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Re: Retiring In Secular Cycles
Old 02-16-2007, 04:02 PM   #81
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Re: Retiring In Secular Cycles

Quote:
Originally Posted by crestmont
Please keep in mind that the most-often quoted data--Ibottson's Annual Yearbook--only reflects long-term returns of 10% because the series starts in 1926 when P/Es were 10.2 and ends when P/Es are almost twice as high. Starting P/E impacts the dividend yield component of total return as well as the capital gain component. Had P/Es at the start been the same as today, long-term returns would have been (necessarily) less than 7%. That alone would be a major change to conventional thinking. The starting point has a major impact.
Please walk me through the math that says an 80% expansion in P/E's results in a greater than 300 bp decline in average 80 year total returns? I think the real answer is closer to 70 bp.
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Re: Retiring In Secular Cycles
Old 02-16-2007, 04:07 PM   #82
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Re: Retiring In Secular Cycles

Quote:
Originally Posted by DRiP Guy
While not showing P/Es, this chart from FPA 1 IMHO shows pretty well that the 10+% returns averaged since ~1990 are atypical, and if past is prologue, we should look for ~6.7% to return. Of course, you seem to be telling us that if P/Es don't move down, we may not get that, either...





Note 1 - linked here under non-commerical fair-use provisions
According to the picture these are "inflation adjusted" returns.

I'll take 6.7% real returns as long as I can get them.
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Re: Retiring In Secular Cycles
Old 02-16-2007, 04:13 PM   #83
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Re: Retiring In Secular Cycles

Quote:
Originally Posted by 3 Yrs to Go
Please walk me through the math that says an 80% expansion in P/E's results in a greater than 300 bp decline in average 80 year total returns? I think the real answer is closer to 70 bp.
I had that same question for the poster earlier and questioned his math (but didn't get a response). I figured the 80% PE expansion accounted for 80 bp of return and the other 9.2% was fundamental.
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Re: Retiring In Secular Cycles
Old 02-17-2007, 02:22 AM   #84
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Re: Retiring In Secular Cycles

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Originally Posted by 3 Yrs to Go
I added an "international" component to my calculation this afternoon and came up with results that are similar to/same as yours. For the international component I used Vanguard's International Value Fund because I didn't want to include the excess US returns over the 1990-2000 period.
By the way, I have figured out that the numbers I was using for the international component were not right. (Oops...) I had intended to use the yen-base numbers for the MSCI All Country ex-Japan index, but upon cross-checking them with the dollar-base numbers and the USD/JPY exchange rates, it looks like they were not yen-base after all. (Probably some basket of currencies?) So I have re-run the numbers using the dollar-based index, with the numbers then converted to yen using the yen/dollar exchange rates.

The results for 4% (which have been inserted into the previous post) are somewhat grimmer looking, probably due to the fact that the yen has risen somewhat since 1990. The portfolio might still last the traditional 30 years, but it is already looking pretty scary. 3% would be much more tolerable:


Year Withd. Balance
1989 ----- 1,000,000
1990 30,000 869,779
1991 30,930 880,224
1992 31,951 817,337
1993 32,462 816,725
1994 32,884 767,875
1995 33,114 812,364
1996 33,081 871,200
1997 33,114 911,763
1998 33,710 862,051
1999 33,912 958,013
2000 33,811 903,148
2001 33,574 861,565
2002 33,339 715,122
2003 33,039 743,367
2004 32,940 742,964
2005 32,940 863,528
2006 32,841 898,114


Quote:
Seems like more international equity and more bonds might be a good way to go.
Yes. Actually one interesting thing is, with a 50/50 domestic/foreign portfolio, the optimum stock/bond ratio looks to be around 45/55.

