PE (10 years average earnings) and historic SWR

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PE (10 years average earnings) and historic SWR

Post by BenSolar »

I've been poking around a bit at the issue of how valuation of the stock market might affect the historic safe withdrawal rate. I will re-post on this thread excerpts of posts I put up over at TMF on the subject. I believe there is a relationship here, but there is a lot of work to be done.

Ben
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The PE Myth

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originally posted at: http://boards.fool.com/Message.asp?mid=18082777

mejayroberts at TMF quoted a Yahoo financial news story (no longer on the net)
There is no link of market P/Es to subsequent returns--no matter how you measure the ratio and no matter over how long (up to five years) you measure returns.


Schiller disagrees. But you have to use a multi-year rolling average earnings figure instead of a one year figure. This was recommended by Graham and Dodd decades ago to smooth out unsustainable fluctuations in earnings which complicate matters. In a 1988 paper Schiller and a cowriter examined the correlation between a 30 year average PE and 10 year returns in the market. They found a very significant correlation.

Here is a paper where Schiller took a look at the results 8 years later in 1996. He found the subsequent years fit the correlation very well. And he found the correlation predicted essentially flat 10 year returns from 1996 to 2006. http://www.econ.yale.edu/~shiller/data/peratio.html

excerpt:
<<
The use of one-year's earnings in the price-earnings ratio is an unfortunate convention, recommended by tradition and convenience rather than any logic. As long ago as 1934, Benjamin Graham and David Dodd, in their now famous textbook Security Analysis, said that for purposes of examining such ratios, one should use an average of earnings of "not less than five years, preferably seven or ten years." (p. 452) Earnings in any one year tend to be affected by short-run considerations, that cannot be expected to continue. In the present time, earnings have suddenly shot up in the last few years, bringing price-earnings ratios down dramatically, but it is doubtful that such sudden changes are meaningful. We extend our moving average even further than Graham and Dodd did, on the supposition that even more smoothing is advantageous, and Graham and Dodd didn't have the data then to make such
smoothing possible.

We chose to represent long-horizon returns, of ten years, since that is what really matters to most investors, because there is so much interest today in long-term investing, and because there is recent evidence in the statistical literature that the long-horizon returns are more forecastable. This may be contrary to one's expectations; one might have thought that it is easier to forecast into the near future than into the distant future, but the data contradict such intuition. This forecastability of the market is not the kind of thing that will enable us to forecast that a crash is around the corner; it is forecasting gradual trends, analogous to forecasting the prospects for a city based on population trends, or forecasting the success of a university in terms of the number of young people who are enrolling.
>>

I've been meaning to find time to modify intercst's latest PE switching spreadsheet to use current price instead of last years price, and to use Schiller's P / 10 year average E (as seen here: http://www.econ.yale.edu/~shiller/data/ie_data.htm) instead of year old price data and 1 year earnings. I think that it stands a good chance at improving results. However time keeps slipping away (d@mn job!) and I haven't gotten the project done ... maybe some day. I don't expect to improve the SWR, but it will be better than using the 1 year E and last years price I am sure, and there is apparently some evidence that a 30 year average E could help.

I do agree that market PE using 1 year E is not helpful.

B.
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PE Switching Revisited

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Please note that when I use SWR in this post it is used in a very limited sense: a withdrawal rate that survived all complete 30 or 40 year historical intervals since 1871. I didn't look at partial periods, leading to some "interesting" results where the 40 year historical SWR was higher than 30 year rate. Results to 2 decimal places are reported, for no good reason. I the difference between 4.2 and 4.1 is likely insignificant in these studies. The REHP Excel spreadsheet is available here: http://www.retireearlyhomepage.com/re2002i.zip

The post below was originally posted at: http://boards.fool.com/Message.asp?mid=18128601

Since intercst graciously updated the REHP spreadsheet to include
Schiller's PE figures (calculated using a 10 year earnings average),
I've been playing around with the PE switching function a bit.

While I haven't done a comprehensive analysis. It does look like there
is enough promise in the results to warrant further study.

