Executive Summary
From the beginning of this book, until the very end the author really pushes the idea of absolute return investing. Which is a strategy of investing by researching stocks vigorously to find companies whose stock are undervalued, and by using portfolio strategies to minimize risk. Though more importantly than strategy is better understanding the markets, first you must understand the market you are investing in then you should formulate a strategy.
The first few chapters of the book the author is simply trying to get the reader to understand how changing P/E ratios can be read from a historical point of view to show which direction the market is heading. Once you understand what kind of environment your investing will take place in then you can better formulate a strategy. Bull markets and bear markets are the two market types, bull investors or relative return investors will have success in bull markets but in bear markets will be subject to the market volatility and will show it on their portfolio. Bear investors or absolute return investors are best suited for either market, but they won’t be nearly as affected by the market’s volatility.
Risk is not a knob; this is something our author wants to make clear. You cannot necessarily turn a knob and increase risk and profits. By doing so you might find yourself losing money. The important thing is to minimize risk, or at least require that investments with a certain level of risk provide the potential for a high level of return.
We see models such as the Financial Physics model which is used to predict future market conditions. You can use this buy looking at historical data to accurately predict where the market will be in twenty to twenty five years. This is largely made possible by the fact that the markets move in cycles, and because economic growth is the main driver in EPS.
Diversification is a widely accepted investment technique, and our author does not suggest that investors not practice diversification, but he simple suggests that the more diversified you are the more exposed you are to the market conditions. The more the market moves the more your portfolio will move. Once again depending on the current market conditions this could be a good or bad thing. If there is a current bull market then this should not hurt your earnings but if it is a bear market then you want to manage risk as much as possible.
Bond laddering and rebalancing are the two main portfolio techniques used in the book. Bond laddering is where you invest your money in fixed securities so that they are maturing every year over a certain amount of years. For example if you invest 0,000 in bonds over 10 years, you would have ,000 maturing the first year, ,000 the second year and so on. As the bonds mature you take the money and reinvest it into another ten year bond. Rebalancing is the next technique, which is useful for managing risk over two different asset classes. For example let’s say you are invested 50% in stock and 50% in bonds, and at the end of the year you show significantly greater increases in the stock market. In order to protect yourself from volatility, you can rebalance by taking the profits made in both markets, and rebalancing them equally. I give an example used in the book in the summary below using monetary figures.
Overall the book was insightful, but I believe it was a product of the times. The book was probably more insightful when it was original published. The book was published in 2005 and written in 2004 following a huge bull market. Since then many important events have taken place, but mainly the markets crashed in 2008 due to the mortgage crisis which has resulted in putting more concentration on absolute investing strategies. Overall the book does a good job of laying out the foundation of investing, but it doesn’t go into a great deal of information on actually picking stocks.
The Ten Key Concepts Managers Need to Know fromUnexpected Returns; Understanding Secular Stock Market Cycles
“Valuation Matters. Over periods of decades, the average rarely happens; above-average returns occur when P/E ratios start low and rise, and below-average returns occur when P/E ratios start high and decline.” (Easterling, 2005, p258).
“The financial markets are much more volatile than most investors realize! Volatility matters. Two gremlins can devastate the returns that are actually realized: negative numbers and the dispersion of returns.” (Easterling, 2005, p258).
“The stock market experiences extended periods of secular bull markets and secular bear markets based on the trend in P/E ratios, which is driven by the trend in inflation.” (Easterling, 2005, p258).
“The Y-Curve Effect reflects the strong relationship between P/E ratios and inflation or deflation.” (Easterling, 2005, p258).
“The current financial conditions indicate either low or negative returns from stocks and bonds.” (Easterling, 2005, p258). Current conditions for this book would have been in 2004.
“Crestmont’s Financial Physics model aligns the interconnected relationships between the economy and the financial markets that determine the stock market’s overall direction.” (Easterling, 2005, p258).
