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Discussion with Ed Easterling of Crestmont Research
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JWR1945
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PostPosted: Wed Aug 06, 2003 6:02 am    Post subject: Reply with quote

That's great. If you have some other stories as to how various charts and studies came into being, I am all ears (and eyes)!

John R.


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hocus
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PostPosted: Wed Aug 06, 2003 6:08 am    Post subject: Reply with quote

The biggest surprise (insight) has been to see the historical cycles

Have you read the book "Stock Cycles?"

If yes, do you have any reaction to that one?


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Crestmont
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PostPosted: Wed Aug 06, 2003 6:11 am    Post subject: Going back Reply with quote

JWR1945 wrote:
You have made an excellent point just before I have posted this...How would you recognize that something has changed, that the data is now telling us a different story?

For example, the market began to tell a different story when the bubble began.

Have fun.

John R.

I would accept that something has changed when we can explain it both fundamentally as well as empirically. For example, we all accept that interest rates are affected by inflation (as inflation increases, so do interest rates). As well, most accept that P/E ratios are driven by interest rates (as interest rates fall, higher P/E's are justified). Lastly, historically the stock market's Earnings Per Share (EPS) has grown over the long term at rates just below the overall nominal growth of the economy. There's also a fundamental basis for that relationship.

When it's all considered in relation to each other--in the context of history and fundamentals--substantial gains over an extended period are unlikely.

I hope it's different or that the fundamentals change, but rationally it's hard to risk ones financial future on hope.

I do believe that there will be postive returns available from the market over the next decade, although probably modest. Techniques like more frequent rebalancing can help to enhance returns in choppy markets. If we're wrong and the market soars, the returns will still be good, though not as good as never rebalancing (in a rising market).

This introduces a second element: RISK. In the current conditions, investors are becomming more aware of return in relation to risk.


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JWR1945
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PostPosted: Wed Aug 06, 2003 6:17 am    Post subject: Reply with quote

Consider talking more about what kind of timing makes sense and what does not.

The word timing has been horribly abused...even to the extent to justify irrational behavior related to stocks. (I.e., they must always go up and nobody can time the market and, since nobody can ever time the market, you should buy stocks regardless of valuations. Price never makes a difference, buy now, etc.)

The word timing is next to impossible to define in a meaningful sense although Hulbert (who evaluates investment newsletter) has been able to define it in a consistent, quantifiable manner, suitable for computers.

Thanks and Have fun.

John R.


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Crestmont
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PostPosted: Wed Aug 06, 2003 6:17 am    Post subject: Stock Cycles Reply with quote

Yes I have read it and did not find it particularly helpful toward understanding the fundamental causes of stock cycles. There are a number of books that speak to long waves, innovation cycles, population, etc. Although they sound reasonable in presentation, they seem to fall short of providing a usuable, fundamentally-based methodology for the next 20-30 years. That's the period I'm concerned about in particular.


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hocus
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PostPosted: Wed Aug 06, 2003 6:23 am    Post subject: Reply with quote

Please respond to any outstanding JWR1945 questions first. Just to put something in the pipeline for after you get caught up, here's my next one.

Do you think it is possible to use historical data to come up with a reasonable assessment of the intrinsic value of a stock investment?


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Crestmont
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PostPosted: Wed Aug 06, 2003 6:28 am    Post subject: Timing Reply with quote

JWR,

We recently posted an analysis titled "Must Be Present To Win (Or Lose)" on our website (www.CrestmontResearch.com). It was created in response to numerous questions that investors are hearing today about patience and not timing the market.

Let's apply that to bonds as well. Is it reasonable to include an assumption that an investor over the next 20-30 years will receive the historical average bond return from these levels? Of course not, since to get to those valuation levels (interest rates), rates have to go back up. And in the mean time, declines in the prices of the bond potfolio could more than offset the coupon. The result would be dismal returns for some time and then better returns in the future. This does not mean that an investor should abandon bonds, but there are better approaches given the current state of the market.

This is generally true for stocks as well.

That being said....just as long term interest rates could continue down to 1% and create strong bond returns, a rise in P/Es could generate strong stock market gains for a while. However, unless we're set to have historically high nominal growth in the economy and earnings for an extended period, the returns are relatively low when one pays a high valuation (P/E) for stocks.


