View of the Market from Doorstep of ER

[Donner]

The old Dividend Discount Model (DDM) can be used to establish an intrinsic value for the stock market by discounting the value of future dividend flows to the present. The Net Present Value of those expected flows, together with the value of the asset at the end of the holding period is theoretically what you should be willing to pay for the asset today.

This type of valuation technique can be applied to the future flow of Earnings just as well as Dividends. However, the contrasting results are intriguing.

As of Dec 31, 2004 the S&P 500 had "core" earnings of $53.80 per share and paid a dividend of $19.44. Let's use 30 years as the holding period of our investment. Next, we need some estimate of the future rate of growth of earnings and dividends. For the last 15 years operating earning have grown at a 6.77% rate and dividends have grown at a 4.0% rate. Let's use those for starters. Using those growth rates, "core" earnings 30 years from now on Dec 31, 2033 will amount to $368.68 and dividends will be $65.37.

Next problem is to determine how we are going to capitalize these flows. Here is where examining Earnings vs. Dividends begins to produce curiously divergent results. The most common expression for earnings capitalization is, of course, the Price to Earnings ratio (P/E). At 1180 on the S&P the P/E on the 2004 core earnings is about 22 times earnings. The most common expression of Dividend capitalization is the Dividend Yield. At 1180 the 2004 Dividend Yield is about 1.7%. The inverse of the Dividend Yield or Price/Dividend (P/D) would thus be about 60 times dividends. So, obviously the markets view earnings and dividends in a different light. Earnings are not dividends and dividends are not earnings. We value Earnings and Dividends differently.

Using a P/E of 20, our expected Dec 31, 2033 core Earnings of $368.68 would fetch a price of 7,373.57. What's that worth to us today? Depends on your personal capitalization rate. What kind of return do we demand to induce us to own this type of risky asset? This is the key to the whole thing. For argument's sake let's just say we need to get an annualized return of 12% to justify an investment in the S&P 500. Ok, so that 7,373.57 on Dec 31, 2033 is worth 275.65 to us today. How about the value of the future flow of Earnings? 30 years of Earnings growth starting from a base of $53.80 and growing 6.77% per year at a 12% capitalization rate is worth 1,055.08 to us today. So based on our inputs and our return requirements, we should be willing to pay no more than 1,330.73 for the S&P today.

Using a Dividend Yield of 1.7 % our Dec 31, 2003 expected Dividend of $65.37 yields a market value of 3,845.40. At a 12 % capitalization rate that 3,845.40 is worth 143.75 today. The Dividend flow for 30 years starting from a base of $19.44 and growing at 4.0% annually is worth 240.73 today. This yields a DDM intrinsic value of the S&P 500 of 384.48 today.

Big difference in intrinsic value whether your valuing earnings or dividends. Why? Look at the growth rates. Dividends aren't as large as earnings to begin with and aren't projected to grow nearly as fast as earnings. At comparable capitalization rates, to get that DDM model to value at something near the Earnings model we would have to grow dividends over the next 30 years at a rate which we have never approached in history. So, earnings and dividends warrant a different cap rate expectation.

[Donner]

Let's look at what the Earnings Model and the Dividend Model tell us about how the markets capitalize these two flows:

Earnings model: 6.77% growth rate; P/E of 20; base of $53.80
Capitalization Rate/ Implied Intrinsic Value
15%/760
12%/1,120
10%/1,519
06%/3,147
05%/3,867

Dividend Model: 4.0% growth rate; 1.7% Dividend Yield; base of $19.44
Capitalization Rate/Implied Intrinsic Value
15%/254
12%/384
10%/534
06%/1,172
05%/1,462

