Retiring In Secular Cycles

[crestmont]

So, starting retirement in a high-P/E environment is sort of a caution flag....

Several key points that I'd like to second:

High starting P/Es are only a caution flag; not a red flag...

Low P/Es are not a natural consequence of high P/Es...high and low P/Es are the consequence of economic conditions (primarily inflation) and to some extent the human component...however, high P/Es rationally present only two scenarios: steady P/Es and lower P/Es--it doesn't provide for the significant increases that drive secular bull markets.

Also:

There's still an 80% success rate for 4% SWR with high starting P/Es...yet that's a lot less than the near 95% that most people expect!

 

[Nords]

As far as history goes, all of the past secular bear markets ended with P/Es below 10...in really bad economic conditions. We've not had an extended period of stable, high P/Es to "demonstrate" the impact of 6.5% returns (which would actually provide success as long as there was not a big drop in the early years). The bigger risk is not an extreme period (i.e. either stability or 10 P/Es), rather it would be enough decline to reduce real returns to 3% or 4%. If history is a guide--unless today's historically high profit margin are surprisingly sustained--a modest decline in P/E over the next decade or so could readily cause returns to be muted and success rates to decline.

I think it's important to look at the human component that drove P/E values below 10. These were not ordinary times, and low P/E's are not a natural consequence of high P/E's, IMHO.

High starting P/Es are only a caution flag; not a red flag...

Low P/Es are not a natural consequence of high P/Es...high and low P/Es are the consequence of economic conditions (primarily inflation) and to some extent the human component...however, high P/Es rationally present only two scenarios: steady P/Es and lower P/Es--it doesn't provide for the significant increases that drive secular bull markets.

There's still an 80% success rate for 4% SWR with high starting P/Es...yet that's a lot less than the near 95% that most people expect!

IMO it took us nine pages to get to:

"This time it's really different. We think."

and

"Be careful out there."

But OTOH I got to read words like "Phillips" and "Bayesian" without the usual "b3aver cheese" or Godwin's Law excursions.

I suspect that even the most blissfully ignorant investors are beginning to hear the word that 10% returns are a thing of the past.

It's been nearly 10 years since Bernstein started writing his "Calculator from Hell" series. I wonder if he'd change any of it today.

 

[Gone4Good]

I ask because it wasn't lower expected returns that caused the failures I'm aware of. Everybody could retire happily with, say, 5% real returns instead of the 7% real average. The failures I've seen were catastrophic: depression and hyperinflation.

Lower returns alone are not necessarily enough to sink the ship. Total equity returns from 1966 to 1981 were about 1.7% nominal. 1966 was one of the toughest periods to start retirement. But if you torture the data by keeping the low equity returns but swap out the inflation and interest rate environment with that of another period, 1966 becomes very survivable. It was the combination of low returns AND inflation that kills you.

It's worth repeating that we just survived a similar increase in oil prices to the one that wrecked the economy and helped cause the stagflation of the 70's. It's all well and good to look at historic cycles but the economy we live with today is a lot different (and better) than the one of 100, or even 30, years ago (what's good for GM is no longer relevant for the U.S - and that's true for any single company and most entire industries).

By my guess, we're at about the half-way mark for this particular economic expansion. If you judge by historic standards you'd conclude it should be winding up about now, but you can't judge apples by looking at oranges. And that's true for profit margins too. American workers have never had to directly compete with workers from India and China before - now they do. And labor's share of GDP reflects that pressure. That isn't a transient factor likely to reverse just because corporate profit margins are near highs reached in other cycles when the economy worked differently.

I guess my long winded point is that you can't simply look at historic cycles and say everything is mean reverting. Some changes are structural and have lasting impacts. P/Es are important. But as long as they are within reason, it will be the real economy that drives equity returns and valuation multiples - not the other way around.

 

[MasterBlaster]

That was one very interesting chart !

The results were after taxes, inflation and fees.

