While being employed by a major Wall Street firm has been extremely difficult over the past year – no, I did not receive a bonus or any TARP funds last year – it does have some advantages. Along with having access to a huge range of investment vehicles, I get to talk to some really interesting people.
One of those people is Ed Easterling who was being dragged around by a mutual fund company (yes, in exchange, I will take a look at their funds, but only use them if I truly see value there). I got to spend 2 hours with Ed discussing his book, his outlook, and otherwise peppering him with questions.
You probably have not heard of Ed, but he is an interesting guy and you should read the rest of this post.
Ed Easterling is the man behind the Crestmont Research web site. His full bio is here. I read his book, Unexpected Returns, in 2005 and have been a fan ever since. If nothing else, look at this chart. It is an excellent graphical representation of how long stock market cycles can last and why we are likely in a secular (long-term) bear market. I’ll try to summarize the conversation, leaving out an amazing amount of technical detail that he presented.
The economic news will continue to be bad for some time, at least through 2009 and potentially well into 2010. Unemployment in particular will worsen into 2010. But, stock markets are forward looking and we could see some rebound in the second half of this year.
Ed’s belief is that we are in a low inflationary environment and his market outlook is based on that premise. If we see high inflation or deflation then the outlook will change, possibly dramatically. His research indicates that secular market cycles are based on two things: inflation and P/E ratios (calculated in his own way, but close to the Shiller model of using 10-year trailing earnings). The combination of low inflation and low P/Es lead to bull markets, as is what happened in the last bull starting in the early 1980s through 2000.
Currently we have average P/Es using his calculations, not low ones. So, even in a low-inflation environment, the conditions do not exist for a secular bull. Conversely, P/Es are not high. Given low and stable inflation and average P/Es, we should have a sideways market. This fits in very well with my operating model: a long-term range-bound market.
This implies up years and down years, but no long-term trend in either direction. He thinks we could easily see 18% up years very soon, followed by down years as P/E ratios revert to the mean.
Of course, this sounds very much like the Japan Scenario. When I asked him about this, he said that he thought that there are some fundamental differences. The most important is that Japan has a declining population/employee pool and we do not. The two key ingredients of economic growth are rising employment and rising productivity. Without rising employment economic growth is extremely difficult. Without economic growth, stock markets decline.
Ed commented that we will have the population base for employment growth for two reasons: 1) immigration and births from immigrants, and 2) delays in retirements as people are forced to work longer. (Reason #2 is an unfortunate source of employment growth.)
While I grant that we will continue to have economic growth and thus stock market growth over the long term, it does not change the short to mid-term outlook. Since their stock and housing bubbles burst in the early 1990s, Japan has experienced a sideways, range-bound market in a low inflation, and sometimes deflationary, environment. Japanese markets have rallied during this time, only to fall again. This is what Ed believes will occur here in the US (given an environment of low inflation).
What does this mean for investors? Buy and hold does not work. Active management is required with a focus on income and hedging strategies. Exactly what I have been telling my clients. It is interesting to find a well regarded strategiest come to the same conclusion, although via a different process. I’m not sure what that means. (My conclusion is based more on the forces of economic deleveraging: in just the last 8 years US consumers and businesses have doubled the amount of debt we hold. We now need to pay it off which will take many more years and continue to put downward pressure on asset prices as they are liquidated to pay those debts.)