stock market return projections

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JWR1945
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stock market return projections

Post by JWR1945 »

stock market return projection

I have separated this post from the Mean Reversion Equivalence thread. Many relevant observations and comments started there. But they digressed from the original purpose of that thread, which was to praise raddr's Monte Carlo model. This discussion is both simple and complex.

A. Overview
This excursion started when I objected to using the Gordon Model to project stock market returns. The required assumptions do not apply in today's market. The key issue is this: the stock market payout ratio has decreased in recent years. This has accelerated earnings growth. I prefer to go back to the Dividend Discount Model and make adjustments to it directly.

First, I confirmed BenSolar's findings. Then I projected the growth rate of the overall stock market.

B. Details
My original observation was based on an eyeball evaluation of graphs of the real earnings amount and the real dividend amounts from Professor Shiller's data. There seems to be a divergence around mid-1948. I looked at historical point values (single year amounts) for the ratio of real dividends to real earnings or payout ratio, the ratio of the real dividend amount to the price (S&P 500 index value) or dividend yield and the inverse of P/E10. I looked at numbers for January of the years 1881, 1901, 1921, 1941, 1961, 1981 and 2001. I chose to start with 1881 since it had the first entry for PE10.

The payout ratios were stable. They were 54.5%, 62.6%, 66.8%, 63.9%, 60.6%, 42.1% and 33.4%. Roughly speaking, today's payout ratio is one half of the older values.

Dividend yields were 4.28%, 4.27%, 7.11%, 6.38%, 3.26%, 4.66% and 1.21%. The values of the inverse of PE10 were 5.41%, 4.78%, 19.52%, 7.19%, 5.41%, 10.80% and 2.70%. If numbers such as 19.52% and 10.80% concern you, remember that they correspond to 1921 and 1981. Both were great years for making investments.

Comparing dividend yields to the values of the inverse of PE10, the ratios fluctuate greatly. They are 79%, 89%, 36%, 89%, 69%, 43% and 45%. The pre-1960 dividend yields were roughly 80% of the inverse of PE10. The number 36% corresponded to 1921 and it represented a rare buying opportunity.

C. Projections

I have made two projections.

a) The first is to double today's dividend yields to match historical payout ratios. I then adjust prices downward to two thirds of Professor Shiller's January 2001 numbers since the S&P 500 has fallen about that far. The S&P 500 dividend yield on January 2001 was 1.21%. Scaling (multiplying by 2 and again by 3/2), the equivalent historical dividend yield is 1.21%*2*1.5 = 3.63%.

For the growth term, I use the 1.1% historical long term growth rate of dividends, not earnings. The faster rate of earnings growth is already accounted for in the decrease in the payout ratio. This faster rate is the effect of retaining a higher percentage of earnings. We have already included a scale factor to adjust for the change of the payout ratio. Dividend growth is the proper choice.

This results in a projection of the overall stock market return of 3.63% + 1.1% = 4.74% (after adjusting for inflation).

b) The alternative approximation is to take 80% of the inverse of PE10 to estimate the dividend yield. In January 2001 this was 2.70%. I then scale by the same 3/2 factor to reflect the decrease in the (index value or) price of the S&P 500 in today's market. This produces an equivalent historical dividend yield of 3.24%. I add the 1.1% historical long term growth rate of dividends. My projection becomes 3.24% +1.1% = 4.35%.

I prefer the second projection. At first blush, its numbers are based on components that seem to fluctuate too much to be of value. But it is only the price component of PE10 that fluctuates rapidly. The earnings component is a ten year average. In addition, the fluctuations are in the right direction. They tell you that stocks do better if you buy when prices are low.

D. Comments

My projections are 4.35% and 4.74% real growth overall. This is will support a withdrawal rate of 4% provided that you can overcome the problem of volatility. These numbers are 1.76% and 2.15% below the historical 6.5%.

These projections are likely to convey accurate information since they are based on crude approximations. It is obvious when these approximations fail. This is much better than having precise calculations that hide a subtle error.

Have fun.