Settings:
Front end/backend payout: 50%
CPI inflation.
Other settings as default.

This scenario has a base 30 SWR of 4.12% at a 60% stocks / 40%
commercial paper allocation.
Base 40 year SWR is 3.99% at a 76/24 allocation.

Activate the stock switching feature by setting intial allocation to 0%
and fixed income series to 6.

Using both high and low PE for switching did not result in anything
interesting. But using just the low to mid switching PE while leaving
the high PE allocation matched with the mid I've found some
interesting results.

It seems like varying the stock allocation in the higher PE years away
from 60% only lowers the 30 year SWR. But, bumping the stock allocation
in lower PE years raises the possibility of some benefit.

For instance:
Allocation for low PE Years: 90%
Allocation for mid and high PE years: 60%

Switch 30 year Notes
at PE SWR
< 8 4.12% PE so low no effect
8 4.15 PE so low little effect
9 4.15 "
10 4.15 "
11 4.41 Big jump here. 40 year SWR is 4.24%!
12 4.38 40 year SWR: 4.28
13 4.38 40 year SWR: 4.32
14 4.13 40 year SWR: 4.21! Inversion here showing effects
of the current bear market on 30 year but not 40
year withdrawal periods. Interesting!
15 4.12 40 year SWR: 4.19
16 4.15 40 year SWR: 4.20
17 4.23 40 year SWR: 4.06
18 4.31 40 year SWR: 4.09
19 4.06 40 year SWR: 4.15 The first time our stock
switching strategy falls below the static
allocation for a 30 year withdrawal period.

What should we take from this series? For one, switching did not hurt
the SWR until you got to a high PE, so attempting a modest PE
switching strategy should be fairly harmless. The 90% allocation at
lower PEs is very aggressive.

One more series:
Low PE stock allocation: 80%
High PE stock allocation: 60%

Switch 30 year Notes
at PE SWR
< 8 4.12% 40 year SWR: 3.70%: rarely in upper allocation
8 4.15 40 year SWR: 3.70
9 4.15 40 year SWR: 3.71
10 4.15 40 year SWR: 3.71
11 4.32 40 year SWR is 4.06%
12 4.30 40 year SWR: 4.17
13 4.30 40 year SWR: 4.19
14 4.14 40 year SWR: 4.19
15 4.13 40 year SWR: 4.12
16 4.15 40 year SWR: 4.12
17 4.20 40 year SWR: 4.02
18 4.25 40 year SWR: 4.05
19 4.09 40 year SWR: 4.11

This series is pretty similar to the other. Again we get no
deterioration in SWR until you switch at a historically very high PE,
leaving you over allocated to stocks when the market is overvalued. At
low PE switch there is little benefit, but no harm. Setting a switch
at 13, just under the markets long-term average might allow you to
catch some extra performance, but I can't say I would increase my
withdrawal unless the extra performance was already in the bag.

Note that both of the series above use a 60% stock allocation for the
higher PE years. If you were looking to optimize for periods longer
than 30 years, you would likely bump that up some.

Nothing conclusive here. But I think it does demonstrate that some
judicious use of market valuation doesn't hurt and can potentially give
outperformance. Using the (Price)/(10 year average Earnings) PE was key I
think, and I would be interested in looking at an even longer average.
I can't speak to the statistical relevance of the series above, and
I'd want to examine a lot more series before trusting it too much. I
definitely don't recommend that anyone set a switch at PE 11, as in
the first series above, take 4.4% and think they are '100%' safe for a
30 year withdrawal period.

Ben

PS While I was careful working on this there are a lot of numbers and
an error or two could have crept in.
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Re: PE Switching Revisited

Post by BenSolar »

A couple of notes about then current PE-10 values:

Schiller's data (http://www.econ.yale.edu/~shiller/data/ie_data.htm ) was updated recently. He has figures for October 2002 in place. At S&P 500 price of 854.63 he has a PE (10 yr) of 21.95. This means the rolling 10 year average earnings is $38.9.

Using that figure we can see that at the October low of 768.6 we had a PE (10) of 19.75. That's the first time it's been below 20 since 1994!

