Navigating range-bound markets
If not for traders' emotions, returns from stocks would be identical to their earnings growth.
I did a Q&A with FT readers in November. Because of its length, I’ve abbreviated it and broken it into three parts. Here is part two:
The exit strategy from a range-bound market
Will my observations continue to play out? In my book "Active Value Investing: Making Money in Range-Bound Markets," I inadvertently created a framework that explains the mechanism behind stock market cycles.
As things change over time one thing remains the same: Our emotions will make us overexcited about stocks, and this will drive stocks to above-average levels, giving us cause to be underexcited (I think I just made up a new word), which will result in treacherous periods of range-bound markets.
If it were not for our emotions, stocks would always hew very close to their value levels (a normalized P/E of 15) and secular market cycles would not occur. I am oversimplifying, but if it were not for emotions, returns from stocks during short, intermediate and long-term periods would be identical to their earnings growth.
Human emotions don’t let valuations (P/Es) remain in their average state of 15, and so they are driven to extremes, on both sides of the mean. Returns from stocks over short (one year) and intermediate terms (5, 10, or 15 years) may have a significant disconnect from their earnings growth. And the disconnect between earnings growth and stock market returns may persist for decades, or even longer.
Over, say, 30 years in the U.S. (it takes that long for bull and range-bound markets to cancel each other out), returns from stocks will be in line with economic growth.
The role of technical analysis and market timing
About a month after my book came out I regretted its subtitle, “Making money in range-bound markets.” People assumed that I knew what the range was, and the name also implied that I use technical analysis. “Sideways markets” would have been a more accurate description, but what’s done is done.
Secular market cycles are full of many cyclical bull and bear markets; the last range-bound market, which started in 1966 and ended 1982, had five cyclical bull and five cyclical bear markets. It is impossible to succeed at short-term market timing, as you have to get two things right: the short-term economic numbers and the market’s response to them, which in many cases may be irrational.
What I propose in the book (and practice at my firm) is active value investing. Instead of being a market timer, I’m a buy-and-sell investor, with a focus on valuing individual stocks.
Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo. He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007). To receive Vitaliy’s future articles my email, click here.
Copyright © 2014 Microsoft. All rights reserved.
These hot movers could rise by double digits in coming months.
VIDEO ON MSN MONEY
Top Stocks provides analysis about the most noteworthy stocks in the market each day, combining some of the best content from around the MSN Money site and the rest of the Web.
Contributors include professional investors and journalists affiliated with MSN Money.
Follow us on Twitter @topstocksmsn.