John R.
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Post by BenSolar »

Hello John, pretty interesting stuff, this. A couple of notes:
JWR1945 wrote:The payout ratios were stable. They were 54.5%, 62.6%, 66.8%, 63.9%, 60.6%, 42.1% and 33.4%. Roughly speaking, today's payout ratio is one half of the older values.
But, you acknowledge that the payout ratio (dividend/earnings) fluctuates from about 50% to over 100% (even pre-1948) when you look at different years, as I noted? And that current (06/02) yield is about 60%, back in the historic range?
The pre-1960 dividend yields were roughly 80% of the inverse of PE10.
The average of the five pre-1960 datapoints I looked at was 70%, and the average of the 4 you looked at was 73%. For a cumulative average of 71.3%.
The alternative approximation is to take 80% of the inverse of PE10 to estimate the dividend yield. In January 2001 this was 2.70%. I then scale by the same 3/2 factor to reflect the decrease in the (index value or) price of the S&P 500 in today's market. This produces an equivalent historical dividend yield of 3.24%. I add the 1.1% historical long term growth rate of dividends. My projection becomes 3.24% +1.1% = 4.35%.
I would use the 71.3% average figure I mentioned above. Or, I should spend a few minutes and figure out the real average. Up to maybe 1996 if we wanted to exclude the current bubble's extremity.

Also, the E-10 has gone up a bit since 2001, so if we use the latest figure for PE-10 to derive current E-10 we have:
Price (01/03): 895.8
PE-10 (01/03): 22.79
E-10: 39.27
Price: (02/12): 830.2
PE-10: (02/12): 21.14
Inverse PE-10: 4.73%
71.3% of inverse PE-10: 3.37% projected sustainable dividend yield.

Hmm. Fractionally higher than your figure, despite using a lower percentage for adjustment, because I am using higher E-10. A tenth of a percent is lost in the noise here, I suppose.
My projections are 4.35% and 4.74% real growth overall. This is will support a withdrawal rate of 4% provided that you can overcome the problem of volatility.
What is nice is that the same strategy that dampens volatility, diversification across asset classes, will likely increase projected returns. The RMS REIT index, for instance is yielding about 6.7% right now. If growth keeps up with inflation, then you have a real return of 6.7%. Even if, as raddr found true in the relatively recent past, growth lags inflation by 1%, you still have a real return of 5.7%. Add the benefits of low correlation to S&P 500, you have increased projected return and lower volatility. Small cap stocks and international stocks (especially value of each) should provide the same benefits.

This type of analysis is extremely persuasive to me. Thank you for the dialog, John.

Ben
"Do not spoil what you have by desiring what you have not; remember that what you now have was once among the things only hoped for." - Epicurus
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Post by therealchips »

My projections are 4.35% and 4.74% real growth overall. This is will support a withdrawal rate of 4% provided that you can overcome the problem of volatility. These numbers are 1.76% and 2.15% below the historical 6.5%.
Thanks for the analysis. Your numbers come out more generous than my assumptions, which feels good.

My personal financial plan lacks data on market volatility. I use 4% as my usual estimate of real growth. This comes from postulating 8% return in the market, half of which is taken by inflation. This assumed 4% real growth may or may not be enough lower than your projections to make up for my ignoring volatility. I am aiming at a withdrawal rate of 3% to be that much safer. I have averaged 3.24% for the last eight years, with a range of 3.06% to 3.84%. It should be easy to get down to 3% when my social security starts in 2 years at age 65. It may be tough to stay that low, that is, at 3% withdrawals, when my mandatory IRA distributions and associated income taxes increases start five years after that. The withdrawal rate could get up to 4% in my late eighties, according to these assumptions I work with.

I estimate that my income taxes in real terms will jump about 50% when I have to take money from the IRA. The taxes will grow strongly thereafter, it seems, until they are considerably more than double what I expect to pay in my sixties. This is the reason I advocate budgeting for living expenses and income taxes separately in retirement. Otherwise, my after-tax standard of living would fall sharply, and more each year, just because I have to make IRA distributions. Intercst advocated using up tax-deferred assets first in retirement to avoid this problem. People need to run the numbers for themselves. For me, the value of tax deferral is so great that it is not beneficial to take any IRA money before I have to.
He who has lived obscurely and quietly has lived well. [Latin: Bene qui latuit, bene vixit.]

