A Sideways Market For the Next Decade?

The chart below shows the Dow Jones Industrials Average from 1947 to the present. This brief history of the Dow has been marked by two eras of rallying markets, followed by a long sideways market. We could be moving into another period of sideways markets for another decade or so.

Poor macro-economic backdrop

There are valid fundamental reasons for these sideways markets. The last sideways pattern has been marked by rising inflationary expectations that begun with LBJ’s guns and butter policy in the Vietnam War. The macro-economic backdrop is not dissimilar to that of the late 1960s and 1970s. America is involved in a war with no end in sight, the fiscal deficit is spiraling out of control and the US Dollar is falling.

Excessive equity valuations

Some investors, like John Hussman, believe that the market is excessively priced. In a recent commentary he wrote that “the S&P 500 remains priced to deliver probable total returns of about 2-4% annually over the coming decade”. Using the methodology described here, Hussman indicates that the market’s cyclically adjusted P/E based on peak earnings is very high. Profit margins are elevated at this point of the cycle and there is the market is not pricing in any room for margin mean reversion (read analysis here).

Pension funds asset mixes likely to favor more bonds

Corporate treasurers are likely to move towards a asset-liability matching framework in defined benefits plans given the advent of changes in accounting policy such as FASB 158 and IAS 19. In Europe there are already suggestions to extend the Solvency II standard to corporate pension plans, which would further accelerate this trend (and has created scare stories like this).

We saw this effect in the UK a few years ago when companies moved towards an asset-liability matching framework. Investors drove the yield on the long-dated gilt to unbelievably low levels as they reached for duration in their portfolios. This asset shift came at the expense of equity weightings and other assets in the pension portfolio.

Comments

[CrossProfit:]

Nice article.

Very bold prediction and I disagree with the basic premise (sideways for a decade) for numerous reasons.

Of all the reasons the one that comes to mind first is the devaluation of paper currency i.e. the dollar. If you look at the 80's, being that many stocks have underlying hard assets, stock prices rallied in order to maintain intrinsic value with relation to the currency they were translated into.

In other words, if a company that had 10 ships in 1982 that was worth 100M (book value) and due to inflation those 10 ships were worth 150M in 1992, likewise the shipping fees (revenue) adjusted upwards accordingly, the stock price rose as well in tandem.

Your thesis would have a better chance of playing out if there was no inflation or currency devaluation, which is not the case as can be determined by following M3.

Hence, contrary to common wisdom, stocks act as a hedge against inflation over time - but only those that have underlying hard assets. This also explains why the metals & mining sector are being awarded higher multiples at this point of the cycle; raw materials more so than the steel manufacturers.

Take CLF for example and view 2007 and 2008 weekly closing charts - notice also the weekly average volume at the bottom chart here:
www.crossprofit.com/vi...

Saul Sterman
CrossProfit

2008 May 16 07:05 AM

[logicalsinger:]

Cam, I also disagree but in a different way. I think stocks will be lower 10 years from now, not sideways. The current market is supported by a commodities/cyclical bubble and as you pointed out correctly, the market PE does not account for cyclicality right now, and is too high.

Saul (Crossprofit), your analysis is correct except for the fact that most stocks trade at a significant premium to book value already. During inflationary times, there will be goodwill compression even if book value grows, resulting in an overall decline in market cap for most companies.

2008 May 16 07:24 AM

[buyitcheap:]

The two consolidating periods also include periods of loose money, war, and high marginal tax rates. Depending on the upcoming election, money may tighten up a bit, we'll still have a war and probably higher marginal rates. This would seem to play into that thesis.

2008 May 16 08:15 AM

[Timon:]

I agree with the post, especially given the prospect of a continued longterm increase in oil prices, and the probable negative effect on growth and profit margins. Sideways, in fact, means negative, even assuming low inflation. If inflation averages 3 percent for the next 10-12 years, and the market stays sideways, you've lost 50 percent of the value of your portfolioe

2008 May 16 09:01 AM

[punk_ash:]

good post and good comments. Anyone who is betting on stocks for real returns will be disappointed, well, what else could you invest in. Of all the asset classes, stocks are the only safe bet, the last thing you want is o hoard cash, too much money printing going on right now all over the globe. Oil could be a safe bet, are you sure about that, things can change a lot in a year. These bubbles are all designed for wealth transfer from Joe 6 pack to WS

2008 May 16 09:49 AM

[batmando:]

I agree, one of the best posts/comments seen on seekingalpha in a long time. HOWEVER I hope for some concrete suggestions in response to punk-ash's question: In what else could one invest?
Looking out to my 5 - 10 "retirement" (is there such a thing anymore?) horizon, what defensive postures are viable?

2008 May 16 12:23 PM

[DaveW:]

space-time,
In my opinion, your best bet is to go with a sector rotation approach. Currently that would be energy - oil (DIG, OIL, or DBO); natural gas (CHK or UNG and COG or REXX); alt. energies (FSLR, PBW), including nuclear energy & uranium (CCJ, USU, PKN); Platinum-based metals (SWC or PAL); Copper (PCU or TGB) - and agriculture (POT, UYM, DBA, MOO, or JJG). This is by no means a comprehensive list, just a primer for thought and research. Most of what I mention have price targets significantly/modestly higher than current levels. Only REXX comes from my personal research, all others come from better investors than myself.

2008 May 16 02:25 PM

[Alphameister:]

Good post and good comments. Hussman is right about profit margins reverting toward the mean. It will happen in any event but faster if the Democrats take the Presidency. While sector rotation can be helpful, as DaveW suggests, I'm convinced that the search for energy, both carbon-based and renewable (solar especially), will yield a secular bull market in those sectors extending far into the future. I expect the American consumer to be stressed for many years and will be avoiding investments in those sectors. The other enduring bull-market theme I see is provided by emerging markets where superior growth is likely to persist. A continuing search for productivity gains and extensive exposure to international markets will produce many winners among tech stocks also.

2008 May 18 12:37 AM