Guess which model Wall Street pushes to the investing public? Yup, all we ever hear about is earnings and earnings growth and P/Es and valuing earnings. But guess what? You and I and every other small individual investor have no hope of ever capturing all those earnings. In theory they belong to us. In reality we will never see them. Earnings to us little guys is like a mirage in the desert. We can see it shimmering in the distance but as much as we chase after it we will never get our hands on it. Capturing earnings is a sensible idea for Warren Buffet or for Verizon going after MCI. An earnings discount valuation model makes sense for them. It is reality for big institutional players. Reality for us little guys is dividends. It is what we have a reasonable chance of actually realizing and what we should reasonably be focusing on. It sets up a philosophical argument on how you value markets: do you put an intrinsic value on the market as it makes sense to the big guy or as it make sense to you and me? Whose reality prevails? It is the same as the best and highest use argument in real estate appraisal.

So what is the market telling us today? Well, if the inputs above are anywhere near the ballpark, the market is telling us that earnings are viewed as a lot riskier phenomena than dividends. The market demands a lot higher rate of return for them than for dividends. Earnings are viewed as more volatile, less certain, riskier and requiring a higher capitalization rate. Dividends are more reliable, certain, constant, less volatile and thus less risky commanding a smaller capitalization rate. Makes sense up to a point. The market at 1,180 is requiring an implied rate of return of 12% on earnings growth of 6.77%. The market at 1,180 is requiring an implied rate of return of 6% on dividends growing at 4.0%.

[Nords]

I gotta say, Donner, that if this is just the doorstep of your ER then you're making it way too complicated.

[Donner]

The Bulls would tell us that this market is pretty well priced based on an evaluation of earnings and poised to move higher as the economy accelerates and earnings improve. That's the story Wall Street will push at us in the next couple of quarters as the economy's momentum carries forward. But the key to market capitalization is the capitalization rate. And that rate is driven to a large extent by returns available in competing asset classes, notably risk free Treasuries. As the Fed remorselessly drives up interest rates in an attempt to head off inflation by cooling the economy, the market's capitalization rate vis-a-vis the risk free rate is going to move up. Look at the charts above to see what happens when cap rates begin moving up. What the market will pay for relatively riskier equity assets moves down. As the perception of risk intensifies the higher the cap required and the lower the market moves, whether it is earnings or dividends that are being valued. This is what is making the markets so nervous today. The market is between a rock and a hard place. Rising rates are pushing cap rates and crushing capital in the process. A tightening Fed monetary policy is a capital crushing machine. It really is an inexorable, irresistible and unavoidable process once in motion.

The question the markets have yet to resolve is how high Alan Greenspan is going to raise rates and how fast. And that will depend upon the perception of inflation. How bad is it now and how bad is it going to get? It’s nail biting time. This market may be bailed out temporarily by good earnings news in the next coupe of weeks. Probably will get a pretty good relief rally. But the underlying problem of cap rates will re-emerge and grind the markets down as long as Greenspan keeps pushing his short term rate. The capital crushing machine is definitely now in gear and moving at low ¼% speed. But if earnings should disappoint at this early juncture in monetary tightening, (something I don't really expect for another couple of quarters) the machine might just move into second gear. Mr. Greenspan is going to have to have better balance than the Flying Wallendas to pull off this policy approach without rolling the markets in the process. And you remember what happened to the Wallendas.

So what does this mean for Mr. and Mrs. Donner and the management of their retirement assets? Well, for us as individual investors, I think it puts the price we will pay for this market at somewhere north of 584 (the market is never going to give me a 10% capitalization of dividends but I think 6.0% is just plain nuts vis-a-vis a 4.6% and rising risk free Treasury rate) and somewhere south of 1,180 (12% cap of earnings now at the mercy of Greenspan's determination to kill inflationary expectations is not enough to compensate for the risk of highly volatile future earnings expectation). Maybe we settle for a fair price around 800 on the S&P where we can justify 'Rational Exuberance'. That would be about an 8.0% cap rate on dividends growing at 4.0% annually for the next 30 year. And about 15% on earnings growing at 6.77% for the next 30 years. A decent reward for the risks that the market wants Mr. and Mrs. Donner to take in equities versus risk free Treasuries. Keeping our feet firmly planted in reality from an individual investor's perspective. That's about a 32% slide from where we are right now. If Warren Buffet, Verizon, the rest of the big boys, and the millions of buy and holders who really don't know or care about risk can afford to assume more of it for less reward than I can rationalize for Mrs. Donner and me then I guess we don't belong in the equity markets. They can own those risks with my blessing. Good luck dealing with the capital crushing machine.

