While most economists and strategists spend time worrying about growth, changes in inflation are usually a much greater driver of financial markets than changes in economic activity. This is because: 1- A surge in inflation usually increases volatility of economic growth--which in turn reduces P/Es and the willingness of the private sector to take risks. 2- As highlighted in The Myth of Reverting Margins, inflation typically takes a much meaner bite out of margins than a recession does. As we wrote back then concerning the US growth/margin relationship: "Margins bear little relationship to the level of GDP or consumption growth. In fact, as the economy accelerated from the mid-1960s to the early 1980s, margins plunged. Similarly, as the economy slowed from the early 1980s to the present, margins accelerated... It is inflation, not growth, which wreaks havoc on profit margins (ironically, if everyone has pricing power, no one makes money). 3- Finally, a surge in inflation typically means interest rates will be rising in the near future. Which means that investors get to lose money on both bonds and equities. For example, from 1966 to 1980 (i.e.: the last "inflationary surge" period), US bonds shed -2% per annum and US equities fell -4.9% per year. Unsurprisingly, given the above, fears are now running high that we may have reentered such an "inflationary bust" period (see The Inflationary Bust Threat). And to be sure, growth almost everywhere around the world is slowing while inflation in almost every country is still accelerating. Now everyone knows where the slowdown in growth comes from: de-leveraging in the financial sector, overextended consumers needing to tighten their belts, transfers of wealth from the private sector to the public sector through high oil prices, etc... And there are of course myriad opinions as to how long the slowdown will last. But meanwhile, on inflation, our clients seem to be much longer on questions than answers. Where does the current inflation spike come from? How long is it going to last? And can inflation abate without a "Paul Volcker" like monetary policy from the Fed? In this ad hoc comment, we aim to review some of these questions and, as we always tend to do--answer these questions with yet more questions of our own! 1- Where Does the Inflation Come From? Just like George Orwell's farm animals, all currencies are equal... though, of course, one is more equal than others. Indeed, the US$ remains the world's reserve currency and, thanks to this status, foreigners cannot impose a particular kind of monetary policy unto the US. As Treasury Secretary Connolly once said: "the US$ is our currency and your problem". And lately, there is little doubt that the US$ has indeed become the world's problem, with its fall in value associated with the spike in commodity prices, which in turn has triggered a sharp upturn in inflation rates all around the world, but especially in the emerging markets (where food and energy represent a much bigger piece of the average family's spending than in most OECD countries). But of course, the surge in commodity prices cannot be the sole explanation for the recent surge in inflation numbers around the world. After all, an event like the spike in oil prices could also prove to be highly deflationary, since it takes money from the private sector and gives it to the public sector which will typically waste it (i.e.: Chavez financing Castro, Ahmadinejad subsidizing Hamas and Hezbollah, etc...). For a commodity price spike to be inflationary, it needs to be accompanied by excess money creation. If it is not, all that we witness is a change in relative prices across the economy (i.e.: oil prices up, auto and house prices down). This is why Milton Friedman once said that "inflation is always and everywhere a monetary phenomenon" while, around the same time, Jacques Rueff made the observation that "inflation is subsidizing expenditures that give no returns with money that does not exist". So given that we are now living through a surge in inflationary prices, the questions we should ask ourselves is a) where the excess liquidity creation of recent years has come from? and b) whether excess liquidity continues to be pushed into the system, hereby guaranteeing further increases in inflation in the coming quarters and years? 