The Little Book of Sideways Markets – Part 1: Sideways Markets

The Little Book of Sideways Markets

How to Make Money in Markets that Go Nowhere

By Vitaliy N. Katsenelson

I am planning to institute a regular feature on this site, whereby I will review one of the books I have recently read on the topic of value investing and then give you, the reader, a chance to win the book! This is the first in the series, and I would love to get your feedback, so please email me with your thoughts/questions and suggestions for future books. Stay tuned to learn how you can win this book!

We have all heard of bear markets and bull markets, but Vitaliy Katsenelson has found a third market type, the cowardly lion market which has occasional bursts of bravado but soon falls victim to fear. The result is a market characterized by secular range-bound or sideways movement. On average, these markets last seventeen years and exist in between secular bull markets, meaning that Katsenelson is saying that there have not been any true secular bear markets (with the possible exception of the Great Depression). The last secular sideways market was 1966 to 1982, and now we are in the midst of another that began around 2000.

The challenge for investors in these markets is that a “buy and hold” strategy simply does not work. The cyclical bull and bear markets give way to a net effect of very little or no movement (witness the performance of market indexers from 2000 to 2010 as evidence). During these sideways markets, long-term gains in earnings (as in, over an entire economic cycle) are offset by losses in the P/E multiple (multiple compression). Investors who have carefully chosen high quality companies with strong earnings growth are left disappointed that these companies end up trading at the same prices (or less) they bought them for, because multiple compression has been so severe (witness Wal-Mart’s earnings in 2000 and 2010 vs its stock price).

Importance of Dividends: The total return of a stock includes the net effect of earnings growth and changes in the P/E multiple, as well as the dividend yield. Throughout a bull market, dividend yield is approximately a quarter of the total investment gains, as both earnings and multiples are increasing quickly (since these markets occur during economic upswings which contribute to Mr. Market being overexcited enough to allow multiple expansion). However, in a sideways market, Katsenelson’s analysis shows that dividend yield is extremely important, contributing 90% of returns. Katsenelson also found that sideways markets tend to end when dividend yields approach 5 – 6% – today they are just 2%, the combined result of valuation and low payouts.

Value Investing in a Nutshell: Katsenelson introduces the character of Teyve from Fiddler on the Roof to illustrate, in a single chapter, many of the concepts of value investing which the reader may be unaware of. He explains time value of money, adjusting discount rates for risk, margin of safety, relative valuation, and the whims of Mr. Market. This is enough to give a taste of the concepts, and for those readers whose interest is piqued, there are other books that go much more in depth (this is, after all, part of the Little Book series, so we just get a taste!). It is a succinct introduction.

Another Allegory: Katsenelson seems to like using allegories to illustrate his points. Besides Teyve, Karsenelson discusses gamblers who, with no process but luck on their side, do well in the short term and are praised for their apparent skills. In the short term this may work, but in the long term, those with well thought out processes will outperform. “As humans, we tend to focus on the outcome of the decision rather than the process. Outcome however, is affected by randomness.” We don’t have any control over randomness, so we end up focusing on the wrong things. This also plays into the value investor’s handbook, which is about focusing on strategy and analysis.

Katsenelson doesn’t stop by simply describing the pitfalls of sideways markets. He goes on to discuss his strategy for outperforming in these markets – Active Value Investing. Stay tuned and remember that soon I will give you a chance to win this book!

Talk to Frank about The Little Book of Sideways Markets.

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