Donner

[charlie]

Donner,

IMHO, it is pretty useless to try to figure out the
current value of the market using the DDM. *You
can get any answer you want by just a small
tweak of the discount rate. *

What is important is what can you expect the
long term return to be going forward.

This is given by the current dividend plus dividend
growth. *(pssst TH, the "Gordon Formula") *

Using your numbers this would give us about 5.7%
nominal. *

Bernstein puts it a little more succinctly here:

http://www.efficientfrontier.com/ef/403/fairy.htm

If you can't live with that, then don't.

Cheers,

Charlie

[cute fuzzy bunny]

(pssst TH, the "Gordon Formula")

I'm changing the 25lb attack cats name to "Gordon". So far he doesnt like it. But he ignores me no more than he used to.

[charlie]

Another favorite link that provides insight into
future expected returns is here:

http://www.investopedia.com/articles/04/012104.asp

Cheers,

Charlie

[Donner]

Charlie--

Thanks for the links. Enjoyed 'em both. I agree with you that any time you start fooling around with net present value analysis you are asking for trouble. Most overrated, overused, misused analytical tool ever devised, IMO. Great for bond analysis where the cash flows and other inputs are knowns but not so hot when all the inputs are variable. Cash flow analysis over a 30 year period makes you want to LOL. But business makes decisions based upon this stuff.

So why even look at it? Well, to me, it's kinda like looking at that three letter analysis that begins with S and ends in R, which you may have noticed I have studiously avoided jumping into. It is what it is. Kinda gives you a ballpark appreciation of where things stand, but you wouldn't want to bet your life on it.

The Gordon equation is the mathematical simplification of the DDM. I liked Bernstein's observation that the P/E multiple or the Dividend Yield fluctuates from day to day, and maybe by a lot over the course of a year, and trying to project one out at some finite point 30 years from now is, well, a pleasant game at best. You can say that about all the inputs. You pays yer money and you takes yer choice! You're right, Charlie --you can produce any result you want depending on what inputs you throw in there.

I think Bernstein beautifully summarizes the long term constraints on corporate growth of earnings and dividends: It is impossible for long-term corporate growth to be higher than GDP growth for this would entail corporate profits eventually growing larger than the economy itself. Beautiful. Bout says it all.

So, it looks like we are stuck with a long term 6% nominal return in stocks - 1.5% dividend yield plus 4.5 % growth in dividends. Well, how does that strike you, risk- wise, compared to 4.5% 10 year Treasuries (and undoubtedly going higher)? That's not much risk premium. Why assume it? Need the dough? What's a long term 6% nominal cash flow worth? What will you pay for it? Gets back to your own personal capitalization rate. What do you have to get paid to induce you to take risks? How long you going to hold the asset? What's your dividend multiple? What are your inputs, Charlie? Hah! LOL! Round and round we go!

Just for fun, when I run that 6.0% long term nominal through my little model I get the following:
Capitalizaton Rate/Implied Intrinsic Value
06%/1,412
07%/1,133
08%/918
09%/751
10%/621

With risk free bouncing around 4.5% right now (and rising, mind you) , don't you think that market capitalization rate has got to start bumping up? Put it another way - how little do they have to pay you to get you to give them your retirement assets? With oceans of surplus capital floating around the system, the answer the market gives to that question today is: not much! But don't worry, Greenspan's capital crushing machine (glompeta! glompeta!) will fix that problem, eventually. :-/

Donner

[charlie]

Donner,

I am a coffeehouse investor in my IRA with a 50/50
allocation ..... one foot in each boat ?

