Beyond The Headlines


November 15, 2021 | François Sicart
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During the pandemic, I have been using my forced time out of the office to review in detail my investing experience of the past fifty years – hoping to gain some enlightenment from this broad view.

My first observation is that, contrary to public complacency induced by twelve years of the current bull market, there have been some serious breaks in the progression of the major indices over this time span.  I experienced these firsthand, and a partial review is very enlightening.

The Pain and Opportunity in Bear Markets

For one thing, I remember well some of the S&P 500 losses that are easily ignored by newcomers to investment as well as by veteran investors. Among those, four stand out:

    Start and End Date        % Price Decline                     Length in days

11/29/1968 – 5/26/1970                   36%                                         543

1/11/1973 – 10/3/1974                     48%                                          630

3/24/2000 – 9/21/2001                      37%                                         546

10/9/2007 – 11/20/2008                    52%                                         408

(Source: Crestmont Research)

This is a small sample to remind the reader that while market declines averaging 43% and lasting longer than a year are somewhat rare, they cannot be viewed as “black swan” events.

Moreover, losses of that magnitude are not recouped rapidly. For example, it took 1.7 years to recover the market peak of 1968, while the Nifty Fifty loss of 1973-1974 took 3.8 years. And after the bursting of the 2000-2002 bubble, the market did not break even until 4 years had passed. More recently, the losses of the Sub-Prime crisis were only erased after 3.1 years. (Source: I should add that declines in some sexier indexes have often been more severe, such as the 77% loss in the tech-heavy NASDAQ Composite Index after the bubble burst. It took almost 15 years (!) to be recouped.

Obviously, there have been many “corrections” of up to 20% or more over the years. But despite the often-dramatic media headlines and sensational TV “breaking news” that they prompted, I attribute those to the normal volatility of investment markets, and to the investing crowd’s bipolar nature. I generally treat these milder episodes as opportunities to fine-tune our portfolios rather than as reasons for panicky overhauls.

Another observation from this retrospective exercise is that we all tend to measure market fluctuations from bottom to top and from peak to trough.  But to get a rational appraisal of the investment performance over a full cycle, we should measure the market progress from peak to peak.

Still another remark is that cash reserves in portfolios provide only a partial safeguard in declining markets. If your stock selections have been strategic, you may do a bit better than the majority of investors, but when the broad market goes down, all portfolios are nevertheless likely to suffer.

Cash should not be viewed as a sanctuary, but becomes very important when the market has already declined and buying opportunities abound. This may seem like an obvious point — but it is only if you have ready cash that you can seize these opportunities. At such times, those who are fully invested have to sell (probably devalued) holdings from their portfolios in order to to purchase attractive stocks that have become irresistibly cheap.

From Value-Contrarian to Contrarian-Value Investing

I sometimes mention that over the years, I have evolved from a value-contrarian investor to a contrarian-value one. This is a nuance, but a significant one. Historically, “value investing” has been nearly synonymous with “contrarian investing.” This made sense, because the stock market is effectively an auction market. If buyers become less aggressive and sellers become more so, the result should be lower prices (hence better value) for the commodity being auctioned.

In more recent years, however, the notion of “value” has become more diffuse. When Benjamin Graham articulated his value-investing philosophy, it was essentially a balance-sheet notion: a company’s readily saleable (current) assets minus total liabilities represented the minimum value of the business in a possible liquidation. If you could buy the company’s shares in the stock market for less than that amount, you made a great purchase.

Since then, powerful inexpensive computers and readily-available databases of corporate financial statements have rendered these value calculations easier and faster to make. The advantage of original value investors has diminished as a result. In addition, the make-up of corporations has evolved from traditional physical product-related activities to lighter, more service-oriented ones, including more immaterial assets such as goodwill, research, or patents, which are harder to evaluate in current dollars and cents. As a result, the focus of valuation has evolved from assets to earnings and, more recently, to estimates of future earnings and growth rates.

Fortunately, technology and the global environment in which businesses operate may have changed, but human nature has not. Hence my own increased emphasis on contrarian investing, which brings me to the meaning of the P/E, or Price-to-Earnings, ratio.

The P/E Ratio: Where Psychology and Value Meet

The P/E is simply the ratio of a stock’s Price over its company’s Earnings per share. Since the dollar price of a stock in the market really tells you nothing about what you are buying, the cost of a share is often expressed, for comparisons, by its P/E ratio, which shows how much you are paying for one dollar of a company’s profits.

Ed Easterling, author of Unexpected Returns: Understanding Stock Market Cycles and President of Crestmont Research, writes “History shows that the change in the market P/E ratio over decade-long periods often doubles or halves investor returns in the stock market.” And, truly, whereas corporate earnings for the whole stock market tend to move up cyclically but in a relatively moderate trend, it is the ups and downs of P/E ratios that command the preponderance of stock market movements. Crestmont Research has on its website a graph that illustrates quite clearly that this volatility reflects the rising optimism or pessimism of the investing crowd – as illustrated by the ups and downs of the market P/E. The site has a wealth of (free) educative statistics and I encourage the reader to visit it:

P/E Ratios Say Something About Subsequent Returns

I should point out that the above remarks apply to the market as a whole. It is possible for stock pickers to uncover stocks of individual companies whose earnings progress will dwarf the negative performance of broad indices. Still, it is an elusive challenge: the chances of identifying enough such pearls to build a properly diversified portfolio are slim. More importantly, it is rare that periods of outsized operational overperformance last forever, and even minor disappointments can be very costly when they occur. Also, when operational success is widely recognized and becomes extrapolated into the future by more investors, these companies’ valuations in the market, i.e. their P/E ratios, reflect higher expectations and become increasingly vulnerable to the slightest shortfall.

It is only prudent to be aware of the broader market environment and also to retain sufficient cash reserves to take advantage of more numerous opportunities when they become available. Such occasions may not be frequent, but in my experience, they provide opportunities to make a difference in long-term patrimony-building.

A few historians and analysts have documented the stock market returns in the 3-to-11 years following various levels of initial P/E ratios. It makes sense that, if you buy an investment whose price already incorporates high expectations, as reflected by the Price/Earnings, your future returns will be reduced accordingly, as the ratio will tend to decline cyclically. Most historical studies vindicate this view. Steve Blumenthal ( regularly compiles updates of several such studies. He summarized his September 10 review as follows:

Logic tells us that coming returns will be negative for the S&P 500 Index over the next 11 years.”

I should stress that this prediction does not suggest that the stock market will go down without interruption for 11 years in a row. It merely indicates that, based on historical precedents, the average annual return on the S&P will probably be close to zero over this kind of longer period. Valuation is not a timing instrument, and that average will probably encompass shorter up and down cycles. But acknowledging the possibility or likelihood of intermediate trends should not prompt us to forget the lessons of history and common sense. Don’t succumb to FOMO (Fear Of Missing Out) as stories of instant and easy fortunes multiply! Instead, keep a steady focus on the goal of building your own patrimony over time.

François Sicart, November 11, 2021


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