2- What Explains the Surge in the Amount of Money? As highlighted above, the US$ is "more equal" than other currencies and, consequently, the Fed holds a "special place" in our current financial system. Undeniably, the Fed is the world's most important central bank and it is thus not that surprising that, as inflationary pressures accelerate around the world, most people are quick to blame the Fed for "falling asleep at the wheel" and allowing money supply in the US to grow unchecked. But is this a valid criticism? After all, as the charts below highlight, narrow money supply growth in the US (i.e.: the aggregate mostly under the control of the Fed) has not seen much of a rise in recent years (incidentally, the same can be said about Japan and money growth is now decelerating fast in Europe): While the Fed did print money aggressively between 2002 and 2005 (M1 annual growth was above +5% and sometimes close to +10%), in recent years, the pace of monetary creation has by and large been tame. So the ‘excess money' had to come from somewhere else. Now as we never tire of pointing out, two sets of players can create money ex- nihilo in our system: central banks and commercial banks. So if the excess liquidity creation has not been the central banks, then the explanation must lie with the commercial banks. And sure enough, in recent years, banks have ridden the 'financial revolution' as hard as they possibly could and we have witnessed an unprecedented expansion in credit (witness the growth in C&I loans at US banks, red line below): And, as we now know, money creation off the banks' balance sheets was also, until recently, going strong. Witness, for example, the rapid expansion in corporate paper outstanding in the period between 2003 and 2007 (red line below): To return to our old favorite, Irving Fisher's equation of MV=PQ, it seems obvious to us that the current increase in P (prices) has more to do with the past few years' extremely buoyant V (velocity) than excessive M (money) growth. A possibility which immediately raises the question of whether velocity will remain as buoyant over the next two years as it did in the 2003-2007 period. 3- Will Velocity Remain As Strong? As the chart below suggests, the answer to the above question is a simple "No". With bank balance sheets under severe strain, and with bank shares almost everywhere around the world plumbing new depths, an increase in the willingness to take risk from private lenders would be very surprising. And sure enough, after its longest period ever in negative territory, our velocity indicator is once again negative after a brief respite: This message of slowing private sector liquidity growth is also confirmed when adding the loans at commercial banks with the issuance of commercial paper (for a total private credit growth aggregate--blue line on following page). We have slumped from an annual growth rate of +13% in private credit one year ago to +2.8% today; a level not seen since 2003 (see chart). So we are now in a situation where a) The Fed is not printing money and b) US financials are de-leveraging rapidly. Thus, if inflation is "always and everywhere a monetary phenomenon", one may conclude that what we are now seeing in the inflation numbers is the echo of the 2003-2007 credit boom, but that looking ahead, the inflation picture should start improving rather dramatically. But such a conclusion would miss out on the other big contributor to global liquidity growth, namely the US current account deficit. 4- The Importance of the US Current Account Deficit Because the US$ is "more equal" than other currencies in our global system, the US current account deficit plays a specific, and very important, role in our global monetary systems. In essence, the US current account deficit provides the world with its working capital. After all, at any given point, the world needs US$. For example, Nokia needs US$ to pay for the chips it may buy in Taiwan. China needs US$ to pay for the iron ore it buys from Australia and Sweden needs US$ to pay for the oil it buys from neighboring Norway... This is why, whenever we see an improvement in the US current account deficit, somebody somewhere goes bust. Indeed, when the US exports a lot of dollars, then the rest of the worlds gets used to a "plentiful" liquidity situation... and when the US exports less money, then somebody gets cut off. So in essence, the current account deficit has always been the mechanism through which the United States could reflate, or deflate, the global economy. When the US current account deficit improved, the US deflated other countries and vice versa. Now today, the US current account deficit still stands at a rather large 6% of GDP. However, the composition of this deficit has changed dramatically: two years ago, around two-thirds of the US deficit went to non-oil producers and one third was for petroleum products. Today, that situation is inversed to the point where one could argue that, while the US is still reflating oil producing countries (which hardly need it), it is now deflating non-oil producing countries by around 2% of GDP. Moreover, should oil prices start pulling back, we would move extremely rapidly into a situation where the US current account deficit was deflating the whole world (below is a chart we borrowed from The Economist)! The fact that the US is no longer reflating non-oil producing countries is a very important change in our economies. Indeed, over the past few years, the prevalent belief amongst investors of all stripes has been: a) the US