The coffeehouse leans toward small cap and value
as apposed to the cap weighted mix of the "market"
as represented by TSM.

If you rebalance low correlation assets you get a little
premium according to the gurus .... about 0.5% extra
return if memory serves. Every little bit helps, right?

Currently Value Index has a yield of 2.34% net of
expenses ... this is what the real world offers to
people like me. Thus using 4.5% dividend growth
plus 2.34% dividend the long range outlook for
Value Index is about 6.84% . If you use the earnings
model, Value Index's P/E of 15.5 translates to about
6.45% real or about 9.45% after tacking on 3%
inflation.

I have not added up all the expected returns of the
coffeehouse, but it would be an interesting exercise.

My meandering point is that I think a coffeehouse
mix of equities should provide a little more juice than
the 6% low- ball we discussed earlier ...... maybe
closer to 7.5% if you sort of average the dividend
model and the earnings model and throw in a little
rebalancing premium.

My bond allocation is committed to "floaters" that
pay 2+% real + CPI .... currently paying about 5%.

Thus at a 50/50 allocation, I hope to see about
6.25% nominal inflation indexed return over the
long haul.

Currently I am drawing down the IRA at a 6% rate
(or about 4% of the total port) so it is a horse
race to see if lasts as long as I do.

Cheers,

Charlie

[MRGALT2U]

Hi Charlie! I still have not started drawing on my IRA,
which is kind of amazing. And now, an epiphany. I have gone for so long now living on so little and paying -0- federal tax, that
maybe when I hit 62 (1 year, 5 months and 11 days)
I won't need the money.
Oh, I will still take it of course

BTW, at our house a "floater" has quite a different
meaning

JG

[Donner]

Charlie--

I think 50/50 over the long run is a pretty solid allocation for somebody in early retirement. Right now its nervous time for both the equity 50 and the bond 50. In a period of rising interest rates both equity and bond values are going to trend lower for awhile and could cause significant erosion to the corpus of your retirement stash. With a commitment to TIPS or TIP-like inflation protected instruments you are rightly concerned about what is going to happen to the CPI. If that CPI doesn't move, it could cause you some problems. And ironically, I think your bond portfolio may suffer the most and the longest from coming short term market turmoil. I don't think we will see interest rates trending lower for a long, long time. And while equities may bounce back in such an environment, I don't see debt recovering market value very quickly once it is lost to spiralling interest rates.

Buy and holders are going to be put to the acid test in the coming months. It's easy to talk about using discipline in your asset allocation plan and remain detached from the day- to-day, week- to- week, month -to -month volatility in the markets. It's another thing to live through it.

I think I could undertake a buy and hold approach and ride through the volatility if I thought I had some cushion in the size of my retriement portfolio. But I feel like my portfolio right now is big enough to support my desired ER lifestyle-- but without any margin for error. I feel like I am right there right now but any significant setback for the portfolio would leave me vulnerable if I were retired. I wouldn't feel real comfortable about retiring with a 25% or 30% drop in the markets right now, even knowing intellectually that markets will recover in time. Awkward place to be given my current short term market outlook as I have described elsewhere.

Wonder if anyone has done any research on the pyschological aspect of "portfolio margin for error" and its implications on asset allocation and willingness of investors to tolerate market volatility? What's it take to feel comfortable with volatility -- 10%, 20%, 30% cushion? More?