Prior to the 1990s the last time it was above 20 was in the 1960s. Prior to the 60's you have to look back to 1937 to find PE (10) over 20.

Ben
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The Hocus Plan: 2% SWR ???

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Originally posted at: http://boards.fool.com/Message.asp?mid=18200598 Surprising results utilizing a 0% stock --> 50% stock switch


One of the tactics used to beat up hocus has been to repeatedly bash him over the head with his 0% stock portfolio. It is loudly stated 'The historical SWR for a 100% fixed income portfolio is only 2.1%. But you are taking 4%! Can't you see 4% is greater than 2%? You are mental, dude! GTFOOH! Why should we listen to you!'

Hocus just defended himself from such an attack. Here is his reponse: http://boards.fool.com/Message.asp?mid=18199416 . In it he reveals that, the REHP study notwithstanding, his financial choices have paid off quite well. Yep, it turns out that maybe he recognized a good deal in 7% CDs, 3.75% real return TIPS, and real estate ownership in a time of historically high stock market valuations.

But that is just anecdotal. There is good evidence that his strategy will provide a historical SWR far greater than the 2% his attackers smash him with. The evidence is two-fold.

First we should establish the benchmark against which hocus is competing: what is the HSWR and 'optimal' allocation for a non-switching strategy with 50 year withdrawal period and Sept. start 3.31% at 64/36. (this uses 50/50 front-end/back-end and commercial paper)

The evidence that hocus's strategy will yield more than 2%:

1) Heavy use of TIPs is a relatively new option, but it undeniably will provide better withdrawal rates than the CD/bond options of the past. This is especially true when you consider the ones that Hocus locked in with a 3.75% return above inflation. A 100% TIPS portfolio with a 3.75% coupon provides a SWR of 3.55% Even with a 2% coupon you optain a 2.53% SWR.

2) A valuation based switching strategy may or may not actually increase withdrawal rates, but it certainly doesn't drop them to 2%. As a very rough model of hocus's plan I used intercst's spreadsheet to find the HSWR for a stock switching strategy in which the stock allocation is 0% above PE-(10) of 18 and is 50% below that.

I calculated the results using a September start date to include the effects of overvaluation as much as possible. I used a 50 year withdrawal period since hocus is in his mid 40s (I think). Front-end back-end withdrawals at 50/50.

Prepare yourselves. 3.4% That is the historical SWR for such a strategy.
Other data points are:
PE HSWR
14 3.44
15 3.42
16 3.36
17 3.50
18 3.40
19 3.32
20 3.37
21 3.38

The average of these is a WR of 3.4% versus the fixed strategy SWR of 3.3%.

This is shock to me that the comparison is this good. Can someone else check these findings? I will repeat again that I am not advocating a switching strategy and I don't consider it close to being proven. Much more work is needed.

Combine the diversification, stabilization, and return benefits of TIPS and real estate ownership into the switching strategy outlined above, and it is feasible that hocus has in fact been following a strategy that will yield a sustained 4% withdrawal rate over 50 years.

Mental? I don't think so. Good work hocus!

Ben
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Ruminations

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posted at: http://fireboards.fool.com/Message.asp?mid=18192579

I think that when the longer term results are in for historical SWRs that have a start in the 1966 time frame, those will set the bar, just as they already do for 30 year withdrawal periods. That time period was characterized by a very long sideways movement in stock price and very high inflation without serious overvaluation of stocks. A switching strategy based on valuation is not much help there. So, I do not expect that a switching strategy based on PE (10 year earnings average) will significantly improve the '100% historically safe withdrawal rate'.

However, I think a PE (10) switching strategy does have the potential to significantly improve a FIRE's actual withdrawals. By being more conservative when the market is valued very high, and being more aggressive when the market is valued low, one can avoid the worst ravage's of a valuation bubble while still capturing lots of growth from stocks. Then one can 'reset' the withdrawal rate as your balance grows to increase your withdrawal amount.

