Kim Shannon, the head of Toronto-based Sionna Investment Managers, recently published a book called The Value Proposition based on her investment process and discipline. The following excerpt was carried on the Morningstar Canada website. Shannon discusses the challenge of finding value in "sideways" markets:
We've talked about looking for value in bear and bull markets, but what about looking for value in sideways or range-bound markets? Sideways markets are prolonged periods of low or no stock appreciation punctuated with spurts of activity that don't amount to much.
Just like the movie, Sideways, with two middle-aged guys getting seriously off track on a road trip in California wine country, sideways markets also get off track and go nowhere. There's a lot of anticipation and expectation, but everything just stalls out and nothing seems to move forward in any meaningful way. Most non-emerging markets have been in this stalled-out mode since the tech blowout in 2000.
What's very surprising about sideways markets is their frequency. Markets have been in range-bound mode for more than 100 of the past 140 years.
The current sideways markets have taken many investors by surprise because until 2000, we had been in one of history's longest and richest bull markets. Many market participants were under the mistaken impression that ongoing increases and upward movement are the norm: they aren't prepared to navigate through the volatile, but overall flat and extremely deceptive, ways of sideways markets.
Sideways markets can deceive
Sideways markets actually play a useful role by mopping up the excesses of a bull market and enabling stock prices to return closer to true company valuations.
But sometimes, investors resist the downward pressures and react wildly. Irrational investor reaction can create extreme volatility and -- at some points -- even drive the markets to new and deceivingly record highs. In fact, when we started to talk about the current sideways markets in the mid-2000s, many of our clients questioned whether or not we had our theory right. Stock prices were continuing to climb to new market heights peaking in June 2008 just months before the downturn in the fall of 2008.
To many, it looked like the start of a secular bull market. But this is how range-bound markets go; there is much precedent for hitting new record highs in the midst of a sideways market. Investors want the good times to continue and often behave as if we could skip through an inevitable correction. Unfortunately, it doesn't work that way. Instead, sideways markets see-saw up and down, with valuations easing downward over time allowing price and value to once again align.
Are we there yet?
Sideways markets can go on for a while, which is why you need a strategy to navigate through them. After any major mania conditions, markets capitulate, consolidate and go sideways for a minimum of 15 years historically (and in one instance for as long as 30 years) to remove the excess and return stock valuations back to a normal range. Typically, sideways markets end when the overall market P/E multiple comes down to just under 10 times.
We need to give immense credit to investor and author Vitaliy Katsenelson for his brilliant research and insights into sideways markets. We have found his work, particularly his book, Active Value Investing: Making Money in Range-Bound Markets, very instructive.
Katsenelson reminds us that stock prices (P) are basically flat over the long term in a sideways market despite its volatility; therefore, most of the adjustment required to get the P/E multiple to single digits comes from earnings (E) growth.
As stock prices remain bound in their range, earnings should continue to grow slowly, gradually eroding the P/E multiple until it bottoms out at a single digit. Because average earnings growth is so modest, it takes a while to rinse all of the excess out of the system and get the P/E ratio to just under 10.
The good news is we are well into this current sideways market. The not-so-good news is that, at the time of writing this book, we likely still have a little while to go before the Canadian market reaches a single digit P/E ratio providing a solid foundation to start moving upwards in a sustainable way.