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JWR1945
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Joined: 26 Nov 2002
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Location: Crestview, Florida

PostPosted: Sun Jul 04, 2004 8:33 am    Post subject: Bernstein 2 Reply with quote

These are my comments from Chapter 2 of our currently featured book The Four Pillars of Investing by William Bernstein. I am not reviewing the full contents of this chapter. Instead, I have extracted a limited number of quotes that should stimulate thought.

One of my assertions about William Bernstein is that it is difficult to determine where his actual numbers come from, as supported by something better than rules of thumb and plausibility arguments. Here is an example from page 52, when he discusses the Dividend Discount Model.
Quote:

Fortunately, mathematicians can help us out of this pickle with a simple formula that calculates the sum of all of the desired values in column four. Here it is:

Market Value = Present Dividend / (DR - Dividend Growth Rate)

Using our assumption of a $140 present dividend, an 8% DR, and 5% earnings growth, we get:..[Emphasis added]

The earnings growth rate replaced the dividend growth rate, but without an explanation.

This paragraph from page 54 has been quoted frequently on these boards.
Quote:

The Gordon Equation is as close to being a physical law, like gravity or planetary motion, as we will ever encounter in finance. There are those who say that dividends are quaint and outmoded; in the modern era, return comes form capital gains. Anyone who really believes that might as well be wearing a sandwich board on which is written in large red letters, "I haven't the foggiest notion what I'm talking about."


From page 56:
Quote:

On an intellectual level, most investors have no trouble understanding the notion that high past returns result in high prices, which, in turn, result in lower future returns. But at the same time, most investors find this almost impossible to accept on an emotional level. By some strange quirk of human nature, financial assets seem to become more attractive after their price has risen greatly..But stocks are different. If prices fall drastically enough, they become the lepers of the financial world. Conversely, if prices rise rapidly, everyone wants in on the fun.


From page 61:
Quote:

In that case, the speculative return will be a negative 3.4% per year, for a total annualized market return of 2.8%. Sound far-fetched? Not at all. If inflation stays at the 2% to 3% level of the past decade, this implies a near zero real return over 20 years. This is not an uncommon occurrence. It's happened three times in the twentieth century: from 1900 to 1920, from 1929 to 1949, and from 1964 to 1984.


From pages 56, 59, 68, 71 and 72:
Quote:

And what does the Gordon Equation tell us today about future stock returns? The news, I'm afraid, is not good. Dividend growth still seems to be about 5% and the yield as we've already mentioned, is only 1.55%. These two numbers add up to just 6.55% [nominal]...

There are three possible scenarios in which equity returns could be higher than the predicted 6.4% [nominal]:..

For starters, the DDM [Dividend Discount Model] tells us to expect cash to yield a zero real return, bonds to have approximately 3% real return, and stocks in general to have about a 3.5% real return..

In Table 2-2, I've summarized reasonable expected real returns, derived from the DDM..

Large U.S. Stocks 3.5%
Treasury Bills and Notes 0-2%

These last few numbers are similar, but not the same.

Have fun,

John R.


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peteyperson
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Joined: 26 Nov 2002
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PostPosted: Sun Jul 04, 2004 10:11 am    Post subject: Re: Bernstein 2 Reply with quote

I think the theory here is that with US equities, overall growth cannot exceed national GDP. Therefore one can take the dividend yield and use the growth rate to extrapolate the future return based on growth numbers. Growth has varied over time but has slowed over the last 3 decades in the US if I recall correctly. I think Bogle's Common Stocks has the GDP growth data in the first few pages. Alternatively, Gillette Edmunds's REITs eBook has the data from 1970 to 2000 on page 16.

Just as a linkage, growth investing works by trying to locate business that can be purchased are reasonable prices and that will grow faster than GDP but are mature enough that they won't go bust by overexpanding or being unreliable early stage business models.

Hope it helps.

Petey

JWR1945 wrote:
These are my comments from Chapter 2 of our currently featured book The Four Pillars of Investing by William Bernstein. I am not reviewing the full contents of this chapter. Instead, I have extracted a limited number of quotes that should stimulate thought.

