Crestmont's Perspective: Beware The Assumptions!

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Crestmont
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Crestmont's Perspective: Beware The Assumptions!

Post by Crestmont »

A. Models are only as good as their assumptions.
B. Valid assumptions are not always good ones.
C. A perfect model with perfect assumptions is rarely valid over the long term.


In any model used to project future savings, whether SWR or other financial planning model, the assumptions are as critical as the structure of the model. Valuation does matter toward future returns in the financial markets. For what it's worth, valuation always affects future returns in any financial instrument or model (by definition).

There has not been an extended period over the past century or more when history can be said to fully repeat itself. Said another way: if an analyst had used historical data before 1950 or before 1975 or before 2000 to estimate what could have been expected over the subsequent 25 years or so, the forecasted scenarios would not have happen exactly as expected. Several key considerations to consider about the using the historical data since the late 1800's as the full analysis set:

1. Prior to the 1960's, interest rates and inflation were not aligned and were inconsistent - after 1960 or so, the relationship is much more consistent (as one would expect fundamentally). [see http://www.crestmontresearch.com/pdfs/i ... onship.pdf]

2. P/E ratios relate to inflation, not to interest rates. This will explain some of the perceived anomalies over the past century. [see http://www.crestmontresearch.com/pdfs/S ... &%20PE.pdf]

3. Stock market returns tend to occur in cycles: P/Es rise when inflation heads toward price stability; EPS (earnings) are fairly constant with the economy over longer periods; therefore stock returns are dependant upon positive trends in P/Es (i.e. inflation trending toward 1%) and suffer when P/Es fall.

4. We are currently in a period of (a) high P/E valuations. (b) low interest rates, and (c) low inflation - significant "Vulnerability"￾ for financial markets and securities. If inflation declines much further (deflation), P/E's will fall. If inflation rises, P/E's will fall as well. The prospects for significant gains in the stock market this decade are dismal (P/Es are likely to decline slightly as EPS increases, with a net result being a very choppy and relatively flat market).

5. CLOSELY NOTE: When using historical data about the stock market and cash returns (especially during the early 1900's), note the substantial dividend yield and cash returns (the commercial paper rate is used in some popular models using historical data). Today, dividend yields and cash yields are significantly lower than the early part of the 20th century. High dividends and cash yields in historical data sets can distort the forecast results from financial planning models (including SWR). Particularly for SWR models, especially in the earlier parts of the 1900's, this enables the hypothetical investor in SWR models to endure large market swings. Without the same level of current cash flow, the SWR models have significantly different results.

6. BIG PICTURE: SWR seems to be about how much a retiree can withdraw from savings without running out of principal over a prescribed long term period. Other retirement planning models help people project the nest egg that they'll have going into retirement. If stocks are destined for mediocre returns (or maybe none over the next decade or so) and other sources of income imbedded in the historical data (i.e. dividends, interest, etc.) are substantially less today, there could be significant implications for investors.

7. Transaction Costs: the assumptions in some SWR and financial planning models assume index returns - without regard for transaction costs, asset management fees, commissions, bid/ask spreads, taxes, etc. There costs can be material - bake them in as well - and total transaction costs often run 1% to 3% annually or more.

8. Techniques: seek advice from an independent financial advisor about techniques to deal with non-trending markets. The stock and bond bull markets of the 1980's and 1990's were trending markets and benefited from "buy-and-hold"￾ and "buy-on-dips"￾ strategies. The next phase could be another secular bear cycle (see http://www.crestmontresearch.com/pdfs/S ... 0Chart.pdf). Note the difference in secular bull and secular bear periods. Ask your advisor about the effect of more frequent rebalancing, covered call option writing, higher yielding preferred stocks and other securities with higher current return, TIPS, hedge funds, and other risk-controlled and value-added investment strategies.