Donner

[Jarhead*]

Charlie--

* * * *I think 50/50 over the long run is a pretty solid allocation for somebody in early retirement. *Right now its nervous time for both the equity 50 and the bond 50. *In a period of rising interest rates both equity and bond values are going to *trend lower for awhile and could cause significant erosion to the corpus of your retirement stash. *With a commitment to TIPS or TIP-like inflation protected instruments you are rightly concerned about what is going to happen to the CPI. *If that CPI doesn't move, it could cause you some problems. *And ironically, I think your bond portfolio may suffer the most and the longest from coming short term market turmoil. *I don't think we will see interest rates trending lower for a long, long time. *And while equities may bounce back in such an environment, I don't see debt recovering market value very quickly once it is lost to spiralling interest rates. *

* * * *Buy and holders are going to be put to the acid test in the coming months. *It's easy to talk about using discipline in your asset allocation plan and remain detached from the day- to-day, week- to- week, month -to -month volatility in the markets. *It's another thing to live through it. *

* * * * I think I could undertake a buy and hold approach and ride through the volatility if I thought I had some cushion in the size of my retriement portfolio. *But I feel like my portfolio right now is big enough to support my desired ER lifestyle-- but without any margin for error. *I feel like I am right there right now but any significant setback for the portfolio would leave me vulnerable if I were retired. I wouldn't feel real comfortable about retiring with a 25% or 30% drop in the markets right now, even knowing intellectually that markets will recover in time. * Awkward place to be given my current short term market outlook as I have described elsewhere. *

Wonder if *anyone has done any research on the pyschological aspect of "portfolio margin for error" and its implications on asset allocation and willingness of investors to tolerate market volatility? *What's it take to feel comfortable with volatility -- 10%, 20%, 30% cushion? *More? *

Donner

Donner: In the withdrawel stage, which I have been in for over 18 years now, I try and push market volatility in the future.
Having spent a good deal of my younger life with a young family in the 1966 to 1981 period, I can no longer tolerate much volatility. (I know what it costs us to stay above ground, and what our needs are.) We have no pension, other than soc. sec., so I better be right.
I agree that we are in a hightly volitale period now, and I don't want to participate.
What I personally have done is change my allocation to 73% short, and 27% (stocks).
By the way, "short" means minimum volitility, Tips, CD"S, hedge fund, I Bonds.
If we in fact need the stocks in 16 years or so, I'm hopeful that they will be worth a few bucks more than they are now.
Meanwhile, I have pretty much detached myself from the long term bond, and stock outlook.
I prefer to concentrate, with the time I am allotted to the things that I truly enjoy. (Golf, and fly-fishing).
Withdrawel is a far different game than accumulation.

[unclemick]

Being able to live on the 2.53% current yield of Vg Balanced Index, ballpark 3% of 50/50 Target Ret. 2015 or the 3.6% of 40/60 managed Wellesley.

The emotions will still suffer - but as long as you just stand there and do nothing per Bogle - might be able to squeeze in some golf or fishing - between worry attacks.

2000 - 2003 was a possible warm up practice for the real game.

Now 1973 -4, That was interesting!

[Jarhead*]

Being able to live on the 2.53% current yield of Vg Balanced Index, ballpark 3% of 50/50 Target Ret. 2015 or the 3.6% of 40/60 managed Wellesley.

The emotions will still suffer - but as long as you just stand there and do nothing per Bogle - might be able to squeeze in some golf or fishing - between worry attacks.

2000 - 2003 was a possible warm up practice for the real game.

Now 1973 -4, That was interesting!

You boys will have to play the next game without me

[Donner]

Now 1973 -4, That was interesting!

I remember 1973-74 very well. I think it takes a little searing experience like that to give a fella a real good appreciation of what they mean by the word volatility.I don't think the young folks on this Board have an idea how ugly and downright disheartening things can get.

I'm with Jarhead, I think I will skip the next dance, too.

Donner

[charlie]

Donner,

I am more concerned about income volatility in my
bond "floaters" than the current market value.
The danger to the market value of "floaters" is if
real interest rates rise since they track the inflation
component of nominal interest rates. IMHO, real
rates are mostly influenced by supply and demand.

The bonds I hold mature in about 9 years and I
don't foresee any problem holding to maturity.

A doomsday scenario is that real rates will spike
when holders of US debt demand a higher risk
premium due to some trigger ....