runs a large current account deficit, b) that US interest rates are low, and that, consequently c) the value of the US$ could only fall. And if the value of the US$ could only fall, then borrowing in US$ to finance whatever real estate project, factory, or financial market speculation made perfect sense. This is why, in a number of countries, we started to witness a growth in central bank reserves which far outpaced trade surpluses and foreign direct investment inflows; all of a sudden, a number of large countries started to save more than they earned! But how can one save more than one earns? The answer, we have argued in the past (see The Surprisingly Strong Growth in Chinese Reserves) is simple: one borrows the difference. As mentioned above, if the perception is that the US$ can only fall against the RMB, INR, VND, MYR, etc... then why borrow in local currency to finance one's capital expenditures or investments? Much better to finance any spending in the ever falling, and cheap to borrow, US$! So what happens when a Chinese property developer, or a Vietnamese industrialist, borrows US$ to finance his latest project? The first thing he does is that he changes the dollars he does not need for RMB, Rupee, Dong, etc... And, at this point, the foreign central bank has three choices: 1- It can allow its currency to rise. This is what Brazil, South Korea... have done in recent years. 2- It can print money to prevent its currency from rising and then sterilize its FX intervention. 3- It can print money to prevent its currency from rising and just accept the consequences of fast money supply growth (usually higher inflation and asset prices). And by and large, this is what most nations on the other side of the US current account deficit (i.e.: Asia and OPEC) have done. And unsurprisingly, these are the countries that are today dealing with the largest inflation threats. We would thus argue that the US current account deficit has been a double inflationary force for the world at large. First, the US current account deficit has pushed a number of countries towards reflation, and secondly, the large US current account deficit has helped propagate the belief that the US$ could only fall, and thus encouraged large borrowings of US$ outside of the US. And the US current account deficit, combined with the willingness to borrow US$, has been an inflationary force for more than just Asia and the Middle East. It may also explain the surge in money growth in Europe! Indeed, with central bank reserves growing very rapidly around the world (despite a high oil price which, at the very least, should have drained the reserves of Asian and European countries), central banks such as the PBoC or the RBI have likely spent the past few years diversifying their reserves, which for all intents and purposes means buying the Euro... And, as we argued in our book The End is Not Nigh, this "diversification" of reserves means buying European government bonds or, in other words, subsidizing the expenditures of foreign governments with domestically borrowed money. Et voila! We are now back to Jacques Rueff's definition of inflation being "a policy which subsidizes expenditures that give no returns (i.e.: government spending in Europe or the US) being financed with money that does not exist (i.e.: central bank reserves that have been borrowed, not earned)!" 5- Will the US Deficit Continue to be an Inflationary Force? Having established that one of the main factors of excess liquidity growth in the world (the willingness of the financial sector to lend very aggressively) had now disappeared, can we rely on the US current account deficit to continue providing excess liquidity to the world. Will an ever growing US trade deficit continue to force other countries to reflate and lead to an ever lower US$? We tend to believe that the answer to that question is a very firm "no". And, this for several reasons: Reason #1: As reviewed on page 6, the US current account deficit is already improving. Moreover, since oil is now a bigger percentage of the US deficit, should oil prices roll over, we could witness the most rapid improvement in the US current account deficit ever seen. But even without oil rolling over, the recent weakness of the US$ argues for a continued improvement in the deficit: As does the weakness in US housing: Meanwhile, the prevalent belief of recent years that borrowing US$ to invest in local currencies was a "no-brainer" is now undergoing a significant test. For example, in recent months, the "long dong" strategy has undeniably failed (the black market now expects a devaluation of over 20% in the Vietnamese currency). The strategy is also failing in India where the Rupee, to many investors' surprise, has been amazingly weak in recent months.... In fact, an interesting development is occurring on the US$: fewer and fewer currencies have lately been rising against the US$ and this despite some pretty poor news from the US (MBIA downgrade, fears on Lehman, weak housing, weak growth, high oil, fears of war with Iran...). Now the typical pattern for an equity bull market is that, as it nears its peak, fewer and fewer shares make new highs even as indices keep on powering ahead. Major corrections are typically preceded by a narrowing breadth... And today, we are undeniably witnessing a deteriorating breath in the "anti-US$" bull market: To cut a long story short, and with hindsight, the large US current account deficit and the weak US$ were another very potent inflationary force in our system. But, at least at the margin, these inflationary forces should abate, rather than acceler- ate, over the coming months. 