In summary: improve '100% safe historical SWR' significantly - no because of the nature of the 1966 bear. Improve one's results in a valuation based bear such as the one we are going through - definitely.

Ben
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Correlation between PE-10 and hSWR

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intercst has plotted PE-10 vs historical 30 year SWR for January starts. He found correlation of -.76 with R squared of .58. Pretty nice grouping around the line, though the usual disclaimers about not enough independent data apply. It is the last graph on this page: http://rehphome.tripod.com/pestudy1.html

A couple of the extreme points on the graph are:
PE-10 -- hSWR
5 ---- 10
24 --- 4

Some wild extrapolations from http://boards.fool.com/Message.asp?mid=18240917:

Currently we are at PE (10) of about 23.

Before this July we were above PE (10) of 25 continuously from August 1996 until June 2002.

If we extrapolate the regression line straight out to higher PEs, we hit 0% max withdrawal rate at about PE (10) of 37. For what it's worth.

The market was above PE(10) of 37 continuously from November 1998 through December 2000.

The market peaked at PE(10) of 44.2. Extrapolating the line out to that data point puts us in the ball park of -2% maximum withdrawal rate.

Now this is a bit ridiculous, I know.

But it does illustrate why some of us think some educated guessing about the future is in order for people trying to FIRE in this era. Blind reliance on the historical record as a guide may not be the best strategy when recent history falls so far outside of the bounds of that record.

Ben
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Post by raddr »

Hi Ben,

Thanks for the repost of your data. It will take me some time to digest it all. It would appear at first glance that dynamic allocation (PE10 switching) probably doesn't significantly raise the SWR but more work needs to be done, no?

Currently we are at PE (10) of about 23.

Before this July we were above PE (10) of 25 continuously from August 1996 until June 2002.

If we extrapolate the regression line straight out to higher PEs, we hit 0% max withdrawal rate at about PE (10) of 37. For what it's worth.

The market was above PE(10) of 37 continuously from November 1998 through December 2000.

The market peaked at PE(10) of 44.2. Extrapolating the line out to that data point puts us in the ball park of -2% maximum withdrawal rate.

Now this is a bit ridiculous, I know.

No, not really. Back on the old MSN board I did similar regression plots of other valuation indicators such as div. yield, total mkt cap/GDP, etc. vs. forward returns and got similar frightening results. The bottom line is that most of these regressions predict close to 0-4% real returns for the broad domestic market going forward.

the usual disclaimers about not enough independent data apply.

Yes, data overlap definitely is a problem for any individual analysis. However, when you have several independent valuation indicators and they all yield similar regressions then I believe that there is quite a bit of significance to the data.
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Post by hocus »

It is feasible that hocus has in fact been following a strategy that will yield a sustained 4% withdrawal rate over 50 years.

That's what the historical data told me when I put my plan together, BenSolar. To be sure, I did not use spreadsheets and such to support my analysis. I looked at the data and did what the data told me would permit a 4 percent SWR for someone in my particular circumstances.

I should note that the strategies you note (diversification and such) were part of what I did to pull my SWR up to 4 percent, but not the whole story. There are a lot of aspects to the SWR question, enough to fill a book-length explanation if you were to spell it all out in one place. There's lots of stuff that I turned up in my research that I have never discussed either here or on the Motley Fool REHP board because the foundation needed for such discussions to be constructive has not yet been established at either place (obviously, this board is a lot farther along than the other one at this point).

I also should note that I do not make any claims that my plan is "100 percent safe." I think that such claims are silly (although it is useful to realize that there are changes that one can make in a plan that pull the SWR up and the safety level down, and that there are circumstances in which that is a sensible thing to do). My safety goal was to be sure that my family's long-term financial security was improved from what it would have been had I not retired early. Once I achieved that goal, I saw no reason not to go the Retire Early route, even knowing that there was a small chance that the plan could fail.

If I had to guess how safe my plan is, I would say that it is probably 90 percent safe. I probably could have made it 98 percent safe by going with a safe withdrawal rate of 3 percent, or 80 percent safe by going with a safe withdrawal rate of 5 percent. The usual rule is that, the more safety you demand of your plan, the lower the SWR you are going to obtain for it.