This may be followed by the US printing money to
devalue our debt .... which would cause real
inflation to take off. The "floaters" will come in
handy in that case.

If real rates and inflation just muddle along with
no significant volatility over the next 9 years then
I expect the income to be comparable to a
conventional intermediate term bond fund.

I am certainly no economist, so this analysis may
be all wet.

Cheers,

Charlie

[Donner]

Charlie--

Inflation is a son-of-gun for retirees to deal with in the current macro environment. I am a little surprised by how tough the risk free Treasuries have hung in there around 4.5% for several weeks now after the Fed's last quarter point and Greenspan's conundrum testimony. I think it is a testament to how much cash and credit creating capacity is floating around out there. And therein is the seed of the problem we face. The reality of risk is being swamped, distorted and literally 'papered over' by lots and lots and lots of dollar bills chasing after any little yield that has the temerity to pop its little head up. It's a frenzy of yield chasing, no other way to look at it. And it expresses itself in bid up asset values and low capitalization rates and low nominal interest rates. Hang the risk.

So we have the curious phenomena of highly resistant risk free and not so risk free interest rates in the presence of "real" inflation affecting real people, especially retirees, and no "official" inflation as expressed by Chinese manufactured goods deflationary bias in the CPI. This is a curve ball we haven't seen before. It's the trickiest situation for monetary policy management that I have ever seen.

The key to what is going to happen in the coming months remains Alan Greenspan. The markets know we have a potentially explosive, unsustainable macro climate in world affairs right now. Oil is a red herring, IMO. Gives the traders something to play with
from day to day. Soon as the summer driving season is over you will see oil back in the 40's or even 30's. Speculative froth at its worst. Busting the oil speculators will bring its own problems, however. Not the least of which will be a false sense of security on the inflation front.

How we are handling risk is another new kind of curve ball. There is a huge, burgeoning, unregulated, uncontrolled, and largely invisible industry which has sprung up almost overnight in the hedging of risk and making money in risk arbitrage. This entails, basically, taking the risk monkey off your back, and putting it on the other guy, for a price. Shifting risk around the room. But risk is risk. Somebody is holding it. A lot of players are now saying: "sure, I'll be the guy who pays off, if you give me a little yield, a little insurance premium, to compensate me for assuming your risk." The guy who shifts the risk for a premium feels he is safe because he has paid somebody to take the monkey. It won't take too many weak monkey grinders, guys who have borrowed a little too much at the short end, a little too levered, in a rising interest rate environment, a little too greedy and overextended reaching for hedge premium income, to bring down the 'strong' players who think they have hedged their bets safely. Can anyone say Son of Long Term Capital Management?

Oceans of Liquidity--inflation--Risk Shifting. Greenspan isn't fooled by today's financial chatter. For the time being he is going to continue "measured" short term increases and try to give the markets more time to unwind "Irrational Greed" ---out-of-control, yield chasing, risk shifting, speculative trading mania. Trouble is sooner or later it will become more and more apparent that the sharpie traders in the markets aren't taking the hint. HIS STRATEGY ISN'T WORKING. The game just goes on and will continue, IMO, until Greenspan injects a little uncertainty into the game. At some point, to maintain the Fed's credibility, Greenspan will have to abandon Plan A and move to Plan B. That would be a surprise, between meetings, 1/2% or more rate hike. That would tell the markets: "I'm serious. The game is over. Unwind now or get crushed." I think Plan B is coming and probably sooner than anybody expects. The markets will take a hit-- probably a pretty big one. But I think Greenspan will sleep easy at night knowing he gave everybody plenty of warning. And a little seriousness now is what we need to disarm the derivatives business, reawaken the concept of reward for risk, make investing for the long haul attractive again, contain "real" inflation and promote long-term stability in the global marketplace.

So, Charlie, I think you are going to get a chance to see if your "no income volatility" approach is going to work over an extended period of time. In a rising interest rate environment you will have to sit o