I started writing my first book, Active Value Investing: Making Money in Range-Bound Markets, in 2005 and finished it in 2007. I 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 was a very high probability that we were 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 the 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 enjoyed during secular bull markets.
In 1999, after 17 years of incredible returns, the mother of all secular bull markets ended with valuations we’d never seen before. For this reason, in my first book I argued that the sideways market that started then might last longer than past ones. In the Little Book I went a step farther with the benefit of hindsight – it was written post-Great Recession. I argued that the economic growth rate going forward would be lower than it was in the past, and thus this sideways market might last even longer than I originally suspected.
Both books provided a framework for how to think about paths that might lie in our future.
Fast-forward a decade. The market we’ve been in was anything but sideways. Was I wrong? Yes.
What I failed to see was how the Great Financial Crisis would change the role the Fed would play in our economy, that it would continue to buy our debt while the economy was expanding. Also, I was blindsided by our government’s changed attitude toward debt (the US debt-to-GDP was at 60% in 2005, at 100% in 2019, and is 130% today). Most importantly, if you had told me that as that our debt pile was growing our interest rates would decline to near zero, I wouldn’t have believed you.
This brings me to today.
In modern stock market history, since the 1890s, we’ve entered into sideways markets when market valuations were very high (check!) at the end of a long-lasting (secular) bull market (maybe; we’ll only know in hindsight, but it’s hard to deny that we’ve had one hell of a run). Price to earnings, not earnings growth, was the largest source of stock market appreciation (check! Stocks are making new highs because of the pandemic and the budget deficits. Think about that.) There was a lot of euphoria about stocks as they became a national pastime (check! Though now they are sharing the spotlight with crypto.)
As euphoria deflates, valuations stop expanding. Investors become disillusioned, bored with stocks. Price to earnings stagnates and then goes into a long-term compression cycle, from above average, through average, to below average. (It then spends plenty of time below average, turning investors away from stocks). Any gains you get from earnings growth are offset by price-to-earnings compression.
Today, stock market valuations are at an all-time high. Rising interest rates and inflation may serve as chilling factors to price-to-earning expansion; after all, declining interest rates were instigators of the price-to-earnings expansion on the way up.
I’ve written two books on this topic and don’t have a burning desire to write another one here; however, here are our Active Value Investment Principles (straight from my books):
- Be an active value investor. Traditional buy-and-forget-to-sell investing is not dead but is in a coma waiting for the next secular bull market to return – and it’s still far, far away. Sell discipline needs to be kicked into higher gear.
- Increase margin of safety. Value investors seek a margin of safety by buying stocks at a significant discount to protect them from overestimating the “E.” In this environment that margin needs to be even more beefed up to account for the impact of constantly declining P/Es.
- Don’t fall into the relative valuation trap. Many stocks will appear cheap based on historical valuations, but past bull market valuations will not be helpful again for a long time. (I cannot stress this point enough.)
- Don’t time the market. Though market timing is alluring, it is very difficult to do well. Instead, value individual stocks, buying them when they are cheap and selling them when they become fairly valued.
- Don’t be afraid of cash. Secular bull markets taught investors not to hold cash, as the opportunity cost of doing so was very high. The opportunity cost of cash is a lot lower during a sideways market. And staying fully invested will force you to own stocks of marginal quality or ones that don’t meet your heightened margin of safety.
- Invest globally. “The larger the pool of stocks you can choose from, the higher the bar – the opportunity cost – that a new stock has to overcome to make it into the portfolio.”