6- Conclusion There is little doubt that, right now, inflation is proving to be a massive headwind for financial markets. And part of that "inflation headwind" is the fear that the Fed, the ECB and other central banks will have little choice but to tighten monetary policy in the coming months. This is most likely true of some central banks, but maybe not all? After all, looking around the world, the inflationary threat is a sure thing in certain regions, and less of a threat in others: • In the US: In a recent paper (see The Dollar's Successful Devaluation), Charles argued that the Fed had just managed to engineer a "good devaluation" for the US$, whereby the currency is brought down without an explosion in monetary aggregates and a rapid acceleration in inflation. This makes the economy competitive and local assets attractive for foreigners. Since then, not much has happened to warrant a change in this view. In fact, since then, the main development has been the roll-over in velocity and renewed fears as to the health of the US financial sector. With velocity plummeting, we think that the bond market is broadly right to not anticipate an acceleration in US inflation. • In Euroland: Just like in the US, the bond market does not seem to really anticipate a massive surge in inflation. And given the very overvalued currency and the inverted yield curve, this makes sense to us. • In the Middle East: The one region of the world which is still experiencing reflation from the US current account deficit is the Middle-East (and to a lesser extent Russia). The unwillingness of policymakers to revalue their currencies (see The Arab Pegs) and the inability of local central banks to sterilize their FX intervention means that the local economies are condemned to continue experiencing inflation as long as they refuse to revalue their currency. More worryingly, a pursuit of the current fixed exchange rate, inflationary policies could lead local economies into the same kind of boom-bust cycle that Vietnam (and maybe India?) are now having to endure. • In India and Southeast Asia: If the US went through a ‘good devaluation' (i.e.: a lower currency without a spike in inflation, triggering an increase in foreign and domestic investments and productivity gains), then it increasingly looks as if India and Southeast Asia have just gone through a ‘bad devaluation' (i.e.: a lower currency which brings about fast money growth, higher inflation, deteriorating trade balances and foreign investor flight). As such, certain countries (India, Vietnam...) are now stuck in the unfortunate position of having to defend their currencies, which is rarely conducive to either economic, or asset price growth. • In China: Inflation is undeniably a problem but, thus far, it seems to be mostly contained to food and energy prices (see A Dummy's Guide to Chinese Inflation). Meanwhile, the only pressures on the RMB are still of a positive nature. Thus, if either the US$ rebounds or commodities roll over (two events that are likely to happen simultaneously), China's inflation problem could dissipate relatively quickly. Chinese and HK shares would then soar. • In Japan, Korea, and Taiwan: Japan, Korea and Taiwan have seen little "hot money" inflows in recent years and have also been better at letting their currencies rise against the US$ (this year, the NT$ is one of the world's best performing currencies with a +6.5% rise while the KRW was one of the best performing Asian currencies between 2004 and 2006). In general rule, these countries today have far less of an inflationary problem than the rest of Asia: While the markets had started to rally in April and early May, the spike in oil prices fuelled fears of faster inflation and triggered a threat of coming rate hikes from the Fed and the ECB. In turn, all these events weighed down equity markets around the world. However, as we have tried to show in this paper: • The inflation threat is very different between countries. At most risk today are the Middle East, India and Southeast Asia. Meanwhile, inflation is far less of a threat in the US, Japan and North Asia. • Given the fact that the forces behind the recent pick-up in inflation are now turning around (strong willingness