Customer Reviews

Unexpected Returns: Understanding Secular Stock Market Cycles

5 star:		(30)
4 star:		(9)
3 star:		(1)
2 star:		(1)
1 star:		(2)

 

 

The stock market's phenomenal rise from 1982-1999 and equally impressive fall beginning in 2000 naturally led many to question the buy-and-hold, "stocks for the long run" conventional investing wisdom of the 1990's. Among the questions: do secular bull and bear markets really exist, and how long do they last? Can we know what causes them? Are they predictable? Can we know which market phase we are experiencing now? If so, what practical benefit does that provide us in forming an investment strategy and making investment decisions?

These are all timely and important questions, and a new book, Unexpected Returns by Ed Easterling, is the most elegantly structured treatment of the subject that I've seen to date, presented with clear historical data to back up the arguments. The surprising thing is how much the average investor experience depends upon stock prices relative to earnings or dividends, and whether these multiples expand or contract during a given investment period. There is a wonderful chart on page 80 of Unexpected Returns that shows just how much investors are dependent upon changes in P/E ratios, not earnings growth, over time for their returns. Easterling shows clearly that the best environment for P/E ratios is when inflation is low and stable and approaches price stability. The further conditions stray from this low-inflation, price stability environment, the greater the downward pressure on P/E ratios. Historically, the highest levels of inflation (such as those experienced in the 1970's) and the most extreme examples of deflation (such as that in the early part of the 20th century in the U.S.) correspond with historically low P/E ratios.

One of the strongest points emphasized by the book is that interest rates and inflation have never been stable for long, and the recent condition of low inflation price stability is a historical anomaly. As long as the current benevolent inflation / interest rate environment lasts, stocks can support P/E ratios in the low 20's; the sooner it changes, and the more drastically, the farther P/E ratios will have to fall. The evidence, as Easterling lays it out, makes it far more likely that the stock market's nice performances in 2003 and 2004 represent nothing more than a typical bear market rally than the beginning of a new bull market. Stock prices and interest rates similar to those prevailing today have historically marked the ends of bull markets, not their beginnings. The recognition of the conditions of a secular bear market requires a different investment strategy than does a bull market - as Easterling would say, row, don't sail.

Unexpected Returns is compact, highly readable, and offers compelling historical evidence for the inevitability of secular bull and bear markets, what drives them, and the clear signals that can be used by enlightened investors to determine the prevailing market cycle in order to improve results in any market environment.
(The review above is a shorter version of one originally published in Value Investor Insight (www.valueinvestorinsight.com) and appears here in this format with permission.)

I almost stopped reading this book. Easterling spent so much time building credibilty for his work that I nearly fell asleep. THEN when he started talking about the stock market, what factors really determine the long term prices and valuations of markets, well, that's when this book took off. Great stuff.

Written for the non-technical reader but doesn't talk down. I thought the charting of various variables in stock market trends and tendencies to be very friendly to read. Easterling spent the time to literally do the graphs and charts in color and that was a nice change of pace.

He doesn't claim to be a seer, he simply does a brilliant job of laying out piece by piece, how to calculate the future of the stock market.

Truly well done and one of the top four or five investment/stock books of the year.

When you read something this well done, you can only appreciate the author and his love, and depth of knowledge of his subject.

Kevin Hogan, Psy.D.
Author of The Psychology of Persuasion
and
The Science of Influence

As an investment manager employing both fundamental and technical analysis, the "Secular Bear Market" seems to me an obvious theme. Major stock market indexes are currently as low as they were in 1998. Six years of a secular bear market and most investors are still using the same strategies that worked in the rising markets of the `90's (buy and hope). This trend is nothing new; stocks have cycled 8 times from upward to sideways, over and over, about every two decades since the 1901. Traditional "buy and hold" relative return strategies rely on the direction of the markets. They enjoy gains when they occur, suffer loses when the market declines, and require a long time horizon that many investors don't have. Skill-based tactical strategies seek gains regardless of market direction using investment manager skill in sector rotation, hedging strategies, and risk management. As Ed says in the book, when the wind is blowing we can let out the sails and enjoy the ride. When the wind stops blowing, you can sit there and wait the wind to come again, or you can get out the oars and start rowing. Based on current technical and fundamental research, it seems the wind may not cast our sails and the oars are now necessary to get where we want to go. This book is truly a remarkable account of the markets history. Very well written and compelling research that all investors must understand.

