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Author: yodaorange Big red star, 1000 posts Feste Award Nominee! Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 459128  
Subject: Looking for a few extra percent of gain Date: 9/8/2011 10:59 AM
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Last week I posted that the most important asset class for non-METARites was human capital. The central theme was that non-METARites reached retirement age with about 13 months of salary saved up which is too small to make a substantial financial impact in retirement.

METARites, for purposes of discussion, were assumed to have a larger financial base to invest with which MIGHT be adequate to make a financial difference in retirement. You can not put hard numbers on how large the financial base needs to be, but suffice to say it must be many times annual salary and/or annual spending. If you are close to retirement (notice I did NOT mention age since financial retirement does NOT have to be perfectly correlated to age), your multiple should be somewhere north of 15X annual spending. If you are a long way from retirement time wise, say decades, then hopefully you are on a path to get to the >15X number by retirement time. If your financial assets are either in this range or you have a plan to get them into that range, this post is for you. If your path is to reach retirement with 13 months of salary saved up, I strongly recommend you spend your time and energy on your human capital asset class, instead of what is discussed below.

The overall goal I propose is to add a few percent of extra investment return per year over a long period of time. If you are looking for a sure fire way to double your money every year, sorry I don’t have that solution. If you are looking to always achieve 20% per year returns over many decades, I don’t have that solution either. A reasonable goal would be to add 2 to 6% additional return per year, compared to your investing benchmarks. If you can add 10% per year, you can teach Warren Buffet a few tricks. I think it is important to have realistic expectations for your investment goals. I regularly hear inexperienced investors state which I consider to be unrealistically high investing goals. These are the type of goals that would have you owning the entire universe if they were extrapolated out several decades. Hopefully in some years you will have outsized gains, maybe >10% greater than the benchmarks. Don’t buy the Ferrari after one of those years, as it will surely be followed by some years where you underperform the benchmarks.

For purposes of this post, I am only going to discuss US large cap equity returns, aka the Dow Jones Industrials/S&P500. I am purposely NOT going to address all of the other asset classes available. The reason I choose to do this is that the prevailing thought, at least until the dotcom and credit crashes was “Stocks for the Long Run” WAS the answer. Start investing when you are young, put 100% of your assets into the SP500 and retire rich some day was the plan. The basis for this belief was that stocks had outperformed bonds, cash and inflation over the long term and would continue to do so in the future. The data most typically cited is about 10% nominal per year return and comes from “Ibbotson Stocks, Bonds, Bills, and Inflation Classic Yearbook.” (Nominal means this is the return without considering the effects of inflation, which lowers the return.)

Ibbotson data starts in 1926 and shows three components of the return:

4.7% earnings growth
4.4% dividend yield
0.9% price/earnings ratio expansion

Total = 10.0% annual nominal return of the SP500 from 1926 through 2009

As we are all aware, blindly investing in the SP500 seemed like a good idea until 2000. It stopped working in the 2000 through 2009 decade, where the SP 500 nominally returned 1.8% per year with dividends reinvested and no taxes paid. A far cry from the 10.0% that investors planned for.

This raises a few questions:

1) What changed to cause the “lost decade” of 2000 through 2009?
2) How likely is the change to persist into the future?
3) When can we plan on returning to 10% annual returns?
4) Is there an alternate plan we should have based on the answers to these question?


The short answer is central to what I personally believe in and practice. The belief is that one can and should use “market timing” to change your equity allocation in periods of time with low expected returns. Market timing in this context is NOT the same as when most people discuss market timing. Market timing in this context is changing your asset allocation over years to decades. Market timing to the masses typically means changing equity positions from seconds to weeks to months. The type of market timing I am advocating is also called “tactical asset allocation.” Understand up front that many people believe this method has not and will NOT be successful. At the top of this list is Burton Malkiel’s book “A Random Walk Down Wall Street.” It is my belief and practice that this method has worked and will continue to work, but each investor must decide on their own. Simply stated the idea is to slowly change your equity allocation as the expected return changes. High equity allocation when high returns are expected and low allocation when low returns are expected. And by expected returns, I do not mean when your Ouija board tells you or the latest “expert” of the day on CNBC the outlook looks rosy. Expected returns in this context has a quantifiable mathematical basis.