That's why it is so absurd to claim a 4 percent SWR for a plan advertised as 100 percent safe. It is rare to find an asset class offering a 4 percent SWR; I don't know that I have ever seen one that combined a 4 percent SWR with 100 percent safety. If I ever do, I'm going to snatch up as much of that asset class as I possibly can.

The closest I have seen is when TIPS were paying a 4.1 percent real return for 30 years. That was a once-in-a-lifetime deal, and I wanted to put as much money as possible into TIPS at the time (I recall this being early 2000, but am not exactly sure). Unfortunately, much of my money was tied up in an employer plan at the time, and the plan did not offer TIPS as an option. I was only able to switch to TIPs after my retirement in August 2000.

I much wanted to tell the REHP board about how great the deal was on TIPS at the time, and I believe that I put up a few posts hinting at what the historical data says on the subject. But at the time the board was very much into the idea that a 74 percent stock allocation too provides a SWR of 4 percent, and I knew better than to push too hard.

It would appear at first glance that dynamic allocation (PE10 switching) probably doesn't significantly raise the SWR but more work needs to be done, no?

Lots and lots of work remains to be done, but these posts by BenSolar come across to me as even more powerful when presented together than they did when I read them separately over at the other board. He has shed a lot of light on some important questions, and I really appreciate his efforts.

When BenSolar says that switching does not significantly raise the SWR, I believe that what he means is that it does not raise it above the 4 percent advertised figure. If you adjust the SWR for a 74 percent stock allocation down to a more realistic number--let's say 2 percent--then I believe that a reasonable switching strategy (not the kind that intercst likes to"study," to be sure) might well pull the SWR up significantly.

In other words, using a value investing approach to stock allocation can indeed produce a safe withdrawal rate higher than what can be obtained from blind faith that putting just about all of your assets into that single investment class is for some mystical reason always "best."
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Post by ataloss »

When BenSolar says that switching does not significantly raise the SWR, I believe that what he means is that it does not raise it above the 4 percent advertised figure.


although early indications suggest that switching might have been of benefit to retirees in 2000 (we will have to wait to 2030 for the remaining data) :wink:
Have fun.

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Post by BenSolar »

Hi y'all,

Thanks for the comments. I do think that using a valuation based switching strategy will help sometimes, but not others. The market conditions of the late 1960s, 1970s and early 1980s were very tough on a stock market/FI portfolio. The problems were less with overvaluation than with truly horrid economic conditions: high inflation, low growth. On the other hand the 1929 bear market was significantly affected by overvaluation, as was the current one.

I do think that robust diversification is the first step. I think that paying attention to valuation is a second step that can be useful when faced with conditions like those prevalent over the last 5 years or so. Anyone who was putting money to work outside the stock market in the late 1990s because of valuation was doing OK in my book. Meanwhile those who bought the 80/20 S&P 500/money market that the REHP study was selling and who retired counting on 4% from that portfolio in 1998-2000 may be in trouble.

Ben
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Scary indeed, raddr

Post by BenSolar »

I wrote something to the effect that an extrapolated -2% SWR for a 30 year period starting at PE-10 44 is a bit ridiculous.

raddr replied
No, not really. Back on the old MSN board I did similar regression plots of other valuation indicators such as div. yield, total mkt cap/GDP, etc. vs. forward returns and got similar frightening results. The bottom line is that most of these regressions predict close to 0-4% real returns for the broad domestic market going forward.

Man, I hate to think how crappy the S&P 500 could continue to be going forward. The current PE-10 of roughly 23 is pretty darn high in the historic record, and it's always been a prelude to rough sailing. All this studying on the issue has definitely made me move to diversify away from the S&P. It is still a big pretty big part of my port, and I'm a little nervous about it.

I guess the broader market is quite a bit better off, I guess, but I don't know where to find TSM earnings for the last 10 years. Do you? Or anyone else? John Bogle has been talking about valuations being back down to pretty much normal, but I'm not sure what he's talking about specifically.