“P/E ratios for the market have a sustainable peak limit in the range of 20-25 when inflation is near price stability – very close to where P/Es were in 2004.” (Easterling, 2005, p259).
“The progressive strategies of absolute return investing rely on skill for seeking consistent returns, and the traditional strategies of relative return investing rely on taking a long-term view of the market risk for return.” (Easterling, 2005, p259).
“During secular bull markets, the investment strategy of, “Sailing” by buying and holding stocks and bonds can be very effective; during secular bear markets, the investment strategy of “rowing” with absolute return strategies can be very effective.” (Easterling, 2005, p259).
“Evolution of the financial markets and investment management is expanding the concept of risk management from use in absolute return strategies to use in traditional portfolio management.” (Easterling, 2005, p259).
Full Summary of Unexpected Returns: Understanding Secular Stock Market Cycles
Planning the Journey
This chapter deals primarily with looking into and analyzing the stock market based on historical data. Evaluating the markets matter because you rarely get the averages as a result on your portfolio; “Above-average returns occur when P/E ratios start low and rise; below-average returns occur when P/E Ratios start high and decline” (Easterling, 2005, p. 9). Often markets are more volatile than most investors realize, and volatility matters when compounding returns annually. This is better explained in later chapters but if year one you invested and got a 20% return, and year two got a -20% return your return would be 0%. If you look at the same percentages with 0,000 dollars being invested, you will have 0,000 at the end of year one, and ,000 at the end of year two. By compounding the returns you actually lost money. If you look at non-volatile markets, where you have positive percentages each year then you would have actually compounded more money than the actual percent shows.
Overall this first chapter looks at the history of P/E ratios and establishes how they react in different markets, but it also puts a great deal of importance on investment strategy. In a Secular Bull Market, the strategy of buy and hold will work, because you can simple, “Sale with the winds”. Where being in a Secular Bear Market, that strategy won’t work, and the best chance of success for any investor is research and understanding the markets. In other words, risk management becomes exceedingly important during times of Bear Markets.
The Principles
The first principle, the author says, “Risk is not a Knob” (Easterling, 2005, p. 12). What he means is this; you cannot turn a knob, increase risk, and get higher returns on your investments. Sure you might be able too, and you might also lose money on your investment. Easterling is trying to address the concept that if you want to make more money simply invest in riskier securities, but in his words, “Higher risk in financial markets can lead to higher losses, when it is not addressed with the tools of risk management” (Easterling, 2005, p. 12).
Our next consideration is from an investor’s emotional perspective. Easterling brings up a good point; he tries to imagine what a financial market would be like on planet Vulcan, where everyone does everything solely based on logic. The idea is this; many people sell off securities at the first sign of trouble, while others won’t sell their securities even though they are in a position to make a nice return on them. It is the greed and hope that the price will rise just a little more and they can squeeze out a little more on their investment. Overall the chapter is suggesting that you put your emotions to the side and use logic in your investments.
Stock Market History
This chapter is pretty long, but to summarize it, the main message is that you have to look at the markets. “Many investors have lost the perspective that the market is volatile and has extended periods of relatively high returns and extended periods of relatively low returns. These high and low periods create a hypothetical average year that rarely occurs as an actual result” (Easterling, 2005, p. 54).
Interest Rates & the Inflation Roller Coaster
We do not know as much about inflation as we think we do. The Feds job is to help keep inflation low, but not negative and then to keep it stable. Throughout history the Fed has succeeded in doing this but the main point is that Inflation is something of a phenomenon and economist are still trying to better understand how exactly inflation works. Interest rates are the other big topic of this chapter, and our author’s first point is that interest rates are not neat and orderly as they might appear. They are volatile, and although they may be headed in the same direction, they are usually, “stumbling over each other along the way” (Easterling, 2005, p. 67). Here our author paints us an imaginary picture of very prestigious financial professionals sitting in a room trying to decide how to set interest rates, but our author points out that this is simply not how things happen. Interest rates are set based on buying and selling from within the market, a market where many investors buy and sell on emotions related to small bits of information they are fed. Our author uses the 6/50 rule, which means that “every six-month period, interest rates have moved by more than 50 basis points somewhere along the yield curve over 99 percent of the time since the mid-1960s” (Easterling, 2005, p. 68). Basis points refer to the percent change, where 100 basis points equals 1%.