to take risk amongst financial firms, growing US current account deficits, overall weakness in the US$), inflation could well start abating in the coming quarters. Moreover, with the turnaround in velocity and the implosion in the banking systems, it seems increasingly likely that neither the Fed, nor the ECB will be willing/have to match their recent hawkishness with rate hikes. • As inflation rolls over in the OECD, the leadership of equity markets should go through a serious adjustment. Are we in a bull, a bear, or a cowardly lion market? As we will see, the answer can make a huge difference in your investment portfolio. This week I am at my Strategic Investment conference in La Jolla. About four times a year I take a break from writing the letter and bring in a guest writer. This week Thoughts from the Frontline will have the very distinguished analyst and author Vitaliy Katsenelson. In his recent book, Active Value Investing: Making Money in Range-Bound Markets (Wiley, 2007), he exhorted investors to fasten their seat belts and lower expectations for the next decade or so. He also provided a strategy for improving returns in this environment, what he calls range-bound or cowardly lion markets. Long-time readers will recognize some themes consistent with my own research, but Vitaliy adds some very interesting twists that I believe will make you think. In today's letter, Vitaliy runs through his analysis of what will happen and provides an overview of how investors can make money in what will otherwise be an ocean of stagnant returns. Warning: the letter will print long, but that is because there are a lot of great charts. Let me also highly recommend Vitaliy's book, Active Value Investing. I think as you read today's letter, you will get a sense of why I am so enthusiastic about his work. You can get you copy at Amazon.com. Bull, Bear, and Cowardly Lion Markets By Vitaliy Katsenelson For the next dozen years or so the US broad stock markets will be a wild roller-coaster ride. The Dow Jones Industrial Average and the S&P 500 index will go up and down (and in the process will set all-time highs and multiyear lows), stagnate, and trade in a tight range. At some point during the ride, index investors and buy and hold stock collectors will realize that their portfolios aren't showing much of a return. I know this prediction has a mild sci-fi feel to it. After all, how could I possibly know what the market will do, especially that far into the future? Though I'll explain in more detail in just a second why I have the audacity to make this prediction, let me offer you a little factoid: over the last 200 years, every full-blown, long-lasting (secular) bull market (and we just had a supersized one from 1982 to 2000) was followed by a range-bound market that lasted about 15 years. Yes, this happened every time, with the exception of the Great Depression, over the last two centuries. Though we tend to think about market cycles in binary terms - bull (rising) or bear (declining) - in the long run markets spend a lot more time in bull or range-bound (sideways) states, roughly half in each, and visit a bear cage a lot less often then we think. This distinction between bear and range-bound markets is extremely important, as you'd invest very differently in one versus the other. Are bull markets driven by superfast economic growth? Are range-bound markets caused by subpar economic growth? Could the subpar market performance be related to high or low inflation? The answer to all these questions is undoubtedly - "no." Though it is hard to observe in the everyday noise of the stock market, in the long run stock prices are driven by two factors: earnings growth (or decline) and/or price-to-earnings expansion (or contraction). As is apparent from Exhibits 1 & 2, either by a decade at a time or a market cycle at a time, it is difficult to find a link between stock performance and the economy (e.g., GDP, corporate earnings growth, or inflation). The connection does exist, but periods of disconnect appear to last for decades at a time. Exhibit 1 Exhibit 2 What about interest rates? Exhibit 3 shows P/Es for the S&P 500 (based on one-year trailing earnings) and inverse long-term bond yields - the implied P/E - the famous Fed Model. This model, despite its name, is NOT endorsed by the Fed; it indicates the existence of a tight relationship between (inverse of) long-term Treasury bonds and P/Es of the S&P 500. Exhibit 3 By taking a look at the last full 1966-2000 range-bound/bull market cycle (see Exhibit 3), we can see that the Fed Model perfectly predicted the direction of equities in relation to interest rates (okay, assuming you could predict interest rates). Long-term interest rates were rising from 1966 to 1982, while implied and actual P/Es were falling. Whereas from 1982 to 2000 interest rates were dropping, and implied and actual P/Es were rising. Intellectually that makes sense, because stocks