Ben
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Post by wanderer »

Man, I hate to think how crappy the S&P 500 could continue to be going forward. The current PE-10 of roughly 23 is pretty darn high in the historic record, and it's always been a prelude to rough sailing. All this studying on the issue has definitely made me move to diversify away from the S&P. It is still a big pretty big part of my port, and I'm a little nervous about it.

1. a hearty "thanks!" to raddr for quantifying how sihtty the s&p could be going fwd.

2. the service this spot on the web does for FIRE wannabes is clearly not being equalled in other quarters. kudos to all who contribute to the fwd looking returns/SWR discussions.

wanderer
regards,

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Post by raddr »

I guess the broader market is quite a bit better off, I guess, but I don't know where to find TSM earnings for the last 10 years. Do you? Or anyone else? John Bogle has been talking about valuations being back down to pretty much normal, but I'm not sure what he's talking about specifically.

I don't know of a source for TSM earnings but the TSM index tracks the S&P500 closely. OTOH, the mid and small cap indices didn't really participate in the bubble and consequently show much better valuations:

http://www.barra.com/research/fundamentals.asp

All this studying on the issue has definitely made me move to diversify away from the S&P.

I've looked very closely at this myself and I have the same feelings that you do. I'm almost rid of the last of my S&P500 holdings. You might be interested in this statement from John Hussman which nicely sums up the S&P500's poor prospects:

Of course, the change in stock prices is the result of both changes in the P/E ratio, and changes in earnings. Over the past 10, 20, 50 and 100 years, peak-to-peak earnings growth for the S&P 500 has averaged just under 6% annually. So let's assume that S&P 500 earnings quickly recover to their year 2000 peak, and then continue to grow at a rate of 6% peak-to-peak into the future. Now do the inconvenient math. Even if the S&P 500 P/E ratio was to reach its historical average P/E a full 20 years from now, the average annual capital gain on the S&P 500 index over that period would be ( [1.06][14/18]^(1/20) - 1 = ) 4.7% annually. Add in an average dividend yield of about 2%, and stocks are priced to deliver a return over the coming two decades of less than 7% annually, even if stocks never see a below-average P/E ratio again.

Carrying that same analysis to the median price/peak-earnings ratio of 11 (the average bear market has ended at a multiple below 9, but 11 was the low of the 1990 bear), the S&P 500 would earn an average annual capital gain of about 3.4% over the next 20 years, and a total return of less than 5.5% annually, even if stocks simply touch that median of 11 even 20 years from now. A lot can happen over 20 years that might prompt such contact.

http://www.hussman.com/hussman/members/ ... latest.htm

So if we ever do get back down to normal valuations real returns are likely to be near 0-3% p.a., even if we can reach a new earnings peak. Real returns could even be negative for years if we get to lower than normal valuations which is the usual case for bear markets like the one we are in now.
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Post by hocus »

I don't know where to find TSM earnings for the last 10 years. Do you?

There was a discussion the other day on the Datasnooper board on the question of "Where to find the data?" A link is provided in that thread that might possibly be of some use in addressing some of these sorts of questions.

http://groups.msn.com/DatasnoopersForum ... ssage=1678

Here'a direct link to the data site:

http://www.globalfindata.com/
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Post by BenSolar »

I don't know of a source for TSM earnings but the TSM index tracks the S&P500 closely. OTOH, the mid and small cap indices didn't really participate in the bubble and consequently show much better valuations


Hmm, I know TSM is something close to 80% the same as S&P 500, and that it tracks it closely. I'm just a bit confused by Bogle's recent comments to the effect that the market was back down to pretty much average valuations in a Smart Money interview:
Market returns come from two simple sources: One is investment or economic return, which includes dividends. Right now, the average dividend yield is about 2%, and future earnings growth has been estimated at about 6%. So we're expecting an 8% investment return in the years ahead, assuming average corporate profit growth. And long-term records show that corporate profits grow at the same rate as gross domestic product.