Please consider reviewing our research at www.CrestmontResearch.com relating to stock market cycles, long-term returns, and interest rate cycles. For each of the charts with links listed above, you'll find a brief description within the Stock Market and Interest Rate sections. We welcome your insights and perspectives to further the research. Our analysis is not above challenge: I welcome it. It has not gotten to were it is today without challenge. All along, I've hoped for rational insights that would support strong upside potential in the financial markets. To date, the results instead have been rather sobering. Our research is not intended to generate predictions; rather it is intended to be provocative and enlightening. Hope it's helpful; there's no cost and it's free of banner ads. I welcome your comments, questions, and persepctives either in reponse to this posting or through our website.

Unlike Bill Murray in "˜Groundhog Day', we don't get another chance to replay our retirement scenario. The risk for a retiree or aspiring retiree of an error in their return assumptions is serious: you only find out that the assumptions were insufficient when it's too late to change the course.

Ed Easterling
Crestmont Research


(A similar version of this composition was first posted in the SWR Research Group board; it's been posted here at the suggestion of "peteyperson."
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Post by raddr »

Hi Ed,

I agree with just about everything in your post. It appears, however, that it is aimed at investors who follow the conventional route of holding S&P500 or "Total Market" funds which, I agree, are poised for poor returns going forward.

What about other asset classes? Many of these did not participate in the bubble we've recently had. Specifically, what about small/microcap value, REITS, emerging mkts./international small cap, etc.? My feeling is that these asset classes are in general not significantly overvalued and that one can build a portfolio that probably will sustain a higher SWR by shunning the total market-type funds and investing in asset classes such as the ones I've mentioned through low-cost index funds or ETF's. Thoughts?
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Post by peteyperson »

Raddr,

What are TIPS offering these days above inflation?

How are these purchased? Do you know if they are available to non-US citizens? Just reading about them in the first chapter of Bernstein's Four Pillars (best explanation of interest rates and bonds yet!)

Petey
raddr wrote: Hi Ed,

I agree with just about everything in your post. It appears, however, that it is aimed at investors who follow the conventional route of holding S&P500 or "Total Market" funds which, I agree, are poised for poor returns going forward.

What about other asset classes? Many of these did not participate in the bubble we've recently had. Specifically, what about small/microcap value, REITS, emerging mkts./international small cap, etc.? My feeling is that these asset classes are in general not significantly overvalued and that one can build a portfolio that probably will sustain a higher SWR by shunning the total market-type funds and investing in asset classes such as the ones I've mentioned through low-cost index funds or ETF's. Thoughts?
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Post by raddr »

peteyperson wrote: Raddr,

What are TIPS offering these days above inflation?

How are these purchased? Do you know if they are available to non-US citizens? Just reading about them in the first chapter of Bernstein's Four Pillars (best explanation of interest rates and bonds yet!)

Petey


Petey,

30 year TIPS are now yielding about 3% over inflation which is pretty attractive IMO. In fact, I'm thinking of buying some more soon. I don't know if a non-citizen can buy them but I suspect you can. Maybe someone else can clarify.
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Post by Crestmont »

Hello Fellow Texan (raddr),

We're not looked specifically at the asset classes that you mentioned, although one of the fundamental elements of our research focuses on the historical cycle of inflation. From where we are today (near 1% inflation), the alternatives are either undersireable or unlikely: if inflation continues lower into deflation, several of the assets you mentioned will not do well; if it turns back upward, some are not likely to do well either; and if it remains steady at 1% or so for the next decade or two, we'll be making history (and the fundamental factors make this less likely as well).

Although we did have a bubble in the general stock market, our research indicates that we're near a reasonable level now. However, due to likelihood of a trend in inflation away from price stability, P/E's are likely to decline and EPS should increase with the economy (from normalized levels that are higher than are currently being reported).

In the instance of stable inflation, the economy would grow at a slower rate, thereby slowing the growth of EPS, thereby limiting the longer term total returns in the stock market to mid-single digits at best. Based upon the level of historical volatility (even in secular bear markets), it could represent quite a ride with minimal gains.