Mike Shell

The author makes a couple of valuable points. First, any long-term investment strategy has to take into account the existence of recurrent "secular" (i.e., indefinitely long) bear markets. Most leading investment advisors recommend a "buy and hold" strategy, but this only works during predominately bull market periods. Most studies of successful investment strategies are biased towards the recent 1982-1999 bull market, which is anomalous in historical terms. The author uses a plethora of graphs and charts to prove that "buy and hold" doesn't always provide the best returns. Obviously, then, it's better to pull out during the bear markets, but that's easier said than done. The author provides a very complete analysis of the characteristics of bear markets, including P/E ratio, interest and inflation rates, and GDP. The problem is that those characteristics don't always correlate with market performance. For example, this book was written in 2004 and the author predicted a bear market. Well, if you heeded his advice, you would have missed the bull market of 2004, 2005 and early 2006, especially in small-mid caps and foreign stocks. Even with high P/E ratios, a bull market can continue for several years: witness the late 90s. It's virtually impossible to time the market even if you monitor the major stock indexes on a daily basis. There is so much volatility on a daily, weekly, monthly, and yearly basis that's it's impossible to know when the market has switched directions. By the time that it is apparent, it's too late to profit. Even in the midst of great bull markets, there might be week, month, or even year-long downturns. The author says nothing about individual stock picking, beyond a general value approach. The book is all about big picture, long term trends. Another problem is that the author's predictions are based on his analysis of market trends going back to 1900. But the market (and economy) is a different beast now that it was in the 40s, 50s, 60s, and 70s. As they say, past performance does not predict future returns.

The investment advice provided here is not useful. He suggests a "portfolio of hedge funds," ignoring the fact that most hedge funds require a minimum deposit of 500K. He also recommends a "bond ladder," an approach which can be easily replicated with a good bond mutual fund, and frequent rebalancing of your portfolio asset allocations. I don't need to spend $25 and five hours reading to learn that!

One thing I did learn from this book is the impact of volatility, which is often ignored in investment strategy recommendations. Volatility cuts into returns in ways that most studies do not account for. Most studies just average the returns across years, but that doesn't reflect real returns. Let's say you invest $100k into a stock that returns 35% the first year and -15% the second. Your average return should be 10% a year, right? Wrong. At the end of the first year you have 135k. Minus 15% the second year leaves you with 115k total, equal to 7% a year compounded. If you had received 10% a year compounded, your final total would be over 121k. That's 6k difference in just 2 years, and the volatility costs add up.

The book is very poorly written, plodding, sooooo boring, with tons of repetition. Just as an example, the graph showing the "Y curve" relationship between P/E ratio and inflation is repeated no less than 3 times.

Ed Easterling's "Unexpected Returns: Understanding Secular Stock Market Cycles"(2005)deals with the issue of bullish and bearish "seasons" in the stock market--such as the U.S. bear markets of 1901 to 1920, 1929-1932(the Great Crash)and 1966 to 1981 and bull markets from 1921 to 1928 (the Roaring 20's)and 1982 to 1999.

Easterling's somewhat dry title belies a rich and important book. Here is the argument in a nutshell:

For the investment horizons that matter to most investors, the time of entry and exit is critical. More specifically, buying into a market with a low price/earnings (P/E) ratio average and selling into a market with a high average P/E has produces by far the best returns, both absolutely and relatively, as well as the most favorable dispersion of returns and the fewest negative return periods.

Average P/E's rise (leading to outsize investment returns) when the economy moves toward a persistent low rate of inflation, of which about 1% per annum is optimal, from either a high level of inflation or deflation. [The same trend that is bullish for stocks is also bullish for bonds, an asset class that Easterling also treats, but with less detail than stocks.] In such an environment, the increasing P/E's attached to stocks multiply the effects of rising market earnings.

These findings imply says Easterling, an activist investment strategy: "rowing," not "sailing." An investor must make strenuous efforts to respond to prevailing market conditions. As a rule of thumb, average P/E's in the 20 times plus area (such as the U.S. equity market now sports) are not sustainable for long except under ideal conditions. On the other hand, market average P/E's of around 10 times or lower present a compelling opportunity for entry.

One problem facing those who would follow Easterling is that it may be difficult while in the midst of a long-term cycle to know when it is reaching a turning point. That will only be obvious in retrospect. Then too, many investors will not feel the luxury to stay out of the market for very long periods or to go short. The practice of spreading constant investment amounts over time intervals, called "dollar cost averaging," may in part address these issues.

Easterling made the prediction in his book, released in April 2005, that then prevailing P/E's implied a coming period of lackluster returns in U.S. stock averages.

