Vitaliy Katesenelson presented at the Value Investing Congress five years ago, one that I didn’t attend, and he talks about market cycles. He notes that what we think of as bear markets have really been long sideways markets.
Sideways markets are the removal of PE premiums from the market, earnings grow but that’s canceled out by the falling PE ratio. It’s only when both PE and earnings decline that you get a bear market. Bull markets end at high valuations (using 12-month trailing earnings)
Problem: profit margins are at a modern high of 15% — they can’t stay at a high level for long, they are extraordinarily mean-reverting because capitalism works. That means earnings have to decline.
Also, over the last 60 years the long run has averaged out to have profis grow at exactly the same rate as GDP growth — not in the short term, because profit margins can expand and contract, but earnings growth has to revert to closer to GDP growth.
But instead of one-year trailing earnings, we should consider 10-year trailing earnings. And be careful about that $7 S&P earnings in 2009 — if you take out the worst of the great recession (down to $50 for the S&P), the average for the last ten years is $65. This is the kind of valuation that has led to sideways markets in the past — 40% or so overvalued compared to the mean.
To believe we’re in a secular bull market you have to believe:
Profit margins will continue to expand, or at least stay at current level.
GDP will continue to grow at a good pace — that’s too “exciting” (China bubble, japan debt bubble, European problems, QE that is unpredictable and could end badly). This is too much of a global experiment to assume that we have robust GDP growth continuing.
You have to assume that PE ratios will continue to expand — that’s unlikely because past secular bear markets ended at valuations like this.
So what does he like? Big dividends. Dividends provided half the returns over the past hundred years and get no attention. And during a sideways markets dividends provide 90% of the returns — so if we’re in a sideways market as he says, that will be where we get any return.
In theory, there’s no difference between a dividend and a stock buyback … but ...