Era of Range Bound Investing
Investing luminaries such as Warren Buffet of Berkshire Hathaway and Jeremy Siegel of Stocks for the Long Run made their marks in the Investors’ Hall of Fame using strategies based on long-term, buy-and-hold investing. While their success speaks for itself, they earned their reputations when that strategy was highly effective, in a long-term bull market where P/Es (Price to Earnings Ratios) kept expanding. That same strategy applied to the broader market can be disastrous in a range-bound market. A portfolio invested in the broader market from 1966 to 1982 would have received no real returns for an entire 16 years, until the next bull market began in 1983. That bull market lasted from 1983 to 2000, when we entered yet another range bound market, as is shown in the chart below.
An investor who bought the broader market at the beginning of the range bound market, (Position 1) on August 31st, 1998 would have lost 19% by October 2002 (Position 3) and 29% by March 2009, (Position 5). That means after eleven years of investing in the broader market, the investor would have lost 29% and that’s ignoring inflation!
An investor who bought at the first peak of this range bound market (Position 2) in March 2000, would have lost 56%, again ignoring inflation, by March 2009, nine years to lose over half of their investment. As for the joy over the latest run up, this same investor would have only gained 9% from March 2000 to today, waiting thirteen years to earn just 9% which translates to an annual rate of return of 0.657%, not even keeping up with inflation!
So what’s the solution? Sell at market peaks and buy at the bottom? Easy in hindsight but how can anyone reliably identify market peaks and troughs when you are sitting in them? Isn’t that market timing, which has been proven repeatedly to be a very effective way to lose money? We aren’t suggesting market timing, but rather price targeting. This means finding a security, a stock, bond, commodity etc. that we like for fundamental reasons, then identifying a price at which we believe purchasing that security has relatively low risk. The single most important factor in returns is the starting valuation.
This is rather intuitive. Let’s use buying a house as an example. Home prices have a long and very strong relationship with median household income levels, which makes a lot of sense when you think about it. How much people can pay for a home is dependent primarily on their income. If mortgages interest rates drop dramatically, the down payments required drops and families no longer have to provide evidence of any income nor have good credit, they may be able to buy a more expensive house than when they were required to put 20% down, have good credit and provide proof of stable income. Sound familiar? When that happens the market can be distorted, but eventually the relationship between home prices and income levels will be restored. If a family buys a home when home prices are at or below the historical norms for the relationship between price and income and mortgages are unusually difficult to get, the risk of the home falling in price is much lower than if they buy the home when that relationship is much higher than historical norms and mortgages are available to anyone with or even without a pulse!
It is the same with investing in stocks, bonds or commodities. The frustrating and complicated part is the waiting. We may have to wait a considerable amount of time to see a price that we like and that period of waiting can be expensive, so if we believe that market conditions are not too insanely out of whack with the price we are looking to pay, we might tip toe in, but will hold off until we get within a reasonable range of our target price before we start loading up.
This means that for us, a cash balance is not so much based on a target allocation for a client’s portfolio, but rather is a by-product of the level of opportunities we see in the markets. If we believe that conditions are significantly over-bought, we will end up having higher cash balances than if we believe that conditions are over-sold.
In any market, buying at the right valuation is the most important decision. In a range bound market, investors must also identify a price at which they believe they need to sell. In a long-term bull market, investors don’t need to worry about selling because prices can continue to go up and up for over a decade. In a range bound market, there is a ceiling for prices and the wise investor identifies where that sits, sells, and patiently waits for the opportunity to buy again.
Meritas recently executed this strategy for our clients with a utilities ETF, ticker symbol XLU. We bought it when we believed that valuations for the stocks within it were attractively priced, then sold when we believed that the prices were becoming entirely too high for the market to withstand.
Bottom Line: In long-term bull markets the buy-and-hold strategy translates into buy-it-and-forget-it and can serve investors well. In range bound markets, like the one we are in today, investors must be more active, identifying not only a price at which to buy, but also one at which they to sell. Next month we’ll discuss this topic further, going into just what generates equity returns.