Luckily for me, someone else has already done a great job building the case on this method of market timing. I refer to Ed Easterling of Crestmont Research (www.crestmontresearch.com) While I practiced this method of market timing before I saw Ed’s work, he did a much better job quantifying how and why this works. He calls it “financial physics.”

Ed’s latest research put’s inflation at the center of the investing universe. He shows that inflation drives PE’s. Everyone understands that high inflation causes low PE’s. What was not well understood prior to Ed’s work with that deflation ALSO causes low PE’s. Ed is NOT in the “point” forecasting business. He does not come out and say he expects inflation to be X% over the next year. What he does is show a range of expectations based on prior history. So he covers both of the hotly debated scenarios we hear about these days: are we headed for deflation or high inflation? In both cases, Ed shows why PE ratios will fall, which is NOT good for equity prices.



Referring back to the three components of equity growth, Ed suggests that PE ratio expansion will case a LOSS of ~ 1.0% per year going forward. So our 10.0% annual return, just dropped to 9.0%

It is not news to anyone, but the current dividend yield on the SP500 is about 2.0%. So the second component of growth, the dividend yield has fallen from 4.4% down to 2.0%. The annual return further dropped to 6.6%.

Ed asks what the GDP growth averaged over the 2000 to 2009 decade:

a) 4%
b) 3%
c) 2%

Most people answer 4% which is reasonably close to the 4.7% long term earnings growth of equities. Unfortunately the correct answer is 1.8%. So despite the spend like a drunken sailor mentality of consumers and government, the US economy only grew at 1.8%.

Referring to our third and final component of equity growth, instead of 4.7% earnings growth, it is reasonable to expect 1.8% going forward. This further reduces our expected annual return from 6.6% down to 3.8% and this is BEFORE inflation.

BOTTOM LINE 1 is that METARites should NOT be planning for nominal US equity returns of 10.0% per year and should be planning on something closer to 3.8% per year.

Please note that I have dramatically simplified the data, models and justification for why the 3.8% is a more reasonable assumption than the 10.0%. If you would like more details I recommend:

a) Visit Ed’s website www.crestmontreearch.com for free data

b) The American Association of Individual Investors just published a new article by Ed that summarizes these points. It is FREE for members. If you are a member, you will be receiving a paper copy of it in the September 2011 issue. You can also view it or download it at:

http://www.aaii.com/journal/article/historical-performance-a...

c) If you have time, I strongly recommend you read Ed’s newest book: “Probable Outcomes: Secular Stock Market Insights.” If you don’t have time, I strongly recommend you make the time to read the book. I consider it that important to your financial success going forward.

http://www.amazon.com/Probable-Outcomes-Ed-Easterling/dp/187...

It covers these issues in great detail, plus many others that I consider mission critical. For anyone that wants to gain additional investing insight, it is the SINGLE book that I recommend you read. Please note that this displaces my old recommendation which was Ed’s first book “Unexpected Returns.” The new book covers all of the same topics plus adds new areas of research.

Also note that Ed’s work sets the stage for similar expectations as Jeremy Grantham, Andrew Smithers and John Hussman. All of these use different approaches, but come to similar conclusions that the 5 to 10 year market outlook for US equities is NOT very strong. Jeremy Grantham’s latest 7 year forecast for the SP 500 is 3.1% per year. This consists of 0.6% real after inflation return plus 2.5% inflation. So Ed’s 3.8% is fairly close to Jeremy’s 3.1%.

BOTTOM LINE 2 is with the expectation of low SP 500 returns, METARites should plan on using a different approach to achieve the 2 to 6% extra alpha I have suggested as a goal. I plan to discuss some of the alternatives in future posts, but the main point is that the status quo investing approach has a low probability of achieving high financial returns. As Ed states, the investing wind is no longer at your back. We are having to invest going INTO the wind which requires different techniques and asset allocation. Part of that approach should be having a lower percentage allocation to the SP 500 IMO at the current time.

