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Bull, Bear, and Cowardly Lion Markets
By Vitaliy Katsenelson
September 2, 2008

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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

Secular Range-Bound

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

Cost of being wrong

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