Measuring volatility is important, because there are gains to be realized with in volatility. Using the tools of risk-management, and understanding the market are the fundamentals of investing in volatile markets.
Secular Cycles
Understanding Secular Cycles is an important concept. Our author uses an example of a farmer; the farmer knows when it is the best time to plant his seeds, so that he yields the most from them. Similarly, there are optimal times to invest when the market conditions are in place to provide a better return.
One of the major topics through the book and certainly in this chapter is historical P/E ratio activity. For example the P/E earnings through-out bull markets will be on the rise. Because of this observation it should be relatively easy for investors to recognize oncoming bull markets. Generally when P/E ratios begin to rise, then a bull market might be around the corner. Likewise, if the P/E ratios are already high, then rising P/E ratios will have little effect on the market.
From the beginning of the book, the idea of using different strategies based on different market conditions holds true inside of this chapter. If your strategy is to buy and hold then Secular bear markets will hurt your portfolio, where as a buy and hold strategy in a bull market should yield favorably results.
Financial Physics
The Financial Physics model attempts to accurately predict future markets based on historical data. By using historical data to estimate the future P/E ratio and Future EPS the model will tell you what future markets will look like. Interestingly enough, the author tests the model using numbers starting in 1975 to predict the future, and the predictions were very accurate for 2003. The model uses Real GDP and inflation to find Nominal GDP. It then uses Inflation to find P/E ratio and Nominal GDP to find the EPS, you multiply the P/E ratio and EPS to find the future stock market conditions.
Investors should use this model as a way to set expectations of future gains. By assessing what the future markets will be like, an investor will be better prepared for the future. An investor may claim his portfolio will perform at 12% annually for example, but by using this model the same investor may realize that next year’s growth will decline by 2% which will indicate lower earnings. An important concept as to why this model works is because EPS has historically followed economic growth, therefore if the economy grows EPS will grow.
Implications from Financial Physics
This chapter talks about many of the same topics regarding investment strategy. It also introduces another model, the Dividend Discount Model. This model assesses your intrinsic value price by taking dividends and dividing them by expected returns minus dividend growth. This is called a stocks intrinsic value, I have seen other models which used different variables to find the stocks intrinsic value. The idea is to find what the stock should be selling for, and then assess what it actually is selling for. So if a stocks intrinsic value is and it is selling for , then the market should move towards the intrinsic value price of . Likewise if it was then the market would move to increase the stock price to an intrinsic value price. The application of this model as a tool for investors should be obvious.
The fair value price is a price that takes into consideration the risk associated with the stock. Just like the intrinsic value, an investor should realize what a fair value price is for an investment. In other words an investor should not invest a in a risky investment if it does not offer the potential for higher returns than less riskier investments. This may seem obvious but it is ultimately up to the investor to manage his money wisely and invest in fairly priced investments.
One of the most important aspects of this chapter is the idea that P/E ratios have a peeking point. When inflation is near stability the P/E ratios should be peeking.
Investment Philosophy
Diversification is the idea of spreading out your portfolio over different securities in order to reduce risk. This is an accepted practice inside of the finance world, but by doing so you also farther expose your portfolio to the volatility of the market. When investing there are two main approaches covered in this book, the absolute return approach and the relative return approach. Absolute return is the strategy which would prevail in a bear market, the strategy of using models, tools, intelligent research, and whatever other means an investor has to make investment decisions. Relative return would be the opposite of that, where the market decides the returns. A relative return approach has the highest chance of being successful in a bull market when the market as a whole is rising. Relative return approach is not without its difficulties, you will still have to realize the benchmarks and actively invest within that asset class.