Easterling acknowledges his debt to Robert Schiller of Yale for source data and data series method. His thesis is consistent with Schiller's cautionary views and provides an important corrective to the optimistic gloss of Jeremy Siegel's "Stocks for the Long Run," at least for investment horizons going out to about 20 years. Siegel's work remains valid and important to understand for those with investment horizons going out longer than this, as well as for those to whom the criterion is not optimal timing but rather probable outpeformance of stocks compared to alternative investment in US Treasury bills and bonds.

Easterling founded and is president of Crestmont Holdings, LLC, a Dallas-based fund of hedge funds manager. He publishes research at his CrestmontResearch site. The author believes his loftily named "financial physics" lend support to a diversified fund of funds strategy--an investment approach he lauds, while giving scant attention to the heavy burden of overhead costs it generally entails.

Andrew Szabo
(Greenwich Financial Management)

Ed Easterling has penned one of the most insightful "big picture" books about the stock market ever written, in the same esteemed category as "Triumph of the Optimists" and Jeremy Siegel's "Stocks for the Long Run." Easterling uses a wealth of data to show that the critical component of long-term excess returns is not earnings growth, dividend yield, or luck, but expansion of the price/earnings ratio. Typically, P/E expansion happens in a slowly falling interest rate environment with mild inflation (2-3%) and stable economic conditions. Remind you of the 1990s?

By contrast, P/E contraction happens during times of econonomic instability, unexpected deflationary or inflationary pressures, or rising interest rates. Remind you of today?

If you invest most of your money at a time when P/E ratios are well above the long-term historical average (as they are now), the best you can hope for is an average long-term return (7%-10%), assuming P/E ratios do not decline over your lifetime. The odds are, however, that the market P/E will revert to its long-term mean over your investing lifetime because interest rates are likely to move higher and inflation is not likely to remain benign forever. While this point seems intuitive, few market participants acknowledge the simple interrelation between interest rates, inflation, uncertainty, P/E ratios, and long-term stock market returns -- a mistake that has huge ramifications, and has a high probability of causing disappointment with the stock market in coming years.

The book isn't just a bearish tome, however -- Easterling presents realistic strategies for overcoming the problem of declining P/E ratios. He lays out the problems using data to back up his case, then presents solutions. Investors would do well to heed his advice.

This is a fantastic book. Gives great reasons as to why future returns are going to be low. Also talks about the critical need to move from Buy and Hold to a more skill based investing approach (i.e. trading on TA ?). The only negative, I see is that he does not elaborate much on what skills/techniques are needed to move to skills based technique. I guess..for that you can invest through his firm.

Unexpected Returns is the best book on investing I have ever read. It's a must for all market junkies, for sure. It's a must for those professionals who work with clents. It's a big plus for investors/traders with intermediate to long term horizons (weeks to months, to 5, 10, 20 years). One of the key practical ideas is that investors need to act differently in a secular bear market than they do in a secular bull market. It's a big picture book with practical applications. Trust me, you will love it! If you want some more information, see Easterling's website at: http://www.crestmontresearch.com. You will get a good idea of what Easterling is all about. I have read the book three times. Then I highlighted the important parts. Then I underlined the most important parts. I am still enjoying it and learning. The price is more than fair; you won't be satisfied with a library copy.

This is a fantastic book to understand long-term market cycles and how they impact a portfolio's returns. Easterling does a masterful job of walking the reader through loads of data and information to understand how elevated P/E market valuations can't continue and how to link economic items such as real and nominal GDP with stock market realities like earnings and P/E valuations. He advocates an absolute return approach during down or choppy markets rather than a passive, relative return approach (that will go down with a declining market). His comparison between the two approaches is excellent and will help you discern what kind of approach you and your broker are currently taking.

My only critique of the of the book is that it fails to help investors apply his insights. Regarding bonds he advocates creating a bond ladder (great advice). Regarding stocks he advises....frequent rebalancing. That's good advice but hardly what I expected after all the great exposition. The final chapter on hedge funds is somewhat helpful but will not apply to the large majority of readers. He seems to defend hedge funds and advocates their inclusion in a portfolio. I suspect Easterling's lack of application is partly due to the fact that he's writing to both sophisticated individuals as well as professional investment managers.

Easterling does a magnificent job of explaining secular bull and bear markets, how they have acted in the past and what we might expect going forward. Many people in the industry try to tell investors that this time is different and point to long term market averages, but Easterling shows why this is misleading at best and backs it up with meticulous research. The key to making money is not to loose money and knowing what to expect from market cycles will help investors navigate the turbulent waters. Risk management can be adjusted to improve the probability of every investor's success. This is a must read for investment managers and their clients.