Chips
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ElSupremo
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Post by ElSupremo »

Greetings John :)
My projections are 4.35% and 4.74% real growth overall. This is will support a withdrawal rate of 4% provided that you can overcome the problem of volatility. These numbers are 1.76% and 2.15% below the historical 6.5%.
Do you think a five year cash(liquid) reserve is enough to smooth out the volatility concern? That is part of my post retirement plan but is of course subject to change.
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Post by JWR1945 »

ElSupremo asks:
Do you think a five year cash(liquid) reserve is enough to smooth out the volatility concern? That is part of my post retirement plan but is of course subject to change.
Fortunately BenSolar has already provided a big part of the answer. He has suggested an excellent approach that is too easy to overlook because it is so familiar. You are doing it already.
What is nice is that the same strategy that dampens volatility, diversification across asset classes, will likely increase projected returns. The RMS REIT index, for instance is yielding about 6.7% right now. If growth keeps up with inflation, then you have a real return of 6.7%. Even if, as raddr found true in the relatively recent past, growth lags inflation by 1%, you still have a real return of 5.7%. Add the benefits of low correlation to S&P 500, you have increased projected return and lower volatility. Small cap stocks and international stocks (especially value of each) should provide the same benefits.
You can also pay attention to dividend yields and their historical growth rates on stocks. There are several blue chip companies that have a long record of increasing dividends. There are others that increase dividends less frequently...but they start out at higher rates. As long as they increase dividends once every three or four years, you can tolerate a little bit of inflation between increases.

You can sell stocks around their 52 week median values (expect an opportunity every now and then even in bad year). That increases your average price per share sold by 5% to 10% compared to selling at a fixed interval. (I.e., compared to dollar cost averaging in reverse...the standard assumption in safe withdrawal rate calculators.)

Having ignored your question so far, ElSupremo, here is my guess: yes. If not 5 years, then 6 or 7 years at the maximum.

In addition: after ten years or so, the stock market is likely to be back at normal valuations. If your retirement is that far off, your prospects are excellent.

Have fun.

John R.
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Post by ElSupremo »

Greetings John :)
In addition: after ten years or so, the stock market is likely to be back at normal valuations. If your retirement is that far off, your prospects are excellent.
At least 12. :D
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Post by wanderer »

You can sell stocks around their 52 week median values (expect an opportunity every now and then even in bad year). That increases your average price per share sold by 5% to 10% compared to selling at a fixed interval. (I.e., compared to dollar cost averaging in reverse...the standard assumption in safe withdrawal rate calculators.)

this was another problem with the re*p prescription - DCA in reverse. and one their recommendation locked you into with sepps. i think the irs bailed them out last year. i don't count on a repeat performance.
regards,

wanderer

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Post by JWR1945 »

I started this thread because I was concerned about how many writers just add percentages...yields, growth rates and so forth...without thinking about what they are doing. It is very easy to become lulled into doing this because of the success of the Dividend Discount Model and its extension, the Gordon Equation.

The Dividend Discount Model equates the intrinsic value of an investment to the sum of all future dividend payments...after applying a discount factor because the payments are delayed. The Gordon Equation makes plausible extensions for companies that pay little or no dividends and then adds a term for P/E (price to earnings ratio) multiple expansion.

There is an excellent mathematical description at the Gummy Stuff site:
http://home.golden.net/~pjponzo/gummy_stuff.htm

There are many cases when adding percentages works. Besides those that strictly meet the requirements of the Dividend Discount Model or the Gordon Equation, there are others. Some are based on mathematical identities. For example:
P/E * D/P = D/E
The P/E multiple times the dividend yield equals the payout ratio.

The problem that I have seen most frequently involves reinvestment of dividends without considering the size of those dividends (i.e., the dividend yield). There have been long periods of time during which the S&P 500 index has gone sideways but with very high dividend yields. With reinvested dividends there can be a sizable total return...which is enhanced because the effects of dollar cost averaging (to a rough approximation).

We cannot simply take the total effect of reinvested dividends, convert it to a percentage and treat it in isolation. Our total return consists of our initial outlay and its price growth plus...emphasis mathematical addition, not multiplication...the return from our reinvested dividends. Adding percentages is (essentially) the same as multiplying.

In terms of my formulas and calculations, I prefer to use BenSolar's numbers to my own. I think that he used greater care in making his calculations.

To the casual reader I must point out that these approximations are very rough. Do not place too much confidence them. OTOH by nature of their simplicity, they are likely to be accurate...which is highly desirable.

