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Same valuation but not as safe

 
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JWR1945
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Joined: 26 Nov 2002
Posts: 1697
Location: Crestview, Florida

PostPosted: Sun Aug 10, 2003 10:32 am    Post subject: Same valuation but not as safe Reply with quote

Mike asked whether he had calculated today's Safe Withdrawal Rate correctly and I said yes. He asked a good question.
http://nofeeboards.com/boards/viewtopic.php?t=1243

It has occurred to me that we are close to pre-bubble valuations but that I am estimating a much lower Safe Withdrawal Rate today. The reason is that dividend yields are lower today than in the past.
http://nofeeboards.com/boards/viewtopic.php?t=1214
http://nofeeboards.com/boards/viewtopic.php?t=1220

This is somewhat paradoxical. Yet, it is consistent. I have written this to show how everything fits together.

Key Findings

My first key finding was that there is an anomaly in the 1881-1920 historical record that distorts the relationship between P/E10 and Historical Database Rates. (A Historical Database Rate is the maximum withdrawal rate for a portfolio that would have survived...assuming that its returns were identical to those of a specific historical sequence.) Looking at data from 1921 on, P/E10 and Historical Database Rates track each other closely.

Next, I examined the data to look for failure mechanisms. I was able to identify a major cause of failure during times of high valuations. It was consistent with a previous finding by others. Heavy selling during times of low prices is the main reason behind failures in retirement portfolios. My discovery was that the Historical Database Rate at high valuations has been only slightly greater than dividend yields. That led to a dividend-based strategy during time of high valuations. Later, I was able to extend it to include all levels of valuation.

What is different

What is different today is that dividend payout ratios are much lower than they have been in the past. If one assumes that corporations reinvest retained earnings at least as well as investors reinvest their dividends...which is a major league assumption in itself, then the total return from stocks should not change. Only the tax treatment should change. Or so it seems.

But it is not so. Volatility changes. And volatility is what kills retirement portfolios.

The mathematics

I have presented Safe Withdrawal Rate formulas previously.
http://nofeeboards.com/boards/viewtopic.php?t=1117
http://nofeeboards.com/boards/viewtopic.php?t=1205

Those formulas are based upon annual returns (or annual gain multipliers).

gummy has developed this good approximation:

the annualized return = the average return - (0.5)*(the standard deviation of annual returns)^2.

It is the same for the gain multipliers that I have used in my formulas. Just replace the word return with the words gain multiplier.

Volatility always reduces the Gain_Product_Term. It always reduces your current balance.

It reduces the other term for a significant fraction of the possibilities. (Given no other constraints, a small gain multiplier value is just as likely to occur earlier as opposed to later. The inverses of gain multiplier terms appear in gummy's magic sum formulas. A small gain multiplier value early on means a bigger value of gummy's magic sum, which is then multiplied by the withdrawal amount.)

The net effect is always the same: volatility hurts during the distribution phase of an investment portfolio.

Valuations and correlations

P/E10 is tightly related to Historical Database Rates. However, it is not possible to isolate the individual effects of dividend yields and prices. Yields were much higher previously than they are today. Even in the 1960s, an extended period of high valuations, dividend yields were around 3%. We cannot point to completed historical sequences that contain today's low dividend rates. We can only point to those that have begun recently and that have many years to go.

We cannot discern the degree with which P/E10 is related to annual returns as opposed to annualized returns. We are outside of the volatility range that existed when we related P/E10 and Historical Database Rates. We have to be careful about projections that rely upon P/E10 in isolation.

Our position of strength

Fortunately, we are in a position of strength. We have not depended upon numbers alone. We have extracted cause and effect relationships that endure. We only have to note that our use of P/E10 to scale from low and normal valuation levels to equivalent high valuations is not as strong as we might have wished. This has always been the least accurate term in our projections.

This condition does not exist today. Valuations are still high.

It may well be that dividend yields once again return to their historical levels when prices (P/E10) fall closer to intrinsic values. If so, P/E10 and the Historical Database Rates will once again be inside their applicable ranges and the original scaling formulas will apply directly. If so, there will be no need to make a qualifying remark.

Have fun.

John R.


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galagan
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Joined: 20 Mar 2003
Posts: 5
Location: Billings, MT

PostPosted: Mon Aug 11, 2003 11:58 am    Post subject: Reply with quote

Quote:
What is different today is that dividend payout ratios are much lower than they have been in the past. If one assumes that corporations reinvest retained earnings at least as well as investors reinvest their dividends...which is a major league assumption in itself, then the total return from stocks should not change. Only the tax treatment should change. Or so it seems.

But it is not so. Volatility changes. And volatility is what kills retirement portfolios.

John, could you offset this volatility change by selling an amount of the stock equal to the retained earnings?

For example, consider two companies:
1. Initial price = $100, earnings = $5, dividend = $3.
2. Initial price = $100, earnings = $5, dividend = $1.

In situation 1, if I own 100 shares, I will get $300 a year in dividends. Book value of my shares will rise $200.

In situation 2, I will only get $100 a year in dividends. Book value of my shares will rise $400; an extra $200 will be retained by the company. By your argument, this increases volatility, which makes a given sequence of withdrawals more risky.

My proposal is to sell 2 shares of stock to raise the extra $200. If the cause of the volatility is company retention of earnings, then this should neutralize the problem.

Assumption: after a year of dividends, the price of the company in situation 2 is $2/share more than the company in situation 1. This is because the company retained the $2 instead of paying it out.

If the assumption is right, then you end up with 98 shares of company 2 stock worth $2/share more than the company 1 stock. If prices stay unchanged, then 100 shares x $100/share (company 1) = $10,000; and 98 shares x ($100+$2)/share (company 2) = $9,996, close enough to be negligible.

Thoughts?

dan


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JWR1945
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Joined: 26 Nov 2002
Posts: 1697
Location: Crestview, Florida

PostPosted: Mon Aug 11, 2003 2:47 pm    Post subject: Reply with quote

Superficially, the answer is NO. OTOH, I think that there is a lot of truth in what you are saying. It ties in closely with peteyperson's thoughts about intrinsic value. We are just beginning to get to where we can talk along these lines and make sense.

Earnings do provide the support for dividends and prices alike. When you average earnings over several years, such as with P/E10, they are reasonably predictable and well behaved. Dividends grow erratically (with some notable exceptions) but they seldom decline. Most people can estimate corporate dividends better than prices.

From examining the 1960s, I think that you are right about being able to tolerate price volatility provided that you only sell sparingly. Some portfolios starting in the 1960s saw stock prices fall in half. But a minimal amount of selling was still OK and stocks did recover later on.

Clearly, if you have to sell stocks, you have some vulnerability to price decreases even when the underlying fundamentals are positive.

Again, I do think that you are on to something. I would suggest that you allow yourself a little bit of flexibility when selling. To a certain extent, price fluctuations may counterbalance management's failure to raise dividends enough to match inflation.

The simple, superficial answer is NO when you constrain yourself to the very highest levels of safety and permit yourself to sell at the very worst of times.

Have fun.

John R.


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