There are a few risk misconceptions addressed in this book. The first is, just because an investor makes a high return doesn’t mean he took on more risk. Our author uses the example of Warren Buffett, he acquired higher returns in his portfolio but he did not necessarily take on extra risk. This is because of the skill of the investor to minimize risk. Another misconception is that higher risk automatically means higher returns. Just because you take on more risk doesn’t mean you will automatically get higher rewards, you could lose your money but also it is up to the investor to assess risk and assess what return the investor requires if they are going to invest in that security. Also as I said before you can minimize risk but still reap the rewards of a higher return.
Row not Sail
This chapter is very much like the others in that it reinforces the point that absolute return investing, or using strategy to invest is a dominant strategy to relative return investing. Relative return investing is where you simply invest and sail with the seas of the market, or in other words the market largely dictates your returns. The buy and hold strategy of relative return investing can be very successful in bull markets.
Techniques for Traditional Investors
Bond laddering is the first technique our author covers, which is a fixed security technique. The idea is simple enough, you buy bonds that mature with the same amount every year over a set amount of year, and as the bonds mature you buy another bond. The example in the book uses 0,000 invested in bonds over 10 years. You would have bonds maturing at ,000 every year, and as those bonds mature you reinvest the money in 10 year bonds.
Rebalancing is the second technique, basically if you are invested in two different asset classes such as stocks and bonds, you can rebalance to prevent losses in the face of volatility. For example let’s say you have 0,000 and you invest ,000 in stock and ,000 in bonds, and at the end of a few years you have ,000 in stocks and ,000 in bonds. To rebalance you simply move ,500 from stocks to bonds to balance them both at ,500. This helps reduce risk by giving your portfolio less exposure to volatility, if after you rebalance your stocks go down then you have rebalanced and won’t take as large of a hit.
Investment Management Evolution
At the beginning of this chapter, the author talks briefly about the history of investment strategy. Basically the idea was that relative investing was the dominant strategy for the beginnings of the market. Benjamin Graham and David Dodd where two professors and investors who came up with the idea of value investing, which is the idea of finding stocks that are undervalued using mathematical means. The book goes on to talk about hedge funds, which it basically says that despite evidence presented in the book that long term buy and hold strategies may not yield the highest results, they still may be best for hedge funds.
The Video Lounge
http://www.youtube.com/watch?v=8P1dpCa9m8s
This video basically lays out the idea of absolute return investing which simply attempts to use strategy, research and portfolio techniques that lead to positive returns. In the video the speaker says that despite recent volatility, over the last three years his absolute return investment portfolios have not showed any losses.
Personal Insights
Why I think:
The author is one of the most brilliant people around…or is full of $ %, because:
I agree with the author, in-fact the idea of absolute return investing is why investing is so appealing for me. The idea of being able to minimize your risk by using investment and portfolio techniques creates a certain challenge to investing that is attractive to me. Easterling is actually looking for much more than just understanding the investment and portfolio strategies, he wants his reader to understand why the markets are where they are, and why in the future they will fluctuate. Understanding the markets is the first step to developing a winning investment strategy.
If I were the author of the book, I would have done these three things differently:
1. Although I feel the book was written excellently, I wish the author had given more insight into picking stocks. He does talk about bonds, but from the point of view of their interest rates, not from the point of view of how to pick companies, but of course this could probably fill another whole book.
2. Overall I cannot say that I have anything else to disagree with the book. It lays out some general information which is designed to help the novice investor or student learn more about the markets. I do believe that in order to better understand the book I recently finished reading, I will have to reread sections of it, but that is not a reflection on the author but simply a result of the nature of this topic. Some of it can be difficult to comprehend at first glance.
Reading this book made me think differently about the topic in these ways:
1. I never thought that an intelligent investor would use a buy and hold strategy with investing. As I learned more I learned about long term investing which made me second guess that. This book basically sheds light on when buy and hold strategies can be most effective, during secular bull markets. Many fund managers invest for the long term, and that strategy may be best in their situation but during bear markets or for short term results that aren’t at the mercy of the market a different investment strategy may be needed.