One of my assertions about William Bernstein is that it is difficult to determine where his actual numbers come from, as supported by something better than rules of thumb and plausibility arguments. Here is an example from page 52, when he discusses the Dividend Discount Model.
Quote:
Fortunately, mathematicians can help us out of this pickle with a simple formula that calculates the sum of all of the desired values in column four. Here it is:

Market Value = Present Dividend / (DR - Dividend Growth Rate)

Using our assumption of a $140 present dividend, an 8% DR, and 5% earnings growth, we get:..[Emphasis added]

The earnings growth rate replaced the dividend growth rate, but without an explanation.

This paragraph from page 54 has been quoted frequently on these boards.
Quote:
The Gordon Equation is as close to being a physical law, like gravity or planetary motion, as we will ever encounter in finance. There are those who say that dividends are quaint and outmoded; in the modern era, return comes form capital gains. Anyone who really believes that might as well be wearing a sandwich board on which is written in large red letters, "I haven't the foggiest notion what I'm talking about."


From page 56:
Quote:
On an intellectual level, most investors have no trouble understanding the notion that high past returns result in high prices, which, in turn, result in lower future returns. But at the same time, most investors find this almost impossible to accept on an emotional level. By some strange quirk of human nature, financial assets seem to become more attractive after their price has risen greatly..But stocks are different. If prices fall drastically enough, they become the lepers of the financial world. Conversely, if prices rise rapidly, everyone wants in on the fun.


From page 61:
Quote:
In that case, the speculative return will be a negative 3.4% per year, for a total annualized market return of 2.8%. Sound far-fetched? Not at all. If inflation stays at the 2% to 3% level of the past decade, this implies a near zero real return over 20 years. This is not an uncommon occurrence. It's happened three times in the twentieth century: from 1900 to 1920, from 1929 to 1949, and from 1964 to 1984.


From pages 56, 59, 68, 71 and 72:
Quote:
And what does the Gordon Equation tell us today about future stock returns? The news, I'm afraid, is not good. Dividend growth still seems to be about 5% and the yield as we've already mentioned, is only 1.55%. These two numbers add up to just 6.55% [nominal]...

There are three possible scenarios in which equity returns could be higher than the predicted 6.4% [nominal]:..

For starters, the DDM [Dividend Discount Model] tells us to expect cash to yield a zero real return, bonds to have approximately 3% real return, and stocks in general to have about a 3.5% real return..

In Table 2-2, I've summarized reasonable expected real returns, derived from the DDM..

Large U.S. Stocks 3.5%
Treasury Bills and Notes 0-2%

These last few numbers are similar, but not the same.

Have fun,

John R.


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JWR1945
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Joined: 26 Nov 2002
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Location: Crestview, Florida

PostPosted: Sun Jul 04, 2004 1:19 pm    Post subject: Reply with quote

Quote:
Growth has varied over time but has slowed over the last 3 decades in the US if I recall correctly.

See pages 9 and 10 of Common Sense on Mutual Funds by John Bogle. Real stock market returns in the US were exceptionally high from 1982-1997. They were 12.8% as opposed to the 7.0% of the very long-term.

[The 1997 cutoff date had to do with data availability, not with changes at the time that Bogle wrote his book.]

Dividend yields have declined steadily.

Growth has been on a tear. A lot of this has to do with the composition of the work force. The Baby Boomers are now in their most productive years. Computer technology is also a big factor. It has improved productivity sharply. [The effect of recent innovations has followed the classical pattern seen in other eras: railroads, automobile, radio and electricity.]

Have fun.

John R.


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peteyperson
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PostPosted: Mon Jul 05, 2004 12:01 am    Post subject: Reply with quote

Actually growth has not been on a tear. Growth rate increased due to increased use of leverage. It is no coincidence that debt levels rose over this period of rapid expansion on a corporate, governmental and personal level. Much like how the fed has borrowed extensively in the last couple of years to try to jump start the economy, this occurred during the late 80s and 90s on a national scale. It is like someone borrowing money on credit cards and saying that their income has gone up.

The only way to get back that kind of growth rate is to increase debt levels still further. At some point however the debt will have to paid off and in the meantime the true reality of the interest servicing costs will reduce growth rates from hereon in. The more leverage gets added, the more future profits get reduced by the cost of the debt load. You can do this when at first rates are low but if rates rise new financing is not as affordable either. So the growth rates are likely to now be below the historical average because debt is at record levels and the corporations, consumers and the government has to pay the piper. This is why Warren Buffett and others have said that expecting higher than 5% GDP growth over the next few years is not realistic.