Have fun.

John R.
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Post by bubble »

We cannot simply take the total effect of reinvested dividends, convert it to a percentage and treat it in isolation. Our total return consists of our initial outlay and its price growth plus...emphasis mathematical addition, not multiplication...the return from our reinvested dividends. Adding percentages is (essentially) the same as multiplying.
Shouldn't it be the price growth or price decline

Here's a piece by a noted bear http://moneycentral.msn.com/content/P41 ... pecial=msn
Contrarian Chronicles
3 investing myths you shouldn't buy into
There are no truths, only risks. Three down years don't guarantee an up year. Buy-and-hold forever is no guarantee of success. And interest-rate cuts guarantee nothing ... absolutely nothing.

Along those lines, I'd like to make the point that there are no ironclad rules of investing. If I had told you three years ago that we would have 12 rate cuts and that they would not inspire the stock market, people would have said I was crazy. Similarly, one of the other big bull arguments is that rates are so low, stocks have to go up. That doesn't happen to be true, either. Obviously, if all things are equal (which they rarely are), and you're buying a stock at 10 times earnings, and interest rates were to be cut in half, there is some chance that you might be willing to pay as much as twice as much for that same stream of earnings. However, there is no law that says this will always be the case. If rates collapsed because the economy was doing poorly, there's some chance those earnings could fall away. This is the situation that exists in Japan, and now here in the United States.

So, falling rates don't guarantee higher prices. Three down years don't guarantee an up year this year. The Fed cutting rates doesn't guarantee that things will get better. There are no absolutes in investing. All one can do is to try to assess the probabilities of what the potential outcomes might be and to incorporate those probabilities, as best the circumstances permit, into managing risk (defined as the chance that you will lose meaningful amounts of money) and reward. We're all going to be wrong in our investments from time to time. The trick is to not get carried out when you make your mistakes.

It seems to me that alot of time is spent on this site trying to determine with a great degree of accuracy what the SWR will be. I don't think it can be done due to the lack of history available and the fact that the future may not be the same as the past.

I think the thread on the Terhost's life shows that we have to be willing and able to make adjustments in investments and even life choices as we go along in life. I have been out of the wage slave world for close to 11 years and don't consider myself retired. What I do and and how I am invested has changed in that time and will no doubt continue to evolve.

Enough rambling and back to enjoying the winter wonderland here in SW Ohio.

Bubble
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Post by wanderer »

I think the thread on the Terhost's life shows that we have to be willing and able to make adjustments in investments and even life choices as we go along in life. I have been out of the wage slave world for close to 11 years and don't consider myself retired. What I do and and how I am invested has changed in that time and will no doubt continue to evolve.

true. still, he must have found his Big 6 life totally suffocating to get out just on CDs. it wouldn't surprise me. also, it appeals to the conservative accountant: make sure you have the cash and temporary flow then figure out how to asset allocate. it's part of why we are him deep in junk. we'll redeploy as opportunities present themselves. it's also a downside of living in a place where you can take a fall quickly.

bounce - your age, former profession, current pursuits, if I may be so bold.

i think a number of the exercises on swrs are important. one thing i would do if i were an aspiring FIREr is to lay out sources of retirement income and expenses using various levels of expense and returns and lay out cash flow changes (college, SSI, pension, relocation to lower cost area, sales of major assets, etc.) i, too, do not attach too much importance to the retrospective (solely historical-based) testing - much energy expended, little light.

yes, your spreadsheet needs to have 60 columns or so if you are 40 or so. ;)
regards,

wanderer

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Post by bubble »

wanderer
bounce - your age, former profession, current pursuits, if I may be so bold.
If You mean Bubble -- I'm 56 and was the guy across the table from you in your audits. The finance guy or industrial accountant trying to figure out what you where concerned about and why you where so confused and misguided. :D As an investor I consider myself to be a value investor and am looking for the dollar bill on the ground that the efficient market theory says isn't there. In December '99 I moved into REIT's big time even going out on margin, it was a fire sale. FOR the future I'm looking at covered call writing (to capture time decay). I'm also an EA and do a few tax returns for neighbors and friends. For exercise and fun I ride my recumbent bike and ref neighborhood soccer games. I also try to attend as many of my kids soccer and hockey games at college as I can.

Bubble :D
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