2. Using diversification to minimize risk is a common practice, but I never really thought about the implications of doing so. Sure it’s easy to say, well I if invested all my money in Google when the stock first entered the market instead of diversifying I would have made more money. I am not saying to put all your eggs in one basket, but rather to understand the idea that the greater you are diversified, the greater your portfolio will be affected by the market conditions.
3. I never really considered relative return investment strategies as a viable way to invest, but after reading this book I think that in a bull market, investing in stocks that will follow the rise of a stock index such as the S&P 500 could result in huge returns. Although, at anytime the floor can fall out from under us, leaving us wishing we had minimized our risk.
I’ll apply what I’ve learned in this book in my career by:
1. Since I actually want to be an investment banker, this book I believe will help lay the foundation to what will ultimately be my own investment strategies. Later in the book it brings up the point that relative investing through buy and hold strategies may be the best investment options for Hedge Fund managers. Regardless, for now I only have my own money to invest and I intend to minimize risk as much as possible.
2. Looking into the future and trying to predict where the markets are heading is a good way to try and decide which strategies will yield the highest results in the future. The book gave a model for predicting future market conditions called the financial physics model, these tools will no doubt help me in my professional career.
3. This book has taught me the importance of understanding how stocks have acted in the past and how to use that information to help me in the present. We live in the information age, and knowledge isn’t just power, it could be the difference between loses and gains. Of course I am speaking of intellectual knowledge, not the knowledge of inside information which is illegal.
Here is a sampling of what others have said about the book and its author:
On Amazon.com a reviewer wrote this, “I almost stopped reading this book. Easterling spent so much time building credibility 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”.
This is pretty accurate to how I feel towards the book, as you got deeper and deeper into it, the book became more interesting to read.
http://www.amazon.com/Unexpected-Returns-Understanding-Secular-Market/product-reviews/1879384620/ref=cm_cr_pr_link_3?ie=UTF8&showViewpoints=0&pageNumber=3&sortBy=bySubmissionDateDescending
Here is an editorial review “Ed Easterling has given the world of investing the single best, easy-to-read, study of stock market cycles of which I know. He lays out a path for you to find your own Unexpected Returns, showing you how to confidently navigate the waters of market volatility. Serious investors will devour this book and profit. It should be required reading for investment professionals.”
I don’t totally agree with this review, the book points you in the right direction but it hardly presents you with the information to be able to start investing and profiting today. Of course that is the nature of things, you pool information from different sources until you are knowledgeable about a subject. Knowledgeable enough to confidently form your own opinions, but still the book provides exactly what it claims to provide which is a better understanding of the markets and where you can look to find unexpected returns in volatile markets.
http://www.amazon.com/Unexpected-Returns-Understanding-Secular-Market/dp/1879384620
Bibliography
Easterling, Ed. (2005). Unexpected returns: understanding secular stock market cycles. Fort Bragg: Cypress House.
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Contact Info: To contact the author of this “Summary and Review of Unexpected Returns,” please email Veron.Blackledge@selu.edu.
Biography
David C. Wyld (dwyld.kwu@gmail.com) is the Robert Maurin Professor of Management at Southeastern Louisiana University in Hammond, Louisiana. He is a management consultant, researcher/writer, and executive educator. His blog, Wyld About Business, can be viewed at http://wyld-business.blogspot.com/. He also serves as the Director of the Reverse Auction Research Center (http://reverseauctionresearch.blogspot.com/), a hub of research and news in the expanding world of competitive bidding. Dr. Wyld also maintains compilations of works he has helped his students to turn into editorially-reviewed publications at the following sites:
Management Concepts (http://toptenmanagement.blogspot.com/)
Book Reviews (http://wyld-about-books.blogspot.com/) and
Travel and International Foods (http://wyld-about-food.blogspot.com/).
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Written by David Wyld
Professor of Management, Southeastern Louisiana University
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