Given the principal risk associated with many of the securities that you mention, one would have to expect quite a premium in return over TIPS for example--which offsets the inflation risk in the withdrawal side of the equation. My analysis suggests that an investor can have 30 years or so of 4% withdrawals (pre-tax) using TIPS (which are currently trading at about 2% plus inflation). There may not be much left at the end at that level of withdrawal, but at least it relatively predictable...or at least balanced with the withdrawal liabilities (both being impacted by inflation in the future).

All the best,

Ed

raddr wrote: Hi Ed,

I agree with just about everything in your post. It appears, however, that it is aimed at investors who follow the conventional route of holding S&P500 or "Total Market" funds which, I agree, are poised for poor returns going forward.

What about other asset classes? Many of these did not participate in the bubble we've recently had. Specifically, what about small/microcap value, REITS, emerging mkts./international small cap, etc.? My feeling is that these asset classes are in general not significantly overvalued and that one can build a portfolio that probably will sustain a higher SWR by shunning the total market-type funds and investing in asset classes such as the ones I've mentioned through low-cost index funds or ETF's. Thoughts?
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Post by wanderer »

Ed -

Just wanted to give you a hearty "welcome" and thank you for participating. We can't get enough great minds thinking about this and I have seen your work (saw it through John Mauldin's link).

I'm a bit more (OK, a lot more :wink:) pessimistic than you on the TSM, and more sanguine on the alternative classes (gold, SCV, EM). I do depart from raddr on REITs right now. Any thoughts on Japan? int'l bonds?

Thanks again for your time, Ed.
regards,

wanderer

The field has eyes / the wood has ears / I will see / be silent and hear
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Post by Cut-Throat »

Does anyone here remember Ravi Batra - Who wrote about the Great Depression of the 1990's? - He wrote this shorty after the crash of 1987.

Moral of the story is that if you keep predicting a Crash, Depression, Downturn you'll eventually be correct. There are people that took Ravi (He was a Professor of Economics ) highly respected until he went out on this limb, very seriously.

Many retirees took his advice, converted everything to cash and went to the mountain cabin in 1990. They missed out on a lot of stock market gains. I have seen a few of them interviewed and they feel as silly as the ones that stockpiled food for the Jan. 1 2000 catastrophe that never happened. We as humans are more likely to believe in calamities than reality.

Remember the crash of 1987 - really scary huh? - If you would have stuck to an original plan this would barely be a blip on the radar screen. 16 years later, it really means nothing at all. Unless you sold that day and have been too afraid to invest ever since.

Where are your balls people? - We'll all be dead in 50 years anyway, so what is with all the chicken shit scare tactics?
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Post by raddr »

Crestmont wrote: My analysis suggests that an investor can have 30 years or so of 4% withdrawals (pre-tax) using TIPS (which are currently trading at about 2% plus inflation). There may not be much left at the end at that level of withdrawal, but at least it relatively predictable...or at least balanced with the withdrawal liabilities (both being impacted by inflation in the future).


Ed,

Thanks for sharing your thoughts. I agree that TIPS are tough to beat right now, particularly since the longer maturities (25+ years) are trading at about 3% real return. Many of us, including myself, are looking at 40+ year retirements, God willing. :wink: It seems that you pretty much have to have a relatively large equity exposure to make due for so long. My philosophy is to stay away from S&P500 stocks which I believe are 30-40% overvalued by almost any valuation metric with which I'm familiar (P/B, P/E10, P/S, Tobin's Q, etc.) and stick those with a higher expected return.

wanderer,

I agree that REITS aren't the screaming buy that they were a year or two ago but the expected real return according to my analysis would be in the range of 4.5-5% which is much better than the 3% predicted for the S&P500 by the Gordon equation.
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Post by wanderer »

Where are your balls people?

kethyet, you want to field this one? :wink:

- We'll all be dead in 50 years anyway, so what is with all the chicken shit scare tactics?

our net worth is up 130% since december 31, 1999. as near retirees, we found the risk of a major market decline and questionable recovery too much to bear. that's why we went heavy on real estate in 2001 and junk and international in 2002.