Thanks,

Yodaorange
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Author: RaptorD2 Big gold star, 5000 posts Top Favorite Fools Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 372704 of 459128
Subject: Re: Looking for a few extra percent of gain Date: 9/8/2011 1:42 PM
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Thanks, yoda. I agree with (and practice) many of these techniques, but on an informal basis. I should quantify it some day, I know.

Part of that approach should be having a lower percentage allocation to the SP 500 IMO at the current time.

But that's the relatively easy part. My question (part rhetorical, part real) is this:

and put that money where, exactly?

Dan

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Author: OffshoreDriller Big funky green star, 20000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 372709 of 459128
Subject: Re: Looking for a few extra percent of gain Date: 9/8/2011 2:20 PM
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<I.Part of that approach should be having a lower percentage allocation to the SP 500 IMO at the current time.

But that's the relatively easy part. My question (part rhetorical, part real) is this:

and put that money where, exactly?


yes, exactly.

Lower allocation to stocks necessarily means higher allocations to SOMETHING ELSE. so what is the something else? cash, forex, CD, bonds, commodities, real estate, gun collections?

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Author: OffshoreDriller Big funky green star, 20000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 372710 of 459128
Subject: Re: Looking for a few extra percent of gain Date: 9/8/2011 2:22 PM
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BOTTOM LINE 2 is with the expectation of low SP 500 returns, METARites should plan on using a different approach to achieve the 2 to 6% extra alpha I have suggested as a goal.


with lower inflation and lower expected returns on basically the whole range of assets, why would we expect the attainable alpha to remain within its historic range?

also, there may be more people chasing alpha (market pricing inefficiencies, at the end of the day) then that alone would also seem to close the gap on what alpha is attainable.

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Author: yodaorange Big red star, 1000 posts Feste Award Nominee! Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 372744 of 459128
Subject: Re: Looking for a few extra percent of gain Date: 9/8/2011 6:57 PM
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RaptorD2 said: "But that's the relatively easy part. My question (part rhetorical, part real) is this: and put that money where, exactly?

Stay tuned . . . my next week's post will be about one hopefully higher alpha asset class. I thought it deserved it's own post and wanted to emphasize "market timing" today.


Thanks,

Yodaorange

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Author: VUCommodore Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 372787 of 459128
Subject: Re: Looking for a few extra percent of gain Date: 9/9/2011 8:31 AM
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Yodaorange --

I'm much looking forward to the rest of this series of posts. Keep up the good work! You are writing clearly, and on a topic that you have clearly thought out more thoroughly and skillfully than most. That is the mark of a great contributor on this or any other board.

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Author: somethingwicked One star, 50 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 372788 of 459128
Subject: Re: Looking for a few extra percent of gain Date: 9/9/2011 8:53 AM
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Thanks Yoda. Book is on order. I look forward to reading it, albeit it sounds like it sits squarely in the wheelhouse of where my biases already lie. Maybe I'll read it with a couple fingers of single malt to help temper that confirmation bias thing... ;-)

As is usual with your posts, you raise salient points of great import. The only thing I might question is the suggestion that those approaching retirement have something north of 15X annual spending. Most studies suggest 25X (4% "safe" withdrawal rate) is really the necessary target for most people. And even that rate is based upon two key assumptions: 1)the Great Depression of the 1930's represents the absolute nadir of economic performance we'll ever see; and 2) human lifespans do not increase markedly beyond what they are today.

If you believe, as I do, that both of those assumptions are likely to be proven false, an even more conservative target - say 50X annual spending - may very well be needed. Of course, that just emphasizes the main points that you raise... how we invest and what we invest in become crucial decisions in whether we're ever able to retire.

As to where to invest, I'd suggest that we are likely to experience economic convulsions that are extraordinarily disruptive. There will be multiple flights to safety - and more than one head fake. Preservation of wealth will be key. I'd recommend precious metals and cash in the near term. Precious metals and real estate in the mid term. And real estate and equities in the long term.

Resource stocks, especially energy related issues, are probably the singular area with little downside. They make take some tactical hits in the near term - as they have recently - but I think they have vast investment upside potential.

Precious metals will blow up down the road.

And it will be an interesting time for all...

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