Sideways market can bring decent returns”$£%*!()_+???

The following is a counter take on a Rob Carrick of the Globe and Mail article “Sideways market can bring decent returns”.

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The point being made about sideways markets is, I assume, that they present valuable opportunities to trade the highs and lows and to reinvest dividends.  But this assumes a number of factors:

  • It assumes that there are dividends to reinvest – in this case the Brandes Sionna Canadian Equity fund has a management expense ratio of 2.65% (Class A shares) and a dividend yield of 0%.
  • That the timing of the manager in question is successful and returns after fees and other impediments (tax drag) beat the index in question.  In this case the fund itself has underperformed its index since launch.   
  • It also assumes that the starting point from which the statement is made is based on reasonable valuations, which was not the case for most major markets towards the end of the 1990s.
  • Sideways markets also need to outperform other investment alternatives and equities need to be attractive relative to these other assets.

At the peak of the 1990s bull market, main market indexes were yielding very little, and investors who were exposed to downward sloping sideways markets (note Canada is one of a few markets that have experienced an upward marginal sideways movement, since most major markets have experienced downward sloping sideways movements) would have received small dividends and often significant capital losses.  

Holding equities in downward sloping sideways markets also runs the risk of accentuated capital depletion for investors relying on capital withdrawals to finance expenditure.   Even in mildly upward sloping sideways (with wild up and down movements) markets, returns for equity investors faced with high management and transaction costs are likely to be minimal, on average.   The current dividend yield on the S&P TSX composite is 2.8% (22 September 3.30pm), for anybody using the 3 January 2000 composite closing level as a base, this is equivalent to a  yield of 3.8%.  Capital gains over the period averaged some 2.6% per annum (geometric annual return) on the index (3 January 2000 to 22 September 2011).   With many a fund’s dividend yield being eaten up by charges, the most the average fund could have expected to achieve in terms of return would have been close to the average return of the market, or some 2.6% per annum.  Inflation since January 2000 has been some 28%, meaning that the average real return for investors with management charges as noted, will have, on average, been no more than 0.47% per annum.  Hardly a reasonable return.

As it stands, a yield of 2.8% on the S&P/TSX is not indicative of massive undervaluation, and neither is a P/E ratio of 15 times historic earnings.  Compared to other major markets with yields in excess of 4% and P/Es below 10 (historic), Canadian markets are not pricing in much downside economic risk. 

Of course, these other markets have seen significant downward sloping sideways markets since the late 1990s: the S&P 500 is back to levels seen in April 1998 when the yield on the S&P was some 1.3%, the French CAC to levels last seen in May 1997, the Dax, levels last seen in April 1998 and the UK FTSE 100 to levels last seen in September 1997. 

In other words, markets in general, for the average investor, are unlikely to have produced decent returns over this period.

From this point on…   

Naturally, from a starting point where yields are higher, market valuations at the lower end of historical price bands, and where bond yield/equity earnings yield relationships favour equities, holding assets in a sideways market poses much less risk, all else being equal, irrespective of the intermediate price movement, providing costs are low and portfolio structure is capable of managing equity withdrawal risks.

But can we assume that we will have sideways markets from this time on?  I am not so sure that we are about to face a further 10 or 20 year period of sideways market movements.   I think the risks that have built up within the system are gaining in momentum and in importance.  A denouement will more likely be swift: the ups and downs of the markets since the late 1990s has been more to do with the avoidance of the inevitable, whereas we are being forced to a point where we can no longer ignore them.  As such, markets are more likely to move down sharply, followed by a starting position of distressed value from which a longer term uptrend can be established. 

The past may have been “sidewaysish”, but the future is unlikely to be so, for this would require the maintenance of a very unstable status quo over a long period of time, which quite frankly is untenable and unlikely. 

High dividend yields may reflect value, but they may also be compensating for the risk of deflation and the decline in economic output that comes with it.  In this case high yields provide a return of capital component in equity valuations and this risk needs to be factored into planning.   Canadian dividend yields may therefore (at the 2.8% noted) not fully factor in the risks of a severe slowdown in global economic growth.

Canada may have been fortunate relative to other markets, but it should be noted that it has also significantly outperformed other markets in relative and absolute terms.   

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