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JWR1945
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PostPosted: Wed Aug 06, 2003 6:30 am    Post subject: Reply with quote

Quote:
As well, most accept that P/E ratios are driven by interest rates (as interest rates fall, higher P/E's are justified).

Is this true? Both prices and earnings should reflect inflation rates (or fail to reflect them) and...these days...they should be closely related to interest rates.

We have a link on the FIRE board to a (lengthy) article by Asness who has refuted this claim. He found interest rates to be explanatory but not predictive. OTOH, he did not identify...as you have...the fundamental change in the relationship between interest rates and inflation in the past.

Have fun.

John R.


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Crestmont
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PostPosted: Wed Aug 06, 2003 6:35 am    Post subject: Intrinsic Value Reply with quote

hocus,

To assess the intrinsic value of a financial instrument, one needs a forecast of future data. I believe that securities are the present value of a series of future cash flows discounted to today based upon the market's assessment of required return.

You can use historical data as an input to develop a forecast for the future. As well, there are many other factors that affect the future cash flows.

Consider 2 questions:

1. What do you expect the P/E ratio of the stock market to be in 20 years?

2. What do expect the EPS for the S&P 500 to be in 20 years?


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JWR1945
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PostPosted: Wed Aug 06, 2003 6:36 am    Post subject: Reply with quote

hocus
Quote:
Do you think it is possible to use historical data to come up with a reasonable assessment of the intrinsic value of a stock investment?


This is an excellent question. While you are at it, please give us your thoughts as to what the words intrinsic value mean or should mean.

Thanks.

John R. (Fascinated and having fun.)


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hocus
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PostPosted: Wed Aug 06, 2003 6:39 am    Post subject: Reply with quote

You can use historical data as an input to develop a forecast for the future.

Is the Gordon Equation helpful in this regard?


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Crestmont
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PostPosted: Wed Aug 06, 2003 6:42 am    Post subject: Reply with quote

JWR1945 wrote:
Quote:
As well, most accept that P/E ratios are driven by interest rates (as interest rates fall, higher P/E's are justified).

Is this true? Both prices and earnings should reflect inflation rates (or fail to reflect them) and...these days...they should be closely related to interest rates.

We have a link on the FIRE board to a (lengthy) article by Asness who has refuted this claim. He found interest rates to be explanatory but not predictive. OTOH, he did not identify...as you have...the fundamental change in the relationship between interest rates and inflation in the past.

Have fun.

John R.

The primary disconnect between a consistently inverse relationship between P/E's and interest rates occurs during deflation.

The pundits never qualify that lower interest rates justify higher P/E's only when inflation is positive.

When inflation falls into deflation, interest rates stay very low. However, deflation leads to decling sales and profits on a nominal basis. The result is a lower current price to reflect the declining cash flow stream. The result is lower P/E's.

We have a chart posted at www.CrestmontResearch.com relfecting what we call the "Y Curve" effect. It reflects this relationship with actual data from the past century.


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Crestmont
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PostPosted: Wed Aug 06, 2003 6:47 am    Post subject: Gordon Equation Reply with quote

I believe that the Gordon Equation is a mathematical formula for cycle waves. If so, the fundamental assumption would be that the past can predict the future. Though it may be a guide, there are so many constantly changing factors in the environment that few companies (if any) have such consistency to make it's use valid.


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Crestmont
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PostPosted: Wed Aug 06, 2003 6:51 am    Post subject: Glancing back Reply with quote

Please let me know if there are prior questions or sub-parts still outstanding...or if there are other issues to touch on?


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JWR1945
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PostPosted: Wed Aug 06, 2003 6:52 am    Post subject: Reply with quote

Quote:
When inflation falls into deflation, interest rates stay very low. However, deflation leads to declining sales and profits on a nominal basis.

Some economists are careful to distinguish between falling prices and deflation. What you have stated is correct.

The distinction is that productivity can increase more than enough to offset any price decrease. Prices fall but profits soar. I usually see this distinction in the context of the days before the Federal Reserve came into existence.

Have fun.

John R.


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hocus
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PostPosted: Wed Aug 06, 2003 6:55 am    Post subject: Reply with quote

Again, please respond to any outstanding JWR1945 questions before addressing mine. But I want to get this one on the table before the deadline for submitting questions strikes.

