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The Second Time Around

06/16/2013

I just re-read one of the best investment books ever written:  Unexpected Returns:  Understanding Secular Stock Market Cycles, written by Ed Easterling in 2005.  When I read it the first time, the most interesting lesson was what he styled the “Y-curve effect.”  He demonstrated pretty clearly that PE multiples decrease whenever there is a change in the rate of inflation.  In other words, investors will pay less for every dollar of earnings-per-share whenever inflation either goes up or goes down.  Change or uncertainty of any sort scares investors and stops them from paying top price for a stock.

Easterling has been in the investment press quite a bit recently, discussing two things:  (1) that the current stock market is NOT over-valued but (2) we remain in a long term bear cycle, despite much recent discussion that we have finally entered the bull part of the cycle.  We often say the market is over-valued based on the price-earnings ratio (P/E), i.e., the stock price divided by the earnings-per-share.  However, there is research from Yale’s Robert Schiller that 10-year cyclically adjusted P/E, or CAPE ratio, is more meaningful.  Using that measure, investors are currently buying stock for 23.2 times each dollar of earnings-per-share of stock, or $23.20 per share for a stock with $1 earnings-per-share, which is relatively low.  During the tech boom of 1999, the CAPE ratio was 44.2 times.

But, that doesn’t mean the secular bear cycle that started in 2000 is over yet.  Market cycles can be as long as 24 years, according to Easterling.  Hitting a market high now is not proof that the bear has returned.  He recalls the market setting a record high in 1972, even though the bullish part of the cycle didn’t begin for another decade.

This caused me to read his book a second time and, of course, absorb even different lessons.  One is that long cycles are harder to identify and predict than short cycles.  The second is that “buy & hold” only works well during the bull cycle but not during the bear part of the cycle . . . duh!

Some people say marriage is better the second time around.  I won’t touch that line, but a book is often much better the second time around.

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