if you'd like to commune with other folks similarly enraptured with large cap growth US equities, i'd recommend this site: http://boards.fool.com/Messages.asp?mid ... bid=112992. unfortunately, the track record there is questionable. they favored withdrawing from paid employment as soon as possible, and were recommending 4% withdrawals in 2000. as a result, several of the more prominent posters are down 50%-60% over the same period. raddr did a fine analysis of where the recommendations of that board would have left a putative investor. i think they were drawing in the 6%-7% range. :wink:
regards,

wanderer

The field has eyes / the wood has ears / I will see / be silent and hear
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ataloss
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Post by ataloss »

Mr Easterling, surely you must agree with this statement by the swr genius:
If we had perfect data, we could calculate the SWR perfectly. It is a mathematical construct. You take all the numbers for all the factors that influence the question, you add them up, and you have the answer. It is an objective exercise.

Hocus 7/18/03


Hocus who invited you here has asked many people to think him for his brilliant insight that has changed the world:
But I did come up with something of earth-shaking importance. I put forward a post that asked "What if we took the Valuation Matters concept and married it to the SWR concept?" That had never been suggested before, and posts that have been put forward to the two boards since have shown that that insight is going to produce the most powerful tool for FIRE investing that the world has ever seen.
hocus 7/27/03

Can you explain why all the financial professionals (including yourself presumably) had failed to appreciate the fact that future portfolio returns would determine future safe portfolio withdrawal rates? (Especially since it now seems sort of obvious) Will you join in thanking him for being the first one to think of this?
Have fun.

Ataloss
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Post by caseynshan »

Just want to compliment you on your research on your website. I have friends that could learn more from 1 hour with single long term returns graph than the hundreds of hours they spend on Technical Analysis.
hmmm

casey
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Post by caseynshan »

Raddr, I keep messing up the quote, but ....
raddr wrote:

What about other asset classes? Many of these did not participate in the bubble we've recently had. Specifically, what about small/microcap value, REITS, emerging mkts./international small cap, etc.? My feeling is that these asset classes are in general not significantly overvalued and that one can build a portfolio that probably will sustain a higher SWR by shunning the total market-type funds and investing in asset classes such as the ones I've mentioned through low-cost index funds or ETF's. Thoughts?


Relatively new to all of this discussion and was wondering where you find sources to determine relative value of small cap / international etc.... Are you looking at PEs for indexes and if so could you point me to a place where those are publically available so I can peek for myself?

Casey
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Post by raddr »

caseynshan wrote:

Relatively new to all of this discussion and was wondering where you find sources to determine relative value of small cap / international etc.... Are you looking at PEs for indexes and if so could you point me to a place where those are publically available so I can peek for myself?

Casey


Hi Casey,

Good question. For basic domestic PE and P/B info try:

http://www.barra.com/research/summary_returns.asp (look at "fundamentals" and (fundamental charts")

http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/

For international I don't have a really good data source other than Morningstar where I like to compare their valuation parameters for similarly constructed domestic and foreign indices, e.g. EAFE vs. S&P500. Ken French's site also has limited int'l valuation info.

Maybe someone else can chime in here. I'm always looking for data sources. :wink:
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Post by peteyperson »

Raddr,

Am I correct in assuming that the principle will rise with inflation, which retains your buying power and so the 2-3% payment reflects that?

At the end of 30 years, do you not get back your original funds, index linked all that time?

What part of the return is taxable in the US? If the inflation linked part isn't, how is this accomplished? I am trying to understand the mechanics of it to see how it might work for UK taxes. I assume the 2-3% real return is taxable and drops. Here that would drop to between 1.5% - 2.3%, excluding the inflation return which is ignored for now.

Petey
raddr wrote:
peteyperson wrote: Raddr,

What are TIPS offering these days above inflation?

How are these purchased? Do you know if they are available to non-US citizens? Just reading about them in the first chapter of Bernstein's Four Pillars (best explanation of interest rates and bonds yet!)