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Re: Retiring In Secular Cycles
Old 02-17-2007, 07:01 AM   #85
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Re: Retiring In Secular Cycles

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Originally Posted by 3 Yrs to Go
My thought in pointing out the 50/50 mix is that most folks (here anyway) seem to be leaning toward more equity heavy portfolios. 60%-80% equity seems the norm here - and that norm may be trending toward conventional wisdom. I also think that conventional wisdom argues for something like 20% international exposure, instead of 50%[...]
Here's what I get at 12/31/06 if I bump up the equity contribution with the equity split 50/50 between the Nikkei and VTRIX.[...]Here's what I get if I limit my international exposure to 20% of the portfolio:
I get the same general trends. Here are 2006 ending values for a 4% withdrawal (next withdrawal at the end of 2006 would be 43,919). The rows are percentage in stocks, columns percentage in foreign (both stocks and bonds have the same foreign/domestic ratio):


Stocks (down) Foreign (across) ->
|
V
----- 0% 20% 40% 50% 60% 80% 100%
000% 468,231 506,763 539,390 553,154 565,053 582,811 591,871
010% 410,533 477,745 543,553 575,495 606,559 665,360 718,583
020% 343,485 439,745 540,843 592,741 645,265 751,309 857,113
030% 268,518 393,148 530,885 604,281 680,429 840,014 1,007,409
040% 187,164 338,482 513,397 609,548 711,307 930,735 1,169,256
050% 101,014 276,411 488,198 608,037 737,160 1,022,635 1,342,268
060% 011,678 207,718 455,214 599,308 757,271 1,114,788 1,525,867
070% 000,000 133,289 414,482 583,006 770,959 1,206,187 1,719,278
080% 000,000 054,097 366,154 558,864 777,589 1,295,746 1,921,515
090% 000,000 000,000 310,500 526,720 776,586 1,382,322 2,131,377
100% 000,000 000,000 247,905 486,516 767,453 1,464,717 2,347,444

.
As it happens, I target 50% foreign, and plan to be 50% in bonds at retirement. I don't feel significant foreign exposure is all that optional, because which is more likely: a) the country you live in takes a dive and the rest of the world doesn't; or b) the rest of the world takes a dive and the country you live in doesn't? And for those times when everybody takes a dive, significant bond exposure is important, too.
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Re: Retiring In Secular Cycles
Old 02-17-2007, 05:40 PM   #86
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Re: Retiring In Secular Cycles

Quote:
Originally Posted by 3 Yrs to Go
Please walk me through the math that says an 80% expansion in P/E's results in a greater than 300 bp decline in average 80 year total returns? I think the real answer is closer to 70 bp.
Quote:
Originally Posted by justin
I had that same question for the poster earlier and questioned his math (but didn't get a response). I figured the 80% PE expansion accounted for 80 bp of return and the other 9.2% was fundamental.
Yes, you are correct that the effect from P/E expansion over the 80 years was < 1%, but if the series had started when P/Es were at today's levels, the dividend yield component of total return would have been more than 2% (200 bps) less. The level of valuation (i.e. P/E) directly impacts the dividend yield realized in the long-term series.

When you invest at higher P/Es, the dividend yield perpetually in the future on those dollars are lower than if you start with P/Es at 10.2 (as it was in 1926, the start of the series that provides 10% stock market returns). Ibbotson's details show 4.5% of the 10% comes from dividends and 0.7% from P/E expansion...had the series started from today's P/E levels, the dividend contribution would be ~half of the level from 10.2 P/Es.

So the combined effect of 0.7% from P/E expansion and >2% from dividend yield contribution totals the 3% (300 bps) that I referenced.

Here's a hidden link to a presentation that I have been delivering around the country to financial advisors when sponsored by several invetsment firms: http://www.crestmontresearch.com/pdf...pectations.pdf. It may shed some light on the issue. I'll keep checking back in case there are further questions.
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Re: Retiring In Secular Cycles
Old 02-18-2007, 10:49 AM   #87
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Re: Retiring In Secular Cycles

Quote:
Originally Posted by crestmont
Yes, you are correct that the effect from P/E expansion over the 80 years was < 1%, but if the series had started when P/Es were at today's levels, the dividend yield component of total return would have been more than 2% (200 bps) less. The level of valuation (i.e. P/E) directly impacts the dividend yield realized in the long-term series.

When you invest at higher P/Es, the dividend yield perpetually in the future on those dollars are lower than if you start with P/Es at 10.2 (as it was in 1926, the start of the series that provides 10% stock market returns). Ibbotson's details show 4.5% of the 10% comes from dividends and 0.7% from P/E expansion...had the series started from today's P/E levels, the dividend contribution would be ~half of the level from 10.2 P/Es.

So the combined effect of 0.7% from P/E expansion and >2% from dividend yield contribution totals the 3% (300 bps) that I referenced.

