Conditions are ripe for a secular sideways market — a market that moves 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, stock prices become extreme — valuations (P/Es) get highly stretched. Sideways markets are a payback for all the fun and returns stock investors enjoyed during secular bull markets.
In modern stock market history, since the 1890s, we’ve entered into sideways markets when market valuations were 1) 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). 2) 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.) 3) There was a lot of euphoria about stocks as they became a national pastime (Check! Though now stocks 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.
To navigate such conditions, here are six active value investing principles (taken straight from my books on the subject):
- 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. Your 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 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.
Vitaliy Katsenelson is CEO and chief investment officer of Investment Management Associates. He is the author of Active Value Investing: Making Money in Range-Bound Markets, and The Little Book of Sideways Markets.