jonathan,

The secular market framework is portable to any market. Growth rates and persistence of growth may between emerging and developed markets, and thus cycles may have different lengths; but the principles I describe in my book should still apply. Human emotions are universal.

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Vitaliy, Do you have a preferred way to use put and call options in this kind of unpredictable market environment?

Edward Dinovo, unknown

VK: Dear Edward,

Options strategy could add value to one’s portfolio in range-bound or any other markets if used opportunistically. The options strategy must evolve along with market dynamics and the price of volatility. For instance, covered call strategy (selling calls against the stock you own) only makes sense if you get paid enough for the call and aren’t forced to hold on too long to an overvalued stock. In the right conditions options could be used as a terrific hedge and amplifier of one’s conviction.

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You wrote recently about the economy being like an athlete on steroids, arguing that its performance is so dependent on special stimulus measures as to be unsustainable. When do you think the ”drugs” will start to be withdrawn by central banks, and how far do you think asset prices will fall? What can investors best do to prepare for the danger?

Andrew Cowell, Derby

VK: Dear Andrew,

The Fed and politicians will likely err on the side of overstimulating the economy, as the career risk for taking the economy back into recession through constrictive monetary policy is too great. To answer the second part of your question, this presentation I address how our company has positioned for today’s steroided economy. (see slides 9-11)

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The once-overvalued US housing market is at the root of the recent crisis. Do you think it is still overvalued, and if not, is there money to be made within it? Surely, although I agree with you about other markets, no one can claim US house prices have been range-bound. How long ’til there is a correction that gives us direction for other assets?

Ian Jameson, Glasgow

VK: Dear Ian,

Robert Shiller knows the housing market better than I do, and he believes it is slightly overvalued.

However, even if the housing market were fairly valued, which is possible, the question I’d want to know the answer to would be, Do housing prices have to come back from significant overvaluation and then stop at fair value? Most financial assets don’t. My guess is that the housing market is no different.

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How useful are the parallels between the relatively new, low-interest-rate economies of the West and the ”lost decade” seen in Japan throughout the 1990s?

Dennis Anderson, London

VK: Dear Dennis,

Actually, Japan has lost closer to two decades, as it problems started in the late 1980s. Here is what I wrote about Japan last week:

“Japan was on the stimulus bandwagon for more than a decade; and with the exception of government debt-to-GDP tripling, Japan has nothing to show for it – the economy is mired in the same rut it was in when the stimulus marathon started. It had a hard time giving up stimulus because the short-term consequences were too painful. Also, Japan is proof that a low (zero) interest-rate policy loses its stimulating ability over time and turns into a death trap for the economy as leverage ratios are geared to low interest rates. Now, even a small increase in interest rates (say, from 1% to 2%) would be devastating for Japan’s economy.”

The US is not Japan: our housing and stock market overvaluations were not as extreme; our corporations are in much better shape (though consumers are in worse shape); we are not xenophobic, thus our population is growing through immigration; we don’t have a significant cultural issue of “saving face” to overcome; thus, although we don’t let bankrupt companies go bankrupt to the degree we should – at least not since Lehman –creative destruction is allowed to exist to a far greater degree here than it was in Japan.

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When did you first become uneasy about credit derivatives? Will there ever be a time at which you think similar products could become attractive? Are you always suspicious that the kind of explosive growth we saw earlier this decade can never really break us out of this long-term trading range you describe? Surely the volatility within the boom-bust cycle can make the savvy investor a lot of profit?

Derek Cartwright, Yorkshire

VK: Dear Derek,

Since Warren Buffett called them “weapons of mass destruction”, in the back of my mind I have thought credit derivatives might be a black swan in the making, just due to their sheer size; but I have little direct interaction with that market and thus have little insight as to what is taking place there.

What I’ve learned from my earlier mistakes – luckily before we went into this crisis– is to stick to stocks I can analyze. For instance, in early 2008 I looked at AIG stock. It appeared incredibly cheap based on reported earnings. But when I started reading the 10k I found a $40-billion entry on the balance sheet that was labeled “other”. I turned to the footnotes and there was little disclosure. I called the company. I inquired as to what “other” was, and they said it was “other”. I put AIG in the unanalyzable category and moved on.

If you think about large financial institutions like AIG, Bank of America, Citigroup, JPMorgan, Goldman Sachs, and even GE with its huge financial arm, they are , I think, unanalyzable. In fact they are more like highly leveraged hedge funds and, as with hot dogs, you don’t really know what goes into them. If you cannot analyze them, you cannot assess their risk, thus you cannot value them; and so if you own them you are not much different from a speculator. There are lots of analyzable stocks out there; I don’t have to own hot dogs.

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Even assuming that one has the correct valuation interval for equity, it is difficult to gauge the timing of convergence of the market price to the perceived fair value. The convergence is most likely contingent on how often the stock is covered in the news, analyst coverage, whether institutional investors like it, etc. Therefore it would appear that one needs to complement fundamental valuation with technical analysis that provides entry and exit points. Besides value, what other indicators are you taking into account? How do you incorporate breadth and depth into the analysis? If the market is range-bound, why not just have a covered call strategy?

Gabriela Soppelsa, New York – NY

Dear Gabriela,

An investor makes makes money from stock appreciation and dividends. Stock appreciation is driven by P/E expansion and earnings/cash flows growth. If you see an apparent catalyst (news or event) that will force P/E to go up – great!

But in my experience I found that it is the apparent absence of a catalyst that creates an undervaluation. Wall Street is fairly short-term oriented, therefore if the stock is undervalued but there is no reason or a catalyst to help it go up in the next quarter or two, it gets dumped.

Here is what I propose. Buy stocks that grow earnings and pay dividends, this will put time on your side – you are getting paid to wait.

Earnings growth is compressing P/E under the stock and dividends are a real time payment for your patience. If a company doesn’t grow earnings and pays little dividend, make sure undervaluation (potential P/E expansion) is significant, or there is a clear catalyst, as time is not on your side in this case.

For instance, If you find a stock that is 20 per cent undervalued, there is no catalyst, no dividend or earnings growth it is probably not worth buying.

I answered your question about options in one of my previous answers.

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What key ratios (fundamental equity analysis) do you use to establish buy or sell signals in range bound markets of this nature?

Edwin Hill, Spokane, WA USA

VK: Dear Edwin,

For companies where earnings and free cash flows are about the same, I set target buy, hold, and sell P/Es. In all other cases I set price targets which I revisit a few times a year.

About the author:

Vitaliy Katsenelson

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email or read his articles click here.
Investment Management Associates Inc. is a value investing firm based in Denver, Colorado. Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy’s book Active Value Investing (Wiley, 2007).


Visit Vitaliy Katsenelson's Website


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