and bonds compete for investors' capital, and thus higher interest rates make equities less attractive and vice versa. However, it is hard to find ANY relationship between interest rates and the animal with its name on the secular market if you look at the first 66 years of the 20th century. None! It is difficult to dismiss the role interest rates play in stock valuations, but they seem to be a second fiddle in the orchestra conducted by economic growth and valuation. If the Fed Model worked flawlessly, how could we explain declining P/Es of Japanese stocks in the last decade of the 20th century, when interest rates declined and were scratching zero levels? It is valuation! If earnings growth in the long run remains consistent with the past, P/E is the wild card that is responsible for future returns. Though continued economic growth appears to be a wildly optimistic assumption given the meltdown of the housing industry in particular, and job layoffs, it is not particularly unrealistic to predict that we will see economic growth overall. With the exception of the Great Depression (see Exhibits 1 & 2), though it had its ups and downs, economic growth was fairly stable throughout the 20th century. Earnings, though more volatile than real GDP, grew consistently decade after decade, paying no attention to the animal (bull, bear ... or cowardly lion - my pet name for range-bound markets, whose bursts of occasional bravery lead to stock appreciation, but which are ultimately overrun by fear that leads to a subsequent descent) lending its name to the stock market. Though economic fluctuations were responsible for short-term (cyclical) market volatility, as long as economic performance was not far from the average, long-term market cycles were either bull or range-bound. Valuation - the change in price to earnings, its expansion or contraction - was the wild card that was mainly responsible for markets being in a bull or range-bound state. Market Cycle Math So let's examine the stock market math for secular bull, range-bound, and bear markets. The following Exhibit 4 shows sources of price appreciation in past bull, range-bound, and bear markets. Exhibit 4 During bull markets, a vibrant, peaceful combination of P/E expansion (a staple of bull markets, a great source of return) and earnings growth brings outsize returns to jubilant investors. Prolonged bull markets start with below- and end with above-average P/Es. P/Es are some of the most mean-reverting creatures, and range-bound markets act as clean-up guys: they rid us of the mess (i.e., deflate high P/Es) caused by bull markets, taking them down towards and actually below the mean. P/E compression wipes out most if not all earnings growth, resulting in zero (or nearly) price appreciation plus dividends. Bear markets are range-bound markets' cousins; they share half of their DNA: high starting valuations. However, where in cowardly lion markets economic growth helps to soften the blow caused by P/E compression, during secular bear markets the economy is not there to help. Economic blues (runaway inflation, severe deflation, subpar or negative economic or earnings growth) add oil to the fire (started by high valuations) and bring devastating returns to investors. A true secular bear market has not really taken place in the US, but one has occurred across the pond in Japan. The market decline caused by the Great Depression, though referred to as the greatest decline in US stocks in the 20th century, only lasted three years and thus doesn't really fit the traditional "secular" requirement of lasting more than five years. Japan's Nikkei 225 suffered (see Exhibit 5) through a true secular bear market: stock prices declined over 80 percent from their 1989-1991 highs until they bottomed in 2003 (the market seems to be coming back now). For more than a decade the country struggled with deflation caused by its banking system coming to a near halt on the heels of a collapsing real estate market and the bad loans that came with it. Of course, all this took place on the heels of a huge bull market, and thus very high valuations. Exhibit 5 A unique aspect that contributed to the severity and longevity of the Japanese deflation was a cultural issue: the Japanese government intervened and did not allow structurally defunct companies to go bankrupt, thus tampering with the nucleus of capitalism (and Darwinism as well), creative destruction. I must admit, it seems that lately we've been importing a lot more from Japan than their cars and flat-screen TVs, as the US government steps in to "fix" our troubled financial firms. (In the following articles I argue against government bailing out homeowners and against the Fed bailing out the economy). Where Are We Today? Today stocks may appear cheap at first glance, at least if you look at valuations of the late 1990s. They are not! To minimize the impact of cyclical profit volatility, let's first take a look