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Historical P/E Rates and Equity Returns?
Old 10-01-2007, 07:58 PM   #1
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Historical P/E Rates and Equity Returns?

I have seen some people predicting much lower equity returns due to a high P/E 10 ratio from Shiller et al. This also seems to be used by some people to question the Fire Calc return data because some of the best returns were from times when S&P P/E ratios were sub 10 and we have not seen those levels for a long time.

What do you all think of these arguments? Is it different this time?

Some things that I see as supporting higher P/E ratios are:

1. Lower income tax rates and lower capital gains rates - The top income bracket peaked at 92% in 1952 and the capital gains rate was 39% in 1976

2. Lower commisions - since commissions were deregulated the cost to trade has come way down. My Money magazine said that in 1972 the average fund charged 8.75% load and the average stock commision was 1.3% of the value for each buy and sell. Don't know what they were historically, but probably as high or higher.

3. Lower spread - Electronic trading vs. market makers, decimilization, more liquidity and volume has reduced spreads by a lot. I don't know if there is any historical data on this, but you can still see a huge difference on thinly traded stocks or closed end funds. I imagine traders got nicked for a few % more in the past than they do today.

4. Increased demand and volume - Steady inflows from 401k and pension plans set a higer baseline. Money stated that MSFT trades more shares in a day now than the entire NYSE traded in a week in 1972

I am sure you can think of others or offsetting trends, but it seems to me that these trends would tend to make the "realized" cash flow higher for the same earnings and raise the P/E of the market from historical averages. It still needs to be grounded in reality as 2000-2002 showed, but the S&P trading at 17x trailing and 15x forward earnings (before the recent rally) does not scream to me "overvalued" because in 19xx the P/E was lower.

What do you think?
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Old 10-01-2007, 08:36 PM   #2
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These are always good conversation starters.

First, it helps to understand that FIREcalc gives you worst-case results. It looks at every period in history, including times of high P/E and gives the surviving withdrawal rate for the worst-case period.

The current P/E is pretty "reasonable," but it seems reasonable because earnings have been so high. If earnings revert to the mean (which they always seem to do), then the P/E might not seem so reasonable anymore. That's why Shiller averages earnings over 10 years and looks at P/E10.

P/E10 is currently pretty high, but it's way off it's peak. And, as you say, there may have been structural changes in the market to support higher-than-historical P/Es going forward.
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Old 10-01-2007, 09:02 PM   #3
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I'm a worn out bear. Thank heavens that I didn't want to sell stocks with big gains and pay tax, or I would be sitting out all of this. Not to mention the coin that I dropped on QQQQ puts.

It's really a new world; bears keep getting gored. They never get anything substantial to eat like some nice raw bull meat.

By the way, thanks for posting on a money related topic.

Ha
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Old 10-01-2007, 09:04 PM   #4
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C'mon, Ha. It's only been 5 years since the bears last feasted. Can't you hibernate for a few more months?
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Old 10-01-2007, 09:34 PM   #5
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Quote:
Originally Posted by haha View Post
I'm a worn out bear. Thank heavens that I didn't want to sell stocks with big gains and pay tax, or I would be sitting out all of this. Not to mention the coin that I dropped on QQQQ puts.

It's really a new world; bears keep getting gored. They never get anything substantial to eat like some nice raw bull meat.

By the way, thanks for posting on a money related topic.

Ha
Me too.
Just keep remembering the old bromide: The market can remain irrational longer than you can remain solvent.
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Old 10-02-2007, 07:44 AM   #6
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Originally Posted by barbarus View Post
Me too.
Just keep remembering the old bromide: The market can remain irrational longer than you can remain solvent.
I guess that is my question, is it irrational or just that the pundits don't really know what is going on?

I ask because I have essentially been 100% equities for the last 10 years in accumulation mode. During the despair of 2000-2002 people were saying that we had to pay for the last 20 years and returns were going back to the mean, expect single digit returns for the next decade, etc.

Instead from 2003-2006 I compounded 24% and am up 15.5% YTD. There is a major disconnect somewhere.

Maybe it is asset allocation? I was more heavily weighted to small caps and international. I had one RS small cap value fund up over 100% in less than 2 years and one Janus international fund up over 100% in 2 years. Those gains were as good or better than I did in tech funds in the 1990s.

I guess as the nest egg goes up I don't want to do anything too stupid, but I am comfortable with the volitility while I am still investing on a regular basis.
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Old 10-02-2007, 09:36 AM   #7
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Perhaps a better indicator than the PE10 would be the PE10 normalized by the 30 year treasury rate.

Your list didn't include the fact that interest rates over the last 5-10 years have been at the lowest levels in our lifetime. That is unless you are a geezer.
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