Petey


Petey,

30 year TIPS are now yielding about 3% over inflation which is pretty attractive IMO. In fact, I'm thinking of buying some more soon. I don't know if a non-citizen can buy them but I suspect you can. Maybe someone else can clarify.
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Post by peteyperson »

Wanderer,

Care to discuss what sort of International exposure you took? Whether it was an international index fund (what cost?) or other specific investments?

Petey
wanderer wrote: Iur net worth is up 130% since december 31, 1999. as near retirees, we found the risk of a major market decline and questionable recovery too much to bear. that's why we went heavy on real estate in 2001 and junk and international in 2002.
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Post by caseynshan »

Thanks raddr

I just read Damodaran's book Investment Philosophies and found it very interesting (possibly a bit elementary for some around here, but not me. he also has a book on investment valuation.)

But anyway he has a significant number of Investment Datasets linked on his site.

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/

(I probably found it from this forum anyway)

casey
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Post by raddr »

peteyperson wrote: Raddr,

Am I correct in assuming that the principle will rise with inflation, which retains your buying power and so the 2-3% payment reflects that?


Yes, the "coupon" is the amount in excess of inflation.
At the end of 30 years, do you not get back your original funds, index linked all that time?


I think that is the way it works.
What part of the return is taxable in the US? If the inflation linked part isn't, how is this accomplished? I am trying to understand the mechanics of it to see how it might work for UK taxes. I assume the 2-3% real return is taxable and drops. Here that would drop to between 1.5% - 2.3%, excluding the inflation return which is ignored for now.


There's the rub. As a US citizen You pay taxes on the coupon as well as the inflation adjustment even though the latter is not paid out with the coupon and is only paid out at maturity. I think TIPS mutual funds usually pay out the inflation adjustment along with the coupon and both are taxable. I'm not sure how this would work for a UK citizen.
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Post by Trex »

Cut-throat wrote:

Remember the crash of 1987 - really scary huh? - If you would have stuck to an original plan this would barely be a blip on the radar screen. 16 years later, it really means nothing at all. Unless you sold that day and have been too afraid to invest ever since.

You all know I am a true beginner, but in the few recommended books and dicsussions I have read- this makes sense to me. I don't know a whole lot about valuations- lately I have questioned the meaning of value (especially in real estate). Is there any correlation to equities?? If so, we never really know what "value" means, right? Any time I find myself questioning the TSM approach I tend to think I'm crystal-balling it- since I haven't really seen anyone talk in specifics about over-valuation. The only thing I'm sure of in my mind (as far as "timing") is to stay away from Bonds. Please remember that I know very little about equities and refrain from hammering me. :)

In the charts and graphs I have seen related to history, it seems that the "value" always increases. Maybe upwards of 60% of the time, people could have argued throughout history that stocks were overvalued. It is true that there are very long periods of time that have not done very well regarding long term TSM approach. From what I have seen, these 40+ year windows of time that were not very good for TSM are not the majority. And that most of the time, one would do exceptionally well using the TSM approach over a very long period.


Who is a newbie to believe?

Trex
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Post by Trex »

Crestmont wrote:

6. BIG PICTURE: SWR seems to be about how much a retiree can withdraw from savings without running out of principal over a prescribed long term period. Other retirement planning models help people project the nest egg that they'll have going into retirement. If stocks are destined for mediocre returns (or maybe none over the next decade or so) and other sources of income imbedded in the historical data (i.e. dividends, interest, etc.) are substantially less today, there could be significant implications for investors.

Doesn't this(if accurate) equate to ten years of buying low?

Trex
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Post by wanderer »

hi, trex.

You all know I am a true beginner, but in the few recommended books and dicsussions I have read- this makes sense to me. I don't know a whole lot about valuations- lately I have questioned the meaning of value (especially in real estate).

You really need to read the Smithers book. q (ratio of market value to BV [adjusted for inflation/replacement cost]) appears to be one helluva indicator on valuation. It appears to tell you, at a gross level, when to get in and out. Basically it helps you avoid the carnage when the market gets unreasonably valued.