at stock market historical and current valuations, based on 10-year trailing earnings, as shown in Exhibit 6. This way we capture a full economic cycle. Exhibit 6 The conclusions we can draw are: • Secular bull markets end at P/Es much above average. The 1982-2000 bull market ended at the highest valuations ever! • Secular range-bound markets ended when P/Es were below average. • Markets spent very little time at what is known to be a "fairly valued" state of 15 times 12-month trailing earnings. Historically, stocks only saw average valuations on the way from one extreme to the other. From 1900 to 2006 the S&P 500 spent less than 27% of the time between P/Es of 13 and 17. • Today, after eight years of plentiful volatility and no returns, what the WSJ called a "lost decade," stocks are not cheap. If you look at ten-year trailing earnings, they are still at levels where previous range-bound markets started. In other words, based on 10-year trailing earnings, stocks are still at 64% above their average stated valuations. Now, if you look at historical valuations where P/Es are computed based on one-year trailing earnings (see Exhibit 7), the picture is not that exciting but less grim. At about 18 times trailing earnings, US stocks don't appear that expensive. Exhibit 7 Unfortunately, the cheapness argument falls on its face once you realize that (pretax) profit margins are hovering at an all-time high of 11.5%, about 35% above their historical (since 1980) average of 8.5%. Similarly to P/Es, profit margins are extremely mean-reverting. As companies start to earn above-average economic profits, new competition waltzes in and competes these excess profits away - arrivederci fat profit margins. Once this happens, the "E" in the "P/E" equation will decline as well, and P/Es will rise from 18 to 22. An additional point: as you see in Exhibit 8, margins don't have to revert and stop at the mean; historically they've gone below the mean - that is how the mean is created. (In the February 4th, 2008 issue of Barron's I rebuffed common arguments against profit-margin mean reversion.) Exhibit 8 As a side note: The bulk of excesses in overall profit margins, 54.5% to be exact (see Exhibit 9), were in "stuff" stocks (i.e., energy, materials, and industrials). Profit margins will deflate when the global economy slows down. This goes far beyond oil and commodities. Companies that make "stuff," which historically have been very cyclical (today is no different) have benefitted from tremendous operational leverage that contributed to considerable improvement in margins. However, leverage works both ways: lower sales and high fixed costs will push margins to the other extreme. Exhibit 9 Financials were responsible for 22% of the excess in margins, as they benefitted from tremendous liquidity hosed down by the Fed over recent years; now they are drowning in it. Their margins are compressing at a faster rate than you can read this. Finally, the "new" economy stocks are responsible for 17% of the excess. However, I'd argue that these industries have transformed substantially since 1988, so that higher-margin software and services now account for a much larger portion of technology and telecom sales. It is kind of like Microsoft (ironically the "new" economy) vs. IBM in 1988: the hardware company (the old economy) vs. the new. Of course IBM of today is lot more of a software and service company than the hardware company it was in the 1980s. Thus the "new" economy stocks should have higher margins than they did in 1988, but by how much? I don't know, but they likely will face a lower margin compression than "stuff" and financials. The bottom line: Remember those long-term double-digit returns you were promised by stock market gurus during the last bull market? Well, an average passive buy-and-hold investor will be lucky to have very low single-digit returns for the long term. In fact, during the last 1966-1982 range-bound market, investors received almost zero real total returns. Analyze and Strategize Fairly depressing stuff, and it sounds like the investor is going to have to eat lower returns. However, there are strategies to improve portfolio performance so that one can do well, even in a trading range. Whether you are a buy-and-hold or stalwart value investor, there are opportunities that don't require you to day trade stocks. You don't have to change your investment philosophy, but you have to tweak your stock analysis and strategy a little to adapt it to range-bound markets. Modify your analysis: To clarify, I created an analytical framework where stock analysis is broken down into three dimensions: Quality, Valuation, and Growth. Quality. Though often it is in the eye of the beholder, in my book I clarify what constitutes a quality company (i.e., sustainable competitive advantage, strong balance sheet, great management, high return on capital, and a lot more). But the lesson here is, you want to