Here's a hidden link to a presentation that I have been delivering around the country to financial advisors when sponsored by several invetsment firms: http://www.crestmontresearch.com/pdf...pectations.pdf. It may shed some light on the issue. I'll keep checking back in case there are further questions.
It doesn't work that way.

The ~10% average annual returns assume dividend reinvestment. So your dividend yield is averaged into the average P/E ratio during the investment period. Over long periods of time, the initial P/E gets very diluted.

For example, if I invested $100 in the S&P 500 in 1930, when P/Es were ~18x, I'd have bought ~6.5 shares. With reinvested dividends my shares would increase to ~134 by 2006, which were worth $192,000 . . . a 10.5% CAGR over 76 years.

If, however, I'd have invested $100 in the S&P 500 in 1933, when P/Es were ~9x, I'd have bought ~10 shares. Those shares would have grown to ~176 by 2006, which were worth $251,885 . . . a CAGR of 11% over 73 years.

---------

Another point, with reference to slide 18 that compares historic "Core returns" of earnings growth + dividend yield. You imply that going forward returns will be lower because of the lower dividend yield. But are you taking into account the "share repurchase yield"? Since 1980 dividend payouts have declined but total payouts (dividends + share repurchases) have remained fairly constant relative to earnings.

See Dividends, Share Repurchases, and the Substitution Hypothesis for one of many articles on the topic.
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Re: Retiring In Secular Cycles
Old 02-18-2007, 11:52 AM   #88
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Re: Retiring In Secular Cycles

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Originally Posted by 3 Yrs to Go
Another point, with reference to slide 18 that compares historic "Core returns" of earnings growth + dividend yield. You imply that going forward returns will be lower because of the lower dividend yield. But are you taking into account the "share repurchase yield"? Since 1980 dividend payouts have declined but total payouts (dividends + share repurchases) have remained fairly constant relative to earnings.

See Dividends, Share Repurchases, and the Substitution Hypothesis for one of many articles on the topic.
Good points, 3yrs. But I often see repurchases considered in isolation like this. Shouldn't repurchases only be considered insofar as they offset dilution (options, secondary offerings, stock swaps, etc)?

Have you seen any papers that track both and publish the net effect?
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Re: Retiring In Secular Cycles
Old 02-18-2007, 12:14 PM   #89
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Re: Retiring In Secular Cycles

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Originally Posted by 3 Yrs to Go
It doesn't work that way.

The ~10% average annual returns assume dividend reinvestment. So your dividend yield is averaged into the average P/E ratio during the investment period. Over long periods of time, the initial P/E gets very diluted.

For example, if I invested $100 in the S&P 500 in 1930, when P/Es were ~18x, I'd have bought ~6.5 shares. With reinvested dividends my shares would increase to ~134 by 2006, which were worth $192,000 . . . a 10.5% CAGR over 76 years.

If, however, I'd have invested $100 in the S&P 500 in 1933, when P/Es were ~9x, I'd have bought ~10 shares. Those shares would have grown to ~176 by 2006, which were worth $251,885 . . . a CAGR of 11% over 73 years.
There is no asset whose return is not affected by the price paid for the earnings stream. We could look at every separate purchase, whether made initially by virgin money or made bit by bit from dividend payments as separate tranches, each tranch more or less bounded as to return at the time of purchase. It is going to take a long time indeed before dividend re-investment at today's yields dominate the initial going in price. Probably a lot longer than anyone in or close to retirement has. And don’t forget, in order to have adequate diversification most of us are going to have our dividend yields cut by mamagement expenses, cut at least by 20% and possibly more.

A related timing factor is this- who are we talking to? If we talking to people whose needs are completely covered by non-portfolio income, any argument can be made. Returns and volatility are meaningless to them.

But if we are talking to people living from portfolio income, your re-investment idea is quite wrong. This person will not only consume his dividend yield, he will also need regular sales to supplement the dividend yield just to pay his bills. So his base suffers from negative DCA. This is how financial retirement failures occur.