BTW, it is a common misunderstanding to assume that increased rates of productivity lead to increased growth and profitability. It leads to increased efficiency but that doesn't always translate. Dell being able to more efficiently turn out PCs means they are beating their competition but it doesn't mean that the PC industry is growing faster than expected in gross sales or profitability.

From John Maudlin newsletter:

Quote:
From 1993 until late last year, earnings only grew by an average of 4% per year on the S&P 500 and less than 1% after inflation. In a raging bull market, earnings growth was less than stellar. 80% of the growth of the stock market was from increasing investor valuations and were not attributable to earnings growth. For the stock market to resume a bull cycle and 8-10% annual growth, valuations would have to double over the next decade to levels never see before, far above the recent bubble.

As mention in another thread of your quotes, the data is not enough, you have to be able to analyse where it comes from and what it means. Why was GDP at much higher rates? Why were growth rates in Japan at much higher rates and why are they in such trouble now? You've got to go deeper or the analysis is just going to mislead people who are reading you. The data in itself is meaningless without background.

Petey

JWR1945 wrote:
Quote:
Growth has varied over time but has slowed over the last 3 decades in the US if I recall correctly.

See pages 9 and 10 of Common Sense on Mutual Funds by John Bogle. Real stock market returns in the US were exceptionally high from 1982-1997. They were 12.8% as opposed to the 7.0% of the very long-term.

[The 1997 cutoff date had to do with data availability, not with changes at the time that Bogle wrote his book.]

Dividend yields have declined steadily.

Growth has been on a tear. A lot of this has to do with the composition of the work force. The Baby Boomers are now in their most productive years. Computer technology is also a big factor. It has improved productivity sharply. [The effect of recent innovations has followed the classical pattern seen in other eras: railroads, automobile, radio and electricity.]

Have fun.

John R.




Last edited by peteyperson on Mon Jul 05, 2004 2:22 am; edited 1 time in total
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JWR1945
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PostPosted: Mon Jul 05, 2004 2:21 am    Post subject: Reply with quote

peteyperson, your macroeconomic picture is flawed. It was not Government spending and debt creation that caused the big jump (both in the GDP and in the stock market) that dates back to the Reagan presidency. It was tax cuts and letting businesses make money.

They myth about the influence of Government debt was exposed during the Clinton presidency. We quickly outgrew the debt. The key was restraining spending.

As for now, we are currently engaged in a world war, which has increased Federal spending, but only by a very small percentage (by historical standards), and we have just ended a mild recession, which always cuts tax revenues.

These days, economist track all dollars throughout the economy. There is no magic via fiat. Earlier descriptions were wrong. Even money in savings accounts are available for business activity via lending.

Have fun.

John R.


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peteyperson
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PostPosted: Mon Jul 05, 2004 3:01 am    Post subject: Reply with quote

Tax cuts help but if they come at the expense of greater Government debt, then it doesn't help a great deal. It is merely a short-term quick fix leaving a long-term problem to fix.

Petey

JWR1945 wrote:
peteyperson, your macroeconomic picture is flawed. It was not Government spending and debt creation that caused the big jump (both in the GDP and in the stock market) that dates back to the Reagan presidency. It was tax cuts and letting businesses make money.

They myth about the influence of Government debt was exposed during the Clinton presidency. We quickly outgrew the debt. The key was restraining spending.

As for now, we are currently engaged in a world war, which has increased Federal spending, but only by a very small percentage (by historical standards), and we have just ended a mild recession, which always cuts tax revenues.

These days, economist track all dollars throughout the economy. There is no magic via fiat. Earlier descriptions were wrong. Even money in savings accounts are available for business activity via lending.

Have fun.

John R.


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hocus2004
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PostPosted: Mon Jul 05, 2004 5:31 am    Post subject: Reply with quote

Here are some words from Pages 71 through 73 of "The Four Pillars of Investing:"

William Bernstein: "In the first chapter we talked about the history of past stock returns--what economists call 'realized returns.' In the past decade, a small industry has arisen that thrives on the promotion and sale of this optimistic data. The message of this happy band of brothers is that past is prologue: because we have had high returns in the past, we should expect them in the future.