Set forth below is a quote from Peter Bernstein from an interview he gave earlier this year following a controversial speech he gave in late January about the future of stock investing strategies. I plan to invite Bernstein (no relation to my other planned invitee William Bernstein) to this forum sometime in 2004, and I'd be interested in any reaction you have to the thought he puts forward in the words below. My sense is that Bernstein believes we are on the threshold of a time at which people are going to need to abandon some long-accepted rules of stock investing and begin development of some fresh approaches.

My question to you is--Do you agree that Bernstein is suggesting something big here and do you think he might be on the right track with this suggestion?

Here is the quote:

"What we've had is a graphic demonstration of boom and bust. That's a familiar pattern. So what's expected is that after the bust, you pick up the pieces and go forward. That this is different, I think is hard to recognize. And people are reluctant to recognize it. In particular, the difference pulls them away from traditional ways of managing their affairs. I mean, it doesn't occur to people to say, "Now, I have to do things differently." Yes, they think, "I won't get caught in the next bubble, I'll get out sooner." But that's different from saying, "The basic investment structure that I've been using, which served me pretty well, is no longer appropriate." That's a big step.

"People are never terribly comfortable with change"
And they have to be persuaded, because they think the long run tells them things that would justify continuing doing what they have been doing.

"I am suggesting that we have to begin by focusing on the meaning of the long run - think about it differently in the post-bubble world. That means that our approach to investing's fundamental problem, asset allocation, has to change. The thrust of my argument is that we are going to have to learn to live without the crutch of things like policy portfolios - because the conditions that justified their existence for so long have been shattered."

End of Peter Bernstein quote.


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Crestmont
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PostPosted: Wed Aug 06, 2003 6:57 am    Post subject: Deflation Reply with quote

JWR1945 wrote:
Quote:
When inflation falls into deflation, interest rates stay very low. However, deflation leads to declining sales and profits on a nominal basis.

Some economists are careful to distinguish between falling prices and deflation. What you have stated is correct.

The distinction is that productivity can increase more than enough to offset any price decrease. Prices fall but profits soar. I usually see this distinction in the context of the days before the Federal Reserve came into existence.

Have fun.

John R.

Yes, there is a clear distinction between falling prices due to excess supply and falling prices due to lower money supply (the true definition of deflation).

It's not clear to me that in conditions of monetary deflation that productivity could reasonably offset profit declines. Nonetheless, most would probably agree that such a condition would be temporary and not sustained over a multi-year period to justify higher P/E's due to 'expected' future gains in profits.


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JWR1945
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PostPosted: Wed Aug 06, 2003 6:58 am    Post subject: Reply with quote

Clarification:

The Gordon equation (or dividend discount model) is simply:

Total Return = dividend yield + dividend growth rate

It is a way of restating the (present) value of all income received from dividends. It is common to see some modifications (e.g., to account for expanding or contracting P/E multiples).

Have fun.

John R.


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hocus
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PostPosted: Wed Aug 06, 2003 7:02 am    Post subject: Reply with quote

Please let me know if there are prior questions or sub-parts still outstanding...or if there are other issues to touch on?

Crestmont:

In the event that you missed anything, please don't worry about it even a little bit. You have been an amazing help to us. You are great.

If there are any questions you have been trying to get to, pleae feel free to do so. But the two hours that you promised us is now up. So please also feel free to return immediately to your other business.

I very much appreciate you being willing to serve as the SWR Research Group's first Special Event Guest, Crestmont. It was a trip. I hope you will check in on the board from time to time to see what we are up to. The board will be generally inactive for the next six months. But I have a lot of exciting things planned for 2004. So you might want to check back sometime next winter.

I am grateful to you both for the help you have given to aspiring early retirees with the important research you have done and for taking time out of your day to come to this board and talk it over a bit with us. I enjoyed the discussion, and I learned some things. It always gives me a big lift to have that happen. Thanks for giving me a big lift!


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JWR1945
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PostPosted: Wed Aug 06, 2003 7:04 am    Post subject: Reply with quote

Quote:
Some economists are careful to distinguish between falling prices and deflation. What you have stated is correct.

I repeat: you have stated things correctly. Discerning the difference (which you have done) is important.

Have fun.

John R.


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