Ha
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Re: Retiring In Secular Cycles
Old 02-18-2007, 12:40 PM   #90
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Re: Retiring In Secular Cycles

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Good points, 3yrs. But I often see repurchases considered in isolation like this. Shouldn't repurchases only be considered insofar as they offset dilution (options, secondary offerings, stock swaps, etc)?
Yes. But the relevant question isn't so much about the level of equity issuance, but whether equity issuance has changed over the sample period. We know share repurchases have increased. And according to the linked Journal of Finance article, they've increased in proportion to the relative decline in dividends. So total payouts to shareholders are at about the same level as they've always been. Unless equity issuance has increased relative to historic levels, total returns to shareholders should also be at about the same level as they've always been (all else being equal). In fact, given the tax advantages of share repurchases, after tax returns may even be better.

The JoF article didn't address relative changes in equity issuance because it wasn't relevant to the specific thesis of their paper. I'm not aware of a study that looks into that issue either. Anecdotally, though, I'd argue that equity issuance has trended downward over the past couple of decades. Modern corporate finance that views equity as the most expensive source of capital is a fairly recent phenomenon. As a result corporations have largely abandoned benchmarks such as revenue growth and market share in favor of risk adjusted returns on equity. I think that's also why we've seen average credit quality of corporations decline across many industries over the past few decades. Companies now know that the weighted average cost of capital is lower for BBB rated companies than those sporting Aaa ratings - encouraging less equity in the capital structure.
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Re: Retiring In Secular Cycles
Old 02-18-2007, 12:49 PM   #91
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Re: Retiring In Secular Cycles

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Originally Posted by 3 Yrs to Go
Anecdotally, though, I'd argue that equity issuance has trended downward over the past couple of decades.
Really? Tell that to all of the tech stock option millionaires. My guess would have been that there was a surge in dilution from 1985-2000.
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Re: Retiring In Secular Cycles
Old 02-18-2007, 01:07 PM   #92
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Re: Retiring In Secular Cycles

Ha,

I agree with your entire post.

What I disagreed with was the assertion that historic equity returns of ~10% are overstated by 300bp because the original purchase date was made at a P/E of ~10x versus today's level of ~18x. ~10% remains the average annual rate over the entire period. Some periods will be higher, and some lower.

Interestingly, if I take my original calculation and extend it for 30 years (instead of 76) SPX returns from 1930-1960 are 10.3% and from 1933-1963 are 12.6%. As expected, the initial P/E caries more weight when amortizing over shorter time horizons. But contrary to what I would categorize as crestmont's (and perhaps your) general assumption, 30 year returns for my initial 18x P/E investment came in about average. My lower P/E purchase came in well above average. So it stands to reason that today's P/E's don't preclude average returns in the years to come.

Many of your other points are addressed by using FIRECalc type simulations. Initial withdrawal start dates include many periods with P/E's at or above current levels (we are not in uncharted territory currently). It also addresses volatility while dollar cost averaging out of a portfolio and includes a management expense drag.

Nothing is fool proof. But if I can survive 100% of historic US periods (which include some initial P/E valuations higher than they are today), and am looking at building a situation that would survive 1990 Japan, I think I should be in pretty good shape.
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Re: Retiring In Secular Cycles
Old 02-18-2007, 01:13 PM   #93
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Re: Retiring In Secular Cycles

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Originally Posted by wab
Really? Tell that to all of the tech stock option millionaires. My guess would have been that there was a surge in dilution from 1985-2000.
What % of the total stock market do they account for? How much is all that equity worth today?

Yes. Equity capital was extremely cheap for some companies in 1999. So cheap it was used to buy multi-million dollar super bowl adds for companies with only a couple of million dollars in revenue. They were stupid heady times. But the fact that almost all of those companies are gone now shows that the late 1990's were the exception that proves the rule.
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Re: Retiring In Secular Cycles
Old 02-18-2007, 01:55 PM   #94
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Re: Retiring In Secular Cycles

More fun with #'s.

I went back and calculated average annualized returns for the SPX where initial P/E's were around 18x. All calculations begin in December of the year stated and end in December 2006:


Year P/E Avg Return
1938 20.6x 11.3%
1945 18.1x 11.5%
1958 19.1x 10.4%
1967 18.1x 10.6%
1971 17.9x 11.3%
1986 16.7x 11.8%
1995 18.1x 9.7%

Seems to me like we have every reason to expect average equity returns going forward.
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Re: Retiring In Secular Cycles
Old 02-18-2007, 02:18 PM   #95
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Re: Retiring In Secular Cycles

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Originally Posted by 3 Yrs to Go
More fun with #'s.

