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Adapt and Profit in Range-Bound Markets
By Charles L. Norton, CFA
RealMoney.com Contributor
11/19/2004 12:00 PM EST
The indices have been stuck in a trading range all year,
but that seems to be giving way to higher prices currently.
The S&P 500 is at its highs of the year, and
the Nasdaq and Dow Jones Industrial Average
are rapidly approaching new high ground.
So are we off to the races and new multiyear highs? Or are
we due to stall out and spin our wheels? Taking a longer-term
perspective may help find that answer.
Stocks have averaged annual gains of around 6% per year
since 1930, but it certainly hasn't been a consistent rate
of return year in and year out. In fact, since 1934, the
market has had four distinct 16-year cycles, in which periods
of expansion follow years of consolidation. And most of
the stock market's gains have come in two 16-year periods
of expansion: 1950 to 1966 and 1982 to 1998.
In between these two rosy cycles, the market was range-bound,
pretty much consolidating for 16-year periods. From 1934
to 1950, stocks averaged only 4.5% per year, and in the
1966-to-1982 consolidation period, stocks fared even worse,
averaging only 2.7% per year.
Source: GNI Capital |
So we could be six years into another 16-year consolidation
period that began in 1998. That's right, stocks could return,
on average, less than the long-term 6% return for the next
10 years. Why did the cycle start in 1998, you ask, when
everyone knows the market topped in March 2000?
If you look at the cumulative advance/decline line, stocks
in general actually began declining in 1998. The headline
indices, which are mostly market cap-weighted, were driven
by huge inflows chasing a few of the largest companies,
even while the average stock was headed lower.
Source: Bloomberg |
Another clue that we may be range-bound for some time is
the S&P's valuation. During consolidation periods, earnings
multiples contract as earnings continue to grow while stocks
move sideways. Once the trailing P/E gets down to the single
digits, stocks appear cheap and the next expansion phase
begins. Multiples increase during expansion cycles as stock
gains outpace earnings growth.
With the trailing P/E on the S&P currently at around
19.6 times, it doesn't seem like an expansion cycle is under
way; those normally start with single-digit multiples. It
seems more likely that the market's multiple will decline
before a large, multiyear move higher commences.
Source: GNI Capital |
But just because the market may be in the midst of a long-term
consolidation period doesn't mean there aren't going to
be opportunities along the way. Within these cycles of subpar
average annual returns, there still are some huge moves
in either direction.
For example, the chart below takes a closer look at the
1966-to-1982 consolidation cycle. If you recall, stocks
averaged just 2.7% per year during this period, but there
were four rallies of 47%, 66%, 72% and 61%. There were also
five selloffs of 22%, 33%, 48%, 19% and 26%. In fact, with
all its weekly ups and downs, the S&P traced out a path
of 1,424% (that's the sum of the absolute value of each
week's change). Clearly, that volatility back and forth
gives the opportunistic investor some good prospects for
making money.
Source: GNI Capital |
Style rotating, or switching between large-cap and small-cap
and growth and value, may be the most profitable strategy
over the next 10 years. It's such a cliche to say that it
will be "a stock picker's market," but in stark
contrast to the early and mid-1990s when all stocks moved
higher, stock selection is much more critical in a market
with sharp swings but no progress.
For example, Callan Associates has published a table of
the historical
investment returns of different asset classes. The color
coding of this chart makes it easy to see that the performance
ranking of the various asset class and investment styles
year to year changes dramatically, and that frequently one
of the best performing styles in one year is one of the
worst in the subsequent years.
More to the point, however, is that during the expansion
years that are displayed on this chart, namely 1984 to 1997,
the very worst-performing asset class or investment style
(the bottom box) still produced a positive rate of return
in nine of the 14 years. In the consolidation period years
of 1998 to 2003 on the chart, the worst performer finished
in the green only once.
This illustrates my point: During expansion cycles, it's
easier to make money because pretty much everything is working.
Large-cap value, small-cap growth, and everything in between
go up during these periods. But in consolidation periods,
stock picking, market-timing and style rotating are critical
to producing consistently strong returns.
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