compromise as little as possible on this dimension, because it is very difficult to recover from significant losses in the range-bound market. Stick to quality. Growth. This dimension consists of earnings (cash flows), growth, and dividends. When you own companies that grow earnings, time is on your side. Dividends are extremely important in range-bound markets, in fact 90% of the returns in past range-bound markets came from dividends, vs. less than 20% in past bull markets. Also, today an average stock (i.e., S&P 500 index) yields only 1.7%. Do you really want 1.7% to be 90% of your total return? Valuation. This dimension requires the most modification: the valuations that we saw in the 1982-2000 bull market are not coming back anytime soon, but don't step into what I call the relative valuation trap. Don't buy stocks based solely on their relative cheapness to their prices in the past, but rather based on what their future cash flows will bring. To combat a constant P/E compression, in the range-bound market increase your required margin of safety. That value (i.e., low P/E stocks) beats growth (high-valuation stocks that have high expectations built in) has been historically documented by numerous studies. After doing extensive study of the 1966-1982 range-bound market, I found that value kills growth. Cheaper stocks had a lower P/E compression and generated bull-market-like returns, plus they had a natural advantage: their lower P/Es led to higher dividend yields. Stock selection matters in the range-bound market. Blindly throwing money at market indices - a strategy that did wonders in the past bull market - will bring market-like returns, which likely will not pay for your dream house or fund your retirement. Strategize: Once you have determined, based on the Quality, Valuation, and Growth framework, what stocks are to be bought and at what prices, you can start applying a range-bound market strategy. A long-lasting secular range-bound market consists of many mini (months to several years long) cycles. For instance, the last 1966-1982 range-bound market consisted of five mini bull, five bear, and one range-bound market (See Exhibit 10). Exhibit 10 Successful investing is a lonely place, as it requires an independent thought process that often goes contrary to the herd mentality. In the range-bound market, a contrarian mindset comes in especially handy, as you'll be selling when everyone else is buying. Your stocks will be hitting their fair value, and you'll be buying when everyone else is selling - during the mini bear markets. This is not to suggest that you need to be a market timer, not at all. Market timing only looks easy with the benefit of hindsight, and it is very difficult to do on a consistent basis. Instead, time (price) individual stocks, one at a time. Buy when they are undervalued and sell when they are fairly valued, and repeat the process over and over again. In other words, instead of focusing on the bowling alley (the market) focus on the ball (individual stocks). Selling is looked upon as a four-letter word, and therefore a sin, in a bull market. A buy-and-hold strategy (which is often just buy and forget to sell) is rewarded richly in secular bull markets - every time you made a "don't sell" decision, stocks go higher. And though buy and hold is not dead but in a coma (waiting for the next bull market), it takes investors to a place of no returns. Forgive yourself the "sin" of selling and become a buy-and-sell investor. The almighty US constitutes 4% of the world population, but its stock market capitalization represents more than a third of the world's wealth. It has been comfortable for us to buy US stocks; it felt safe. However, by solely focusing on US stocks we are insulating ourselves from a greater pool of stocks to choose from. You don't need to become an Indiana Jones of international investing by venturing into fourth-world countries like South Paragama or Liberania (ok, I made those up, didn't want to offend folks in Turkmenistan or some other places heading towards the stone age), but there are plenty of countries that have a stable political regime and the rule of law. I could be wrong but I doubt it What if I am wrong and the range-bound market I describe is not in the cards? After all, history is prolific about the past but mute about the future. What if they find life on Venus and our economy starts growing at double digits and the secular bull market thunders upon us? Or the current credit market problems spill into a Japanese-like prolonged recession, causing a bear market? Every strategy should be evaluated not just on a "benefit of being right" basis, but at least as importantly on a "cost of being wrong" basis. An active value-investing strategy has the lowest cost of being wrong in comparison to other investment strategies, as you'll see in Exhibit 11. Exhibit 11 Switzerland, Planes
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