"Welcome to another lost decade"

Vitaliy Katsenelson recapitulates his secular range-bound market thesis on GuruFocus today ("Welcome to another Lost Decade"), this time with a slight twist: he thinks a 1990-? Japan-style bear market is also a possibility going forward. As I noted in the comments there, Katsenelson's diagnosis makes sense, but his prescription ("active value investing") seems limited:

why rely on any form of long-only investing -- even his active value investing -- if we are in for possibly another decade like the last one? How did long-only value investing fare in 2000-2002 or 2007-2008? How will it fare when the current cyclical bull rally inevitably leads to another cyclical bear correction?

Katsenelson's Secular Range-Bound Market Thesis Updated

Below is a presentation of Vitaliy Katsenelson's secular range-bound market thesis, updated as of this month (longtime readers may recall I linked to an earlier version of this last year). It's worth taking a few minutes to scroll through this. I think Katsenelson is right in his diagnosis, and his prescriptions (slide 29) seem reasonable, for the most part, but for me the raise a question: why be net long at all, if we are in a secular bear or range-bound market? Why not be market-neutral¹ or even net short?

Avi Presentation

¹I'm adding this footnote on 12/30/09. After I wrote the post above, I found a professional investor who had the same idea ten years ago, and has produced some impressive returns since then: Marc Mayor of Inside ALPHA. I found out about Mayor when he joined Short Screen as a premium member earlier this month.

Mark Hulbert Whistles Past the Graveyard

In his column in yesterday's New York Times business section (Strategies: "The Road Back from the '29 Crash Wasn't So Long After All"), Hulbert writes that, although the Dow didn't match its 1929 peak until 1954, investors who bought and held the Dow at its 1929 peak would have been made whole in real terms four and a half years later, thanks to double digit deflation and double digit dividend yields. Of course, today we have a fiat currency and a Federal Reserve committed to fighting deflation, and dividend yields on Dow stocks average in the low single digits, so Hulbert's example doesn't seem terribly apposite.

Stocks for the (Very) Long Run

From John Authers's column in today's Financial Times ("Long View: Why baby boomers will put their faith in bonds"):

US stocks have now underperformed Treasury bonds since 1969. Very few savers actively putting money away today started much before 1969. Most of them did so during a period when the cult of the equity held sway. For this whole generation, that belief in equities has proved badly misplaced. Various long-term surveys show that there have been very long periods of underperformance by equities in the past.

But we can say that the current sell-off is almost without precedent for its speed. [Research Affiliates' Rob] Arnott’s figures show that as Wall Street opened on Friday it was already dealing with the second biggest six-month decline in its history. The only bigger six-month drop was barely larger, at 51 per cent, at the end of the crash of 1932.

The good news is that 1932 marked the bottom of the great bear market of the 1930s, and that stocks rallied more than 100 per cent in a matter of weeks.

The bad news is that there were still 22 years to go before stocks regained their highs in nominal terms, and 26 years before they regained their highs in real terms, an event that did not happen until 1958.

[...]

All of this could shatter our confidence in stocks as the vehicle for the long run. While the evidence is still unequivocal that they do perform best over the very long term, the periods may be so long that they do not help some people during their lifetimes.

A couple of thoughts on this:

1) The shattering of confidence Authers mentions above, and the associated revulsion toward stocks, explains the multiple compression that Vitaliy Katsenelson wrote occurs during secular range-bound (or bear) markets (see his graphic above, or this post for elaboration on Katsenelson's thesis).

2) This column wouldn't have been a revelation to Benjamin Graham. Unlike the advocates of buy & hold indexing in recent years, Graham was well aware that stocks, broadly speaking, could under-perform for painfully long periods. Graham wrote this on p.12 of the third edition of his Security Analysis, which was published in 1951:

"Prior to 1929, one could say with some logic that the course of common stock prices appeared to be so determinedly upward that the intending holder of high-grade stocks for investment could afford to buy them at any time and to ignore their fluctuations. In the past 20 years there is no longer any clear-cut evidence of an underlying and persistent upward trend in common stocks taken as a whole."

Hence, Graham focused on investment strategies that didn't rely on a secular bull market lifting most stocks¹. Incidentally, he didn't know it when he wrote the quote above, but a new secular bull market had already begun when the third edition of Security Analysis was published -- one that would continue for about another 15 years.

The graphic above is from Katsenelson's website.

¹Worth remembering though that even Graham took a beating during the Great Crash: According to James Grant, in his introduction to the latest edition of Security Analysis, Graham lost 70% of his money (The Dow dropped 89.5% over the same 1929-1932 period).

John Hussman from May 2007

From one of Dr. Hussman's weekly market commentaries in May, 2007, five months before the end of the cyclical bull market that began at the end of 2002 ("How Much Do Interest Rates Affect the Fair Value of Stocks?"):

In recent months, I've used a wide variety of analytical methods (discounted cash flows, normalized earnings, price/peak earnings calculations, etc) to show that stocks are currently priced to deliver unusually poor long-term returns – stated simply, the U.S. stock market is more overvalued than at any point in history except during the late 1990's bubble.

It's worth reading the rest of that column, for Dr. Hussman's skeptical take on the Fed Model, and the conventional wisdom about the relationship between interest rates and stock valuations.

"Market Downturn Shatters Faith in Stocks"

In a post a few months ago ("A Secular Range-Bound Market?"), we discussed Vitaliy Katsenelson's thesis that we are currently in a secular range-bound market¹ that started in 2000 that will likely continue for another ten years or so. The key driver of these secular range-bound markets, in Katsenelson's thesis, is multiple compression, driven by psychology: as investors give up on stocks, stocks gradually start trading at lower multiples. By the end of the last secular range-bound market in 1982, for example, the S&P 500 traded at 9x its trailing twelve months' earnings; at the end of the previous secular range-bound market, in 1950, the S&P traded at 7x its trailing earnings. An article in today's Los Angeles Times, "Market downturn shatters faith in stocks", gives some anecdotal examples of investors giving up on stocks:

Even now, the vast majority of investment advisors would strongly urge people not to give up on stocks, especially when most of the damage to their portfolios arguably has already been inflicted.

Most individual investors are sticking with that advice.

[...]

But for many, this time is different.

"What's really scaring investors today is whether this mega-meltdown will take 25 years to get back to even, like it did after the Great Depression," said Sam Stovall, chief investment strategist at Standard & Poor's.

The article goes on to quote a couple of boomer investors; the first quote is from a 55-year old accounting consultant named Don Abbee:

"I feel fairly helpless, and I don't know what I can do to change it," he said. "If you stay in the stock market long enough, it's supposed to come back up, but I'm becoming more skeptical. This market feels different."

Bill Orton, a 46-year-old political consultant, is going through a similar apostasy. His faith in the stock market, merely shaken by the tech crash, is now shattered, he said.

A stock fund he bought a few years ago has plunged in value, while U.S. savings bonds he picked up at the same time have been a rock of stability. Orton now declares himself finished with stocks.

"But I am feeling really good about those savings bonds," he said. "I like bonds."

When enough investors decide that they like bonds too, we'll probably see the average dividend yields on stocks rise until stocks become attractive to them. It's worth remembering that there have been times when the average dividend yield on stocks was higher than the average yield on corporate bonds.


¹Secular, Katsenelson's terminology, refers to trends that last for 5 years or longer; cyclical refers to trends that last for less than five years. So the current secular range-bound market has included the cyclical bear market from 2000-2002, the cyclical bull market from 2002-2007, and the current cyclical bear market.