"The ability to estimate future stock and bond returns is perhaps the most critical of investment skills. In this chapter, we've reviewed a theoretical model that allows us to compute the 'expected returns' of the major asset classes on an objective, mathematical basis. The message from this approach is not nearly as agreeable. Which should we believe: the optimism of the historical returns, or the grim arithmetic of the Gordon Equation?

"It should be obvious by now where my sympatheies lie. Warren buffett famously said that if stock returns came from history books, then the wealthiest people would be librarians. There are numerous examples of how historical returns can be highly misleading.

"My favorite comes from the return of long Treasury bonds before and after 1981. For the 50 years from 1932 to 1981, Treasury bonds returned just 2.95% per year, almost a full percent less than the inflation rate of 3.80%. Certainly, the historical record of this asset was not encouraging. And yet, the Gordon Equation told us that the bond yield of 15% was more predictive of its future return that the historical data. Over the next 15 years, the return of the long Treasury was in fact 13.42%--slightly lower than the predicted return because the coupons had to be reinvested at an ever-failing rate.

"The fundamental investment choice faced by any individual is the overall stock/bond mix. It seems more likely that future stock returns will be closer to the 3.5% real return suggested by the Fisher DDM method than the 7% historical real gain...."

"Unfortunately, although the DDM informs us well about expected returns, it tells us nothing about future risk. We are dependent on the pattern of past returns to inform us of the potential risks of an asset. And in this regard, I believe that the historical data serves us well."


I think Bernstein has it right. The volatility of stock returns has played a critical role in the determination of which withdrawal rates survived in the past, and any SWR methodlogy that ignores this factor is analytically invalid for purposes of determining SWRs. Changes in valuation levels have also played a critical role in the determination of which withdrawal rates survived in the past, and any SWR methodology that ignores this factor is analytically invalid for purposes of determmining SWRs.

The SWR is whatever the data says it is. It is impossible to report accurately what the data says without looking at data that bears on both of these critical factors of the question being analyzed.


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hocus2004
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PostPosted: Wed Jul 07, 2004 3:06 am    Post subject: Reply with quote

"There are numerous examples of how historical returns can be highly misleading."

I was reading over this thread this morning and I noticed something that hadn't caught my attention before.

I have made note a good number of times to the statement in William Bernstein's "The Four Pillars of Investing" that the methodology used in the SWR study published at RetireEarlyHomePage.com produces "misleading" results at times of high valuation. The statement above is stronger since in the statement above Bernstein refers to the results obtained by looking only at historical return data and ignoring data on the effects of changes in valuation levels as not just misleading but "highly misleading."

In future references to Bernstein's views on the intercst methodology, I will be using the phrase "highly misleading" to describe his position on the results generated by REHP-type studies.


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hocus2004
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PostPosted: Tue Jul 13, 2004 2:30 am    Post subject: Reply with quote

Here's a link to an article from the Efficient Frontier site that sums up some of the important points made in Chapter Two of "The Four Pillars of Investing."

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

William Bernstein: "I'm going to discuss the single most important issue in finance - future stock market returns - in the clearest, most descriptive, least mathematical terms possible.

"....Nobody knows what the market is going to do tomorrow, next month, or even in the next five years. And in the final analysis, what the market does over such relatively short periods is irrelevant to the average investor. What is important is return over the next few decades, and we do have a pretty good idea of what's going to happen over such long time periods.

"The biggest area of confusion among the investing public concerns just where stock returns come from. The most popular misconception is that future stock returns somehow derive from past stock returns - that is, from the Stock-Returns Fairy. In the past few decades, the packaging of historical financial returns has become an industry bigger than the GDP of some South American nations. The silliness of this approach is obvious: if you pay twice as much for an asset as you should have, that increases the return of the guy who sold it to you, just as surely as it reduces your future return.

"So just where do stock returns come from? In order to answer this question, first ask yourself this: how much would you be willing to pay for a business that distributes $10,000 each and every year?...Thus, in the very long term, stock price increases come from only one source: increases in dividend income.

"....The value of the stock market almost exactly tracks the dividends and earnings it produces; in short, it behaves just like any other business. "


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Mike
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PostPosted: Tue Jul 13, 2004 4:20 am    Post subject: Reply with quote

Quote:
Thus, in the very long term, stock price increases come from only one source: increases in dividend income.

The traditional path of living off of the dividends, without touching principal, seems to be a reasonably good ball park strategy.


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