Unexpected Returns

I have just finished reading Ed Easterling’s new book, Unexpected Returns, Understanding Secular Stock Market Cycles. Ed Easterling is the president of Crestmont Research, which manages a fund of hedge funds.

Ed Easterling has posted almost all of the information in his book at his web site. His book helps you put everything together. But if you are on a tight budget, you can save some money if you spend enough time reading and learning what is on his site.
Crestmont Research

Ed Easterling summarizes his ten key concepts on pages 258-259. Here is my edited, abbreviated list.

1) Valuations matter. Above average returns occur when P/E ratios start low and rise. Below average returns occur when P/E ratios start high and end low.
2) Financial markets are much more volatile than most investors realize! Volatility matters.
3) The stock market experiences extended periods of secular bull markets and secular bear markets based on the trend in P/E ratios, which is driven by the trend in inflation.
4) The Y-Curve Effect reflects the strong relationship between P/E ratios and inflation or deflation.
5) The current financial conditions indicated low or negative returns from stocks and bonds.
6) P/E ratios for the market have a sustainable limit in the range of 20-25 when inflation is near price stability.
7) During secular bull markets, the investment of buy and hold can be very effective. During secular bear markets, the investment strategy of seeking absolute returns can be very effective.

Ed Easterling makes a powerful case that we are in a secular (i.e., relatively long-term as opposed to short-term, one or two decades as opposed to one or two years) bear market. He has broken the components of stock market returns with far better precision than others. He approaches this issue from several different, but complementary starting points.

Ed Easterling’s Y-curve presents us with a powerful insight and the numbers that go along with it. Any move away from price stability, whether toward inflation or deflation, causes price to earnings P/E ratios to fall. Any move toward price stability, whether from inflation or deflation, causes P/E ratios to rise.

Another major finding is that corporate earnings grow around 85% to 90% of the Gross Domestic Product’s NOMINAL growth rate. The REAL (inflation adjusted) rate of growth of the GDP is very consistent, currently around 3%.

[NOTE: This rate has fallen from a very long period averaging 3.5% down to 3.0% during the last two decades. Economists may point to this as evidence that the officially reported rate of inflation is HIGHER than it should be. That is, subtracting a smaller portion of the NOMINAL GDP would bring the reported REAL GDP back up to its historical norm. Observations such as this are highly unpopular. Social Security checks and salary increases are adjusted according to the reported rate of inflation.]

If you are able to predict the level of inflation at the end of a period, you can predict earnings growth.

With earnings growth and the current dividend yield, you can calculate the growth rate of your investment before adjusting for changes in the price to earnings P/E ratio.

[NOTE: Total return equals the dividend yield plus the earnings growth rate plus or minus an adjustment for changes in the price to earnings P/E ratio.]

Ed Easterling has also supplied a graph showing the relationship between the dividend yield and the price to earnings P/E ratio.

Starting from today’s P/E, dividend yield and inflation rate, you can calculate everything that you need just by making assumptions about what inflation is likely to do over a specified period. All of the relationships have statistical uncertainty. The relationships allow you to calculate the same kind of information in different ways. Combined, you end up with a very good picture of the future.

In case you did not know it, the future looks grim. We are in a secular bear market.

Ed Easterling has provided some excellent insights about stock market statistics. It is best to treat bull markets and bear markets separately. In a bull market, price to earnings P/E ratios increase. In a bear market, the market’s price to earnings P/E ratios decrease over an extended period of time. There has never been a period with stable P/E ratios.

The market has single digit gains and losses only about one-third of the time. About one-half of the time, the market increases 16% or decreases 16%. In bull markets, all of the 16%+ changes have been on the upside. It has been a very pleasant ride. In a bear market, about twice as many 16%+ moves are down versus the 16%+ moves that are up. It is an unpleasant, choppy road down, with big moves up interspersed that give you false hope.

So? What can we do today?

Unfortunately, Ed Easterling manages a fund of hedge funds and he points us in the direction of absolute return strategies (such as long-short strategies, arbitrage strategies and many others) as implemented by professionals.

He does identify two approaches for the masses.

The first is to invest in bond ladders. He demonstrates that intermediate-term bond ladders (with 7 to 10 year securities) have consistently returned almost all of the return of longer ladders (e.g., 20-year securities) with almost none of the risk of the longer ladders. In addition, he explains why it is almost always a bad decision to cash in any of the bonds before its maturity. [You pay transaction fees, commissions and taxes. What do you do with your money? There are no attractive substitutes among bonds at that moment. You get the privilege of paying capital gains taxes and you must reinvest in an inferior bond.]

The other is to rebalance more frequently in a bear market.

In terms of Safe Withdrawal Rates, we have found that switching allocations in accordance with valuations is a better idea. Switching includes rebalancing, while taking advantage of our ability to assess the relative likelihood of risk and reward. If not switching allocations, we can still do better by being away from stocks in times of unreasonably high valuations.

High dividend stocks might protect you. The biggest issue is how well the dividends compensate for future price decreases. If the price drops right away, being out of stocks is best. If the price does not drop for several years, you might be better off because the income from dividends received may add up enough to cover the drop in prices.

Still, if you have no idea of how well your investments are likely to perform, rebalancing does protect you a little bit on the downside in times of high valuations.

Have fun.

John Walter Russell
I wrote this on May 17, 2005.