Expect the Unexpected

in Book Review
February 23rd, 2006 – The Motley Fool 

By Vitaliy Katsenelson, CFA

After reading Jeremy Siegel’s book Stocks for the Long Run, one gets a strong sense of security about investing in the stock market. Over long periods, the market overcame catastrophes like a global influenza pandemic, the Great Depression, the Cold War, two Gulf wars, two world wars, terrorist attacks, natural disasters, and much more. All of those events look like small potholes on the long road to prosperity when you put it into historical perspective.

I use Siegel’s excellent book in my graduate investment class because it provides a very good historical overview of financial markets. However, students often ask me after looking at the well-defined upward slope of the stock market line on a 200-year chart, “Why bother tinkering with stock picking? Just buy an index fund and forget about all your worries.”

Should investors buy an index fund in any market environment, regardless of the market’s valuation? Does market valuation matter? After all, over the long term, stocks have produced a very respectable rate of return. 

Unexpected Returns, the very insightful book by Crestmont Research’s Ed Easterling, provides an answer to that and many other questions.

“Soar into space, and the earth loses its distinctive features: the Himalayas flatten; the Grand Canyon appears no deeper than a ditch … but it gives few, if any, clues to the harsh geographical and financial realities that you should face walking across the earth’s surface. … If you take a long-term view on the stock market, perhaps fifty or seventy-five years, it becomes a beautiful blue chip market. But the long-term rise in the market obscures the realities that affect almost every investor.” 

What does Easterling mean by that, exactly? Here are a few of his key points:

Market valuation matters When buying an individual stock, investors must make the distinction between a good company and a good stock — they’re not always the same thing. For example, Wal-Mart(NYSE: WMT) is arguably a great company. It has a great balance sheet, a respectable return on capital, and a solid moat around its business. But the investor who purchased the stock in 1999 at 39 times earnings received no returns from the stock, with the exception of collecting a skimpy dividend. Although Wal-Mart has grown earnings more than 15% since, its excessive valuation has deterred the stock from rising (the valuation has since dropped to 17 times earnings). The same is true for other blue chips like Johnson & Johnson(NYSE: JNJ), First Data(NYSE: FDC), Microsoft(NYSE: MSFT), and Coca-Cola(NYSE: KO), to name a few.

When buying an individual stock, investors must make the distinction between a good company and a good stock — they’re not always the same thing. For example, is arguably a great company. It has a great balance sheet, a respectable return on capital, and a solid moat around its business. But the investor who purchased the stock in 1999 at 39 times earnings received no returns from the stock, with the exception of collecting a skimpy dividend. Although Wal-Mart has grown earnings more than 15% since, its excessive valuation has deterred the stock from rising (the valuation has since dropped to 17 times earnings). The same is true for other blue chips like , , , and , to name a few.This distinction often fails to translate when investors are talking about the stock market. Even when the stock market approaches a very high valuation, a buy-and-hold strategy is encouraged and investors expect to receive “average” returns. But average returns rarely happen. Returns that investors receive are a function, to a large degree, of a starting P/E. That makes a lot of intuitive sense. Returns from stocks are comprised of stock appreciation and dividends. Stock appreciation consists of P/E expansion and earning growth.

“Periods that start with above-average P/Es produce below-average returns, and periods that start with below-average P/Es produce above-average returns.” Easterling proves this point time and again with numerous tables and charts.

The market is expensive Today’s valuation is still above average as we’re coming out of one of the biggest bull markets of 20th century. The S&P 500 is trading at 17 times trailing earnings, compared with the historical average of around 15.

Today’s valuation is still above average as we’re coming out of one of the biggest bull markets of 20th century. The S&P 500 is trading at 17 times trailing earnings, compared with the historical average of around 15.

Still, some would argue that the S&P’s forward P/E of 15 is about average. The problem with this argument is that the historical averages are calculated based on trailing, not forward, earnings. Thus, the forward P/E is not useful for gauging today’s market valuation because we’re comparing apples to oranges.

Also, the current dividend yield of 1.7% is far below the historical 100-year average of 4.4% — another confirmation of relatively high market valuation. Easterling argues that dividend yield is arguably a better yardstick of market valuation than P/E. P/E can be distorted during recessions (and economic booms), when dividends are more stable and unaffected by earnings adjustments. 

Easterling makes another very interesting observation. Investors often associate bear markets with subpar or declining earnings growth and associate bull markets with above-average earnings growth. Nothing could be further from the truth. During the bear markets that took place in the 20th century (with the exception of the Great Depression), when stocks declined 4.3% on average per year, nominal GDP grew 6.9% — in fact exceeding the nominal GDP growth of 6.3% experienced during the bull markets, when stocks rose 14.6% a year on average.

Bottom line Unexpected Returns raises many very important questions. It doesn’t– nor does it claim to — provide specific investment solutions. However, it does provide important investment insights. Easterling makes a very compelling case for active, more “hands-on” investment strategies in today’s investment environment. The sense of security about stocks the book fosters goes away pretty quickly after putting it down. Yes, buying an index fund and forgetting may work if one’s investment horizon is 50 years or longer, but that’s not the case for the rest of us. As economist John Maynard Keynes said, “In the long run, we are all dead.”

raises many very important questions. It doesn’t– nor does it claim to — provide specific investment solutions. However, it does provide important investment insights. Easterling makes a very compelling case for active, more “hands-on” investment strategies in today’s investment environment. The sense of security about stocks the book fosters goes away pretty quickly after putting it down. Yes, buying an index fund and forgetting may work if one’s investment horizon is 50 years or longer, but that’s not the case for the rest of us. As economist John Maynard Keynes said, “In the long run, we are all dead.”

It would be just plain wrong to leave the reader on this less-than-optimistic note. In future articles and in my upcoming book, I’ll discuss an investment strategy that will work in today’s market environment. 

Fool contributor Vitaliy Katsenelson is a vice president and portfolio manager with Investment Management Associates, and he teaches practical equity analysis and portfolio management at the University of Colorado at Denver’s Graduate School of Business. He and his company own shares of First Data. His company also owns Johnson & Johnson. The Motley Fool has a disclosure policy.

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