Wednesday, February 9, 2011

John Mauldin's Outside the Box: A Sideways View of the World - by Vitaliy Katsenelson

Most of the time common stocks are subject to irrational and excessive price fluctuations in both directions as the consequence of the ingrained tendency of most people to speculate or gamble . . . to give way to hope, fear and greed.

–Benjamin Graham

As the saying goes, the more things change the more they remain the same. Whether a trade is submitted by telegram, as was done at the turn of the twentieth century, or through the screen of an online broker, as is the case today, it still has a human originating it. And all humans come with standard emotional equipment that is, to some degree, predictable. Over the years we've become more educated, with access to fancier, faster, and better financial tools. A myriad of information is accessible at our fingertips, with speed and abundance that just a decade ago was available to only a privileged few.

Despite all that, we are no less human than we were 10, 50, or 100 years ago. We behave like humans, no matter how sophisticated we become. Unless we completely delegate all our investment decision making to computers, markets will still be impacted by human emotions.

The following example highlights the psychology of bull and cowardly lion markets:

During a bull market stock prices go up because earnings grow and P/Es rise. So in the absence of P/E change, stocks would go up by, let's say, 5 percent a year due to earnings growth. But remember, in the beginning stages of a bull market P/Es are depressed, thus the first phase of P/E increase is normalization, a journey towards the mean; and as P/Es rise they juice up stock returns by, we'll say, 7 percent a year. So stocks prices go up 12 percent (5 percent due to earnings growth and 7 percent due to P/E increase), and that is without counting returns from dividends. After a while investors become accustomed to their stocks rising 12 percent a year. At some point, though, the P/E crosses the mean mark, and the second phase kicks in: the P/E heads towards the stars. A new paradigm is born: 12-percent price appreciation is the "new average," and the phrase "this time is different" is heard across the land.

Fifty or 100 years ago, "new average" returns were justified by the advancements of railroads, electricity, telephones, or efficient manufacturing. Investors mistakenly attributed high stock market returns that came from expanding P/Es to the economy, which despite all the advancements did not turn into a super - fast grower.

In the late 1990s, during the later stages of the 1982–2000 bull market, similar observations were made, except the names of the game changers were now just-in-time inventory, telecommunications, and the Internet. However, it is rarely different, and never different when P/E increase is the single source of the supersized returns. P/Es rose and went through the average (of 15) and far beyond. Everybody had to own stocks. Expectations were that the "new average" would persist – 12 percent a year became your birthright rate of return.

P/Es can shoot for the stars, but they never reach them. In the late stage of a secular bull market P/Es stop rising. Investors receive "only" a return of 5 percent from earnings growth – and they are disappointed. The love affair with stocks is not over, but they start diversifying into other asset classes that recently provided better returns (real estate, bonds, commodities, gold, etc.).

Suddenly, stocks are not rising 12 percent a year, not even 5 percent, but closer to zero – P/E decline is wiping out any benefits from earnings growth of 5 percent and the "lost decade" (or two) of a sideways market has begun.


Related books:

The Little Book of Sideways Markets

Unexpected Returns

Probable Outcomes