Customer Reviews

Unexpected Returns: Understanding Secular Stock Market Cycles

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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 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, published in April 2005, that then prevailing P/E's implied a coming period of lackluster returns in U.S. stock averages. This has proved true to date.

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 CrestmontResearch.com. The author believes his loftily named "financial physics" lends 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)