The history of the stock market shows that there are two main types of markets:

- Structural bull markets

- Structural ‘sideways’ markets, or markets showing no particular trends or in which prices stay ‘flat’. In his excellent book 'Active Value Investing', Vitaliy Katzenelson (1) also uses the term range-bound to describe this type of market.

I use the term ‘structural’ to refer to extended periods of around 10 to 20 years, such as the structural sideways market of 1966-1982, the structural bull market of 1982-2000, the structural sideways market of 2000-?, and so on.

The chart below illustrates these phenomena in the case of the Dow Jones Industrial Average.
Click here to enlarge chart

 
Source: Stifel Nicolaus

Within structural bull markets corrections of varying scale can occur (such as the stock market crash of 1987). For long-term investors, such corrections are not that significant, as the upward trend is well-established.

Within structural sideways markets, there are cyclical bull and bear markets (by cyclical, I mean movements of shorter duration ranging from a couple of months to a couple of years). The chart below shows these trends for the period 1998-2011. An investor investing passively in the index over this period would not have earned any money so to speak.

13 years with a lot of volatility
Click here to enlarge chart

Source: Bloomberg, Gluskin Sheff

The conclusion to be drawn from these two types of markets is not that equities should be shunned in structurally sideways markets, but that a much more active investment strategy is required. An active strategy is required in terms of the periods during which we want to be ‘in the market'; in terms of regions / sectors to which priority should be given, and in terms of the selection of companies in which we want to invest.

What is the link between the foregoing and the current situation?

Since March 2009, the significant rise in share prices has brought the markets to a crossroads. As investors, we have to decide which side we are on:

- Either we are on the side of those who think that March 2009 was the start of a new structural bull market;

- Or we are on the side of those who think that the period since March 2009 was just a cyclical bull phase within a structural sideways market.

In the first case, the best strategy is to stay invested and not focus too much on interim corrections, as it will be almost impossible to time these corrections.

In the second case, an investor should envisage a gradual exit from the market. At the very least, such an investor should carefully reexamine the rationale behind his or her equity investments. 

Two years ago, the situation was different

An investor did not need to have a precise idea of the type of market he was in. Stock prices had just fallen by 50% and were at the bottom end of the range that had been prevalent since 2000. In other words, knowing whether the markets were on the verge of a cyclical or structural recovery was not important. Even those who were convinced that stocks were in a structural sideways market were able to take advantage of the cyclical recovery in stock prices. This is not the case today where the markets are in the upper range of the past 12 years.

Equity prices are in the upper part of their trading range

Source: Bloomberg

I have on a number of occasions discussed our conviction that we are still in a structural sideways market and that it will take years before western equity markets manage to sustainably exceed 2000 levels again. Structural bull markets start when stock valuations are low and end when valuations are high. Prices then stagnate while profits continue to rise. Stocks that were expensive in 1966, for example, become cheap in 1982 paving the way for the next bull market. The valuations observed at the end of the last bull market in 2000 were extremely high, which explains why even after 11 years of price stagnation and rising profits, equities are still not cheap. 

Difference of opinion

I am aware that there is a difference of opinion on this point. Many observers consider that equities are cheap, which is an easy conclusion to reach if:

- equities are valued based on models using the currently very low levels of interest rates,

- we presume that companiesprofit margins, which are currently at historically high levels, will remain at these levels or rise even further. This is tantamount to betting against history, which shows that profit margins usually tend to return to their historical average. This seems logical in a market economy in which too-high margins attract competition, while rising competition has the impact of reducing margins.

One way of getting round the problem of the currently high levels of profit margins is to value companies based on their sales or their book value. Another is to take the average of earnings over a number of years. The chart below uses the price/earnings ratio developed by Robert Shiller, a Professor of Economics at Yale University, which divides the share price by the average earnings of the past 10 years to avoid using an exceptionally bad or good year. According to this ratio, the US market is currently overvalued by around 30%. It is true that European equities seem less expensive. This is nevertheless partly due to the composition of European indices and particularly the preponderance of financial stocks in these indices which seem cheap but are not necessarily so as illustrated in the recent capital raising exercise by Commerzbank.

Shiller PER for the U.S. equity market

Source: Morgan Stanley

Using artificially low interest rates to value equities seems risky to say the least. At Banque de Luxembourg Investments (BLI), we apply a 9% discount rate in our valuation models as a broad general rule. Lowering this rate to 6% would significantly increase the intrinsic value of the companies we analyse and reveal numerous buying opportunities. By doing this, however, we would reduce the margin of safety that we require in our investments.

Finally, interest-rate valuation models give an idea of the relative appeal of equities over bonds but reveal nothing about the absolute attraction of equities. It could be that in the next 10 years, equity returns beat those offered by bonds, but that does not mean that equity returns will be good. The history of the stock market shows that an investment in the US market at current valuation levels has on average generated an annual return of 3% in the following ten years.

(1) Vitaliy Katzenelson: Active Value Investing; Wiley Finance