Did the chart indicate what the level of fees were and the tax rate ?? Did these results come from a model with an after-tax account and some level of trading generating capital gains and other taxes along the way. ?

I didn't notice it as the chart was very busy.

 

[wabmester]

Did the chart indicate what the level of fees were and the tax rate ?? Did these results come from a model with an after-tax account and some level of trading generating capital gains and other taxes along the way. ?

Yes, the expense and tax drag assumptions are pretty high, but I picked that chart figuring it would reflect some of the selling costs and capital consumption of a retiree.

Here are the assumptions:

pdf link

And he has other charts without some of these drags as well:

link

Lots of intersting stuff on his site. It'd be nice to get some tax modeling incorporated into FIREcalc since there is an effect on returns.

 

[d]

with so many comments made, perhaps i've missed it ... p/e cannot be evaluated without context ... the 10yr treasury is today earning 4.68% ... a "p/e" > 21!!

 

[haha]

with so many comments made, perhaps i've missed it ... p/e cannot be evaluated without context ... the 10yr treasury is today earning 4.68% ... a "p/e" > 21!!

Warren Buffet cautions against sliding your discount rate too far down no matter what prevailing interest rates are.

People often underestimate the influence of the discount rate chosen on the present value of a series of cash flows.

I think the "Fed Model" or similar is very helpful if you are in the business of selling securities to others, because it sounds plausible. As a buyer for one's own account I (and Warren) find it less useful.

Ha

 

[ashtondav]

Why not just buy decent shares with decent dividends and a good record of raising them? A starting 4% should be pretty easy. Then just live off the dividends, which more or less rise with inflation. Buy a truckload of index linked bonds for minor withdrawals to supplement the dividends if they don't rise.

Never need to sell any equity. No need to care about secular cycles.

 

[wabmester]

Why not just buy decent shares with decent dividends and a good record of raising them?

Dividends are paid out of earnings. Earnings growth is cyclic. Right now, we're pretty high in the earnings cycle. Relative to historical cycles, we're at a high peak.

So, which high-yield stocks/sectors have a record of paying out increasing dividends in bear markets? I'd bet the financial sector isn't one of them, for example, but I really don't know.

 

[d]

Earnings growth is cyclic. Right now, we're pretty high in the earnings cycle. Relative to historical cycles, we're at a high peak

... 'tis true, and worrisome ... though a peak can only be seen in hindsight

 

[FIRE'd@51]

So, which high-yield stocks/sectors have a record of paying out increasing dividends in bear markets? I'd bet the financial sector isn't one of them, for example, but I really don't know.

Actually most of the big money-center banks and S&L's grew their dividends faster than inflation during the 2000-2003 bear market.

 

[wabmester]

Actually most of the big money-center banks and S&L's grew their dividends faster than inflation during the 2000-2003 bear market.

Good point. In an economic bear, short-term rates are likely to go down, which is good for banks.

 

[crestmont]

... 'tis true, and worrisome ... though a peak can only be seen in hindsight

I'm not sure how to get the chart to reproduce, but it's missing important information that needs to be put into perspective. If you start the chart (EPS/GDP) in the late 1940s (as the prior quote/post does), then it relfects what could be 'normal' high levels that are similar to today. Yet if you go back another twenty years, you'll see that the severe trough of the 1930s was probably being rebalanced by the above-average period of the late 1940s--the average ratio for the 1920-1950 period (with its extremes) is virtually the same as the post-1950 period. A number of historical economic relationships are much more consistent than most non-economists appreciate. The current level of EPS/GDP is 50% over the historical average...either this time is different and we've entered a new era, or earnings growth can be expected to be well-below GDP growth for quite a while to restore a century-long relationship. Just food for thought based upon observations of history and recognized economic principles, this is not a prediction.

 

[wabmester]

Just food for thought based upon observations of history and recognized economic principles, this is not a prediction.

Ed, I just found this article written by you with a bit more detail on the earnings cycle.

link

Edit: oops, looks like this is just a reprint of an article on your site: pdf link