Vitaliy Katsenelson, our CIO, has laid out his thesis on sideways markets in two books, Active Value Investing (Wiley, 2007) and The Little Book of Sideways Markets (Wiley, 2010). This article, published in the November 2010 issue of Institutional Investor magazine, also gives a general overview of the sideways market thesis.
Every long-lasting bull market of the past two centuries was followed by a sideways market that lasted about 15 years. The Great Depression was the only exception.
Despite common perception, secular markets spend a lot of time in bull or sideways phases, and roughly an equal amount in each.
Stock prices are driven in the long run by two factors: earnings growth (or decline) and price-earnings expansion (or contraction).
Though economic fluctuations are responsible for short-term market volatility, long-term market cycles are either bull or sideways if the economy is growing at a close to average rate.
Prolonged bull markets start with below-average P/Es and end with above-average ones.
Sideways markets follow bull markets. They rid us of the high P/Es caused by the bulls, taking them down to and actually below the mean.
Bear markets begin at high starting valuations. But whereas in sideways markets economic growth softens the blow caused by P/E compression, during secular bear markets the economy is not there to help.
P/E compression — a staple of sideways markets — and earnings growth work against each other, resulting in zero (or near-zero) price appreciation plus dividends.
Become 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 your 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. Absolute valuation tools such as discounted cash flow analysis should carry more weight.
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.
What if a sideways market isn’t in the cards? If a bull market develops, active value investing should do at least as well as buy-and-hold strategies or passive indexing. In the case of a bear market, your portfolio should decline a lot less.