I went back and calculated average annualized returns for the SPX where initial P/E's were around 18x. All calculations begin in December of the year stated and end in December 2006:


Year P/E Avg Return
1938 20.6x 11.3%
1945 18.1x 11.5%
1958 19.1x 10.4%
1967 18.1x 10.6%
1971 17.9x 11.3%
1986 16.7x 11.8%
1995 18.1x 9.7%

Seems to me like we have every reason to expect average equity returns going forward.
I haven't (and likely won't ) check the individual years you have cited. I am sure you are correct. What I would wonder is if at least some of these years might be years in which the PE is high only because the earnings are at a cyclical low. That is why Prof. Shiller smooths earnings by using Price/(10 year mean of earnings), and John Hussman uses Price/Peak Earnings.

Ha
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Re: Retiring In Secular Cycles
Old 02-18-2007, 03:12 PM   #96
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Re: Retiring In Secular Cycles

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Originally Posted by HaHa


I would wonder is if at least some of these years might be years in which the PE is high only because the earnings are at a cyclical low.
Well, if we finally come full circle back to cycles, I guess I'll admit my ignorance and say that while it is evident that Easterling uses P/E 1 as a direction signal for his "Bull" v "Bear" call, I'll be danged if it is clear to me what I would expect next -- notice that prior 'cycles' vary in duration, and so it is not clear to me what the crystal ball would have me do... that's why I am going to (boring) continue to DCA, continue to purchase equities, via an index, and keep my wits about me if I can.

Again, hoping I will be forgiven for my ignorance, I did note that only one of the "called" bear market periods even went actually negative (below the zero avg period return line), out of more than a one hundred year history, and then only slightly negative and for the briefest of all the "called" periods; be they bull or bear. given that, why should I worry about hopping around trying to guess on the future around the bend, when I have a pretty good idea of what will happen over what I consider reasonable periods of time, that I think I am prepared to endure?



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Re: Retiring In Secular Cycles
Old 02-18-2007, 03:13 PM   #97
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Re: Retiring In Secular Cycles

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Originally Posted by HaHa
I haven't (and likely won't ) check the individual years you have cited. I am sure you are correct. What I would wonder is if at least some of these years might be years in which the PE is high only becuase the earnings are at a cyclical low. That is why Prof. Shiller smooths earnings by using Price/(10 year mean of earnings), and John Hussman uses Price/Peak Earnings.

Ha
Don't know.

But I suspect a more elegant answer is that when the starting and ending valuations are the same, your return is purely a result of the underlying investment. If we started with a P/E of 18x and ended with a P/E of 9x, returns would be below average and above average if we ended with a P/E of 30x. Having said that, it is nice to see that every decade over the past 70 years witnessed P/E's as high as those currently observed.
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Re: Retiring In Secular Cycles
Old 02-18-2007, 03:39 PM   #98
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Re: Retiring In Secular Cycles

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I haven't (and likely won't ) check the individual years you have cited. I am sure you are correct.
You're too trusting kind.

But I began to question my calculations after I this:

I calculated returns from Dec 1945, when P/E was 18.1x to Dec 1974 when P/E was 9.8x . . . assuming they would be quite bad. However, my calculation showed average annualized returns over this period were still 9.4%.

I was suspicious of that result so I double checked it with Bloomberg which said total returns for SPX were 9.3% (close enough).

So even after a 50% drop in P/E, average annual returns were still pretty decent (for that time period at least).

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Re: Retiring In Secular Cycles
Old 02-18-2007, 08:22 PM   #99
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Re: Retiring In Secular Cycles

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Originally Posted by 3 Yrs to Go
It doesn't work that way.

The ~10% average annual returns assume dividend reinvestment. So your dividend yield is averaged into the average P/E ratio during the investment period. Over long periods of time, the initial P/E gets very diluted.
Actually, the impact of reinvestment is attributed to the dividend category of total return. I believe that's why Ibbotson's tally reflects 4.5% from dividends. It doesn't get allocated to EPS growth or P/E change...starting valuation does impact the future impact from dividends. Nonetheless, as others have pointed out, most retirees will be using their dividends rather than reinvesting them.