Is there any correlation to equities?? If so, we never really know what "value" means, right?

FMO (via Gary Eldred) has made a compelling case in a number of posts (see the earliest threads).

One good way to find value is to look for the thing everyone hates. Lately, cash has been widely lambasted (crummy returns). But in real terms it hasn't done too bad. And cash gives you a flexibility you really need. So, we have a goodly sum set aside. (This is also because we anticipate doing a owner-builder in the near future.)

Any time I find myself questioning the TSM approach I tend to think I'm crystal-balling it- since I haven't really seen anyone talk in specifics about over-valuation.

You are "timing," I guess. Or just not buying stuff blindly. PE/PB/PFCF/q - they all tell a pretty grim story the last 8 years or so.

You know what I saw in an article at cbsmw today? how the economy was turning up. they knew cuz temp agencies are on upswing. the evidence: monster.com or some other big one was at 1,000X estimated earnings (which had been halved two weeks earlier). iirc, kelly was at nearly 155X estimated earnings. i thought they were joking. hey, at least they had earnings. :shock:

the only thing I'm sure of in my mind (as far as "timing") is to stay away from Bonds. Please remember that I know very little about equities and refrain from hammering me.

continued full-time employment in a low cost locale, paying off the mortgage, res RE, junk bonds, int'l, saved our FIRE dreams. I wish I'd done a bit more S&D like raddr (coulda used precious metals and SCV), but I don't wanna complain. trex, the monthly amounts pouring off our junk bonds could sustain us in our anticipated retirement and they represent "only" 20% of our port.

In the charts and graphs I have seen related to history, it seems that the "value" always increases. Maybe upwards of 60% of the time, people could have argued throughout history that stocks were overvalued. It is true that there are very long periods of time that have not done very well regarding long term TSM approach. From what I have seen, these 40+ year windows of time that were not very good for TSM are not the majority. And that most of the time, one would do exceptionally well using the TSM approach over a very long period.

The majority of the time, TSM makes sense. Smithers and the q folks think broad market cap makes sense 2/3 of the time. But the average horizon, the dribs and drabs way of building one's port, the average temperament of the average investor, and the relatively high current (starting - for newbies) valuations are not conducive to "staying the course". 18 years of a bull market is what justifies ltbh. we have probably entered a period when that sort of approach will be difficult to sustain.

Who is a newbie to believe?

Believe nothing (esp. from folks with an axe to grind) and be very skeptical of anonymous claims on the internet about outperformance.

Use your common sense. Read. A lot. Start with bernstein's home study course. Read Global Investing by Ibbotson and Brinson. Read Smithers, Grantham, Dreman and the other value folks. They'll help you minimize regret and that will keep your hand in the fire longer and more effectively.

The other thing you want to focus on, in this order, is: motivation and lbym. If you "fix" motivation - establish a burning desire to achieve FI, your creativity will zoom, the FI hinderances you encounter will be seen for what they are - cancers that need to be excised, and the means for doing so will start falling into place. In our case, it became very apparent that efficient use of our human capital and greater representation from asset classes other than US LCG equities (esp. real estate and high quality bonds).

lbym is a piece of fixing your FI approach but it deserves separate mention because, whatever SWR you believe is correct, the more you are able to tighten your belt (while maintaining your sanity) the quicker you will attain FIRE. the opposite side of the "4% rule" is that, for every dollar less that it takes you to live the lifestyle that you enjoy, you can afford to have $25 less in your nest egg. The power of this means that, while some folks choose to argue vehemently about this or that SWR, we have identified methods that will allow us to live at a 1.6% SWR. Mainly by the good investment decisions we mentioned earlier and by lbom overseas.

More than you asked for, I know. I was pleased that you were bold enuf to not post this on the newbies board and wanted to encourage you.
regards,

wanderer

The field has eyes / the wood has ears / I will see / be silent and hear
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