The other part of return is speculative or emotional return. Right now the market is selling at about 16 times earnings. If 10 years from now it is still selling at 16 times, then the speculative return will be zero. I think that could go up. The long-term norm is 15, but I think it could go up to 18, it's a guess, but it's a 12% increase from 16 times, and that, spread over 10 years, would be another percentage point or two of speculative returns. Therefore the combination would give you stock returns of 9% or 10% a year. So a realistic and reasonable expectation would be for future stock returns of between 6% and 10%


I can't see where he would get a PE of 16 from. Anyone have a guess? I can't imagine the TSM is that low. Geez, he is talking about multiple expansion!.

Any thoughts? If you look at 2003 estimated operating earnings for the S&P 500, then you get in the neighborhood of PE 16: http://www.spglobal.com/SP500EPS.xls

Hocus, thanks for the link, seems like some good stuff there, but, at least in the free section, they don't address the total stock market.

Ben
"Do not spoil what you have by desiring what you have not; remember that what you now have was once among the things only hoped for." - Epicurus
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Post by raddr »

Ben,

He's way wrong:

Market returns come from two simple sources: One is investment or economic return, which includes dividends. Right now, the average dividend yield is about 2%, and future earnings growth has been estimated at about 6%. So we're expecting an 8% investment return in the years ahead, assuming average corporate profit growth. And long-term records show that corporate profits grow at the same rate as gross domestic product.

First of all, even if you use peak earnings from 2000 the earnings growth rate has been 1.5% per year in real terms or 4.7% in nominal terms (since 1900, Schiller's data). Add the 1.5% to the dividend and you get an expected 3.5% real return. Secondly, earnings lag GDP by about 2% per year - not 0%.


The other part of return is speculative or emotional return. Right now the market is selling at about 16 times earnings. If 10 years from now it is still selling at 16 times, then the speculative return will be zero. I think that could go up. The long-term norm is 15, but I think it could go up to 18, it's a guess, but it's a 12% increase from 16 times, and that, spread over 10 years, would be another percentage point or two of speculative returns. Therefore the combination would give you stock returns of 9% or 10% a year. So a realistic and reasonable expectation would be for future stock returns of between 6% and 10%

This is nowhere near being right. The S&P500 is selling at about 17 times peak earnings vs. the historical average of about 11.5. Thus if we get back to normal over 10 years this will decrease the expected 3.5% return by about (11.5 / 17.0) ^ (1 / 10) - 1 = 3.6% per year yielding a negative real return
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Post by BenSolar »

Nicely put, raddr.

I'm with you, I'm afraid :cry:. I would like to know what the heck he's using to get a market PE of 16. If you look at PE-10 it shows basically the same overvaluation as the peak earnings view. 23 current vs 15.5 average.

Plus, I'd rather use the historic earnings growth rather than his estimate of 6%. He just seems way to optimistic, and I don't understand it.

Thanks for the good analysis
Ben
"Do not spoil what you have by desiring what you have not; remember that what you now have was once among the things only hoped for." - Epicurus
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Post by raddr »

Ben,

Plus, I'd rather use the historic earnings growth rather than his estimate of 6%. He just seems way to optimistic, and I don't understand it.

I respect John Bogle and admire the way he's taken the mutual fund industry to task for putting their greed above investor's interest. I can only hope he isn't deliberately misleading investors with flawed analyses put forth like the one you quoted. I think that he also really misses the boat in not stressing diversification.
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Post by raddr »

I'm afraid I misspoke a bit when I took Mr. Bogle to task for this:

And long-term records show that corporate profits grow at the same rate as gross domestic product.

This statement is technically true. Unfortunately, however, the same can't be said of per share corporate profits which lag GDP by about 2% per year:

http://www.efficientfrontier.com/ef/702/2percent.htm

You still need to use the per share number in projecting future market performance which is what I did, correctly I think, in my post above. Mr. Bogle ignores the 2% dilution effect in his analysis which leads to an overestimation of future returns based on historical trends. The bottom line is that we would still see flat or negative real returns in the next 10 years or so if corporate profits stay steady and PE ratios return to normal.
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