Quote:
Originally Posted by DRiP Guy
Well, if we finally come full circle back to cycles, I guess I'll admit my ignorance and say that while it is evident that Easterling uses P/E 1 as a direction signal for his "Bull" v "Bear" call,

Easterling/Crestmont generally uses P/E10 and similar approaches to smooth the earnings cycle (which tends to distort P/Es)... Further, I don't make short-term bull & bear calls; only perspectives about the expected longer-term returns.

Starting P/E is a major determinant of future stock market returns...no different than starting bond yield is a major determinant of total return from bonds. There are only 3 sources of returns from the stock market: (1) EPS growth, (2) dividend yield, and (3) P/E change.

(I) EPS growth is closely tied to economic growth over longer periods (decades plus or minus)...since GDP-R is likely to grow at 3% plus inflation of 1-3%, EPS growth will be 4-6% (actually slightly less since public company EPS grows slightly slower than all companies...due to new company start-ups and smaller company growth rates).

(II) If you start by paying higher valuations, your dividend yield is lower.

(III) P/E change has a major impact over 5, 10, 20 year periods. If you don't withdraw capital from your portfolio, it becomes less of an issue over 30, 40, or 80 year periods.

Today's valuation level is either (a) near 18...if you believe that we have shifted to a profit margin level that is 50% higher than the average rate for the past 100 years, or (b) near 25...if you believe that we're at a profit cycle high and that "this time will not be different".


Quote:
Originally Posted by 3 Yrs to Go
I calculated returns from Dec 1945, when P/E was 18.1x to Dec 1974 when P/E was 9.8x . . . assuming they would be quite bad. However, my calculation showed average annualized returns over this period were still 9.4%.

I was suspicious of that result so I double checked it with Bloomberg which said total returns for SPX were 9.3% (close enough).

So even after a 50% drop in P/E, average annual returns were still pretty decent (for that time period at least).
P/E10 in 1945 was ~13 and did decline slightly near 11 in 1974...yet the reason for ~9% returns is the starting level of P/Es and the impact on dividend yields as well as the inflation rate over that period (~3.5%) which drove nominal EPS up by more than would be expected if inflation is closer to or below 2%.

Just curious, for those in this group that expect average (10%) returns, what are your assumptions for the three components of total return:

1. EPS growth,
2. Dividend Yield, and
3. P/E Change?



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Re: Retiring In Secular Cycles
Old 02-18-2007, 09:51 PM   #100
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Re: Retiring In Secular Cycles

Ed,

Thanks for pointing out that you do not try to predict cycles in advance, and I also appreciate your careful restatement of the components driving valuations.

I don't know if I'll try to tackle all your questions, but I will opine that for me, I think "this time will not be different", at least if that means inventing some hitherto unused method of valuation.

But at the same time, I want to assert that 'not being different' to my understanding could allow for shifting importance between the addition each component brings to the overall value equation, if supported by evidence. We can change the variables and still balance an equation, without completely retooling or discarding the underlying formula.

I am way out of my own depth here. But it seems to me that if we happen to believe that efficiencies in the market, or in company profit generation (labor and other internal efficiency changes), change in regulations or tax climate, inflation, or other weighting movements, can alter the expected performance, then we need not throw out the baby with the bathwater in terms of looking to the historical data to guide us on the continuum leading into the future.

I am a simple man.


Given the P/Es and valuations for the last few years, things will either go up, sideways or down. I have literally no clue what they will do short term. But I see no evidence the system is fundamentally unsound, that global economic crash is likely, or any other reason for me to not wait out any temporary correction that may be in the offing, or if the direction is the other way, to enjoy the gains that may come if the bull is extended directly.

Thanks for adding information and ideas to the thread!

Oh, and I don't expect 10%, myself. I expect about 6.7% net, over the next fifteen or twenty years.


Ed, the following is a legit question, not trying to bait you or be a pain: if I had used the information available post facto on the spreadsheet to move out of the market on the bear cusp, and into the market on the bull cusp, exactly as defined through Crestmont, how much better would an investor's backtested overall returns have been? I know we have no magic formula that would have given us that ability, but as I said above, the only reason I see to care about bull or bear or P/E versus historical seems to be to help decide to get in or out of the market, right?

But if the value of that would have been to avoid a two year period of -2% net, versus 2% real if I had been in bonds instead, I just don't see that as giving me a good payoff for the effort, worry, and non-zero chance of botching it up.
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