Basic Estimates and Refinements

I talk about refinements separately from estimates. This example may help you understand the distinction.

Background

I posted this on Conversation #54699 about “Probabilities; risk and time, etc.” It is part of post #68. It is on the Morningstar Vanguard Diehards board.

DIFFERENT METHODOLOGIES PRODUCE SIMILAR RESULTS:

John Mauldin recently drew attention to Ed Easterling's calculations at Crestmont Research. Ed Easterling uses single year P/E and earnings estimates in his calculations.

Crestmont Research
Crestmont Stock Market Section
Beyond The Horizon

In Figure 6, the Outcome Matrix: the range of annualized returns is -5.2% to 6.9% (nominal).

Ed Easterling's favorable returns assume low inflation. If 2%, the 6.9% nominal annualized return would be close to 4.9% real.

Ed Easterling's least favorable returns assume higher inflation (or deflation). If 4% inflation, the -4.9% nominal annualized return would be close to -8.9% real.

Ed Easterling's real annualized returns range from -8.9% to 4.9% (approximately).

HOWEVER: "The annualized returns do not include dividends (currently less than 2%) or transaction costs." This places Ed Easterling's estimate of the real, annualized, total return in the neighborhood of -7% to 7%.

HERE ARE MY CALCULATIONS:

Stock-Return Predictor: 1.1% (real) plus and minus 6% (outer confidence limits) from -4.9% to 7.1% (real). The inner confidence limits (20% and 80% probabilities) are -1.9% and 4.1% (real).

NOTE: I have a BEAR MARKET STOCK-RETURN PREDICTOR built into the Simplified Retirement Trainer A as well as a copy of the standard Stock-Return Predictor. If you are willing to accept the notion that we are in a SECULAR (LONG LASTING) BEAR MARKET, these predictions should be more accurate.

The BEAR MARKET STOCK-RETURN PREDICTOR estimates a real return of -1.4% (real) at Year 10 plus and minus 5%. The outer confidence limits range from -6.4% to 3.6% (real). The inner confidence limits (20% and 80% probabilities) are -3.9% and 1.1% (real).

The Stock-Return Predictors estimate real, annualized, total returns directly.

Summary: At Year 10, the real, annualized, total return of stocks (starting today) will be:

Ed Easterling: -7% to 7%.
Stock-Return Predictor: -5% to 7% (most likely 1%).
BEAR MARKET Stock-Return Predictor: -6% to 4% (most likely -1%).

Distinctions

The basic estimate is what the Stock-Return Predictor tells us. It gives my most reliable estimate with minimal assumptions.

Close to it is the BEAR MARKET STOCK-RETURN PREDICTOR. I originally reported the details in “Bulls, Bears and P/E10 Predictions.”

Bulls, Bears and P/E10 Predictions

I took advantage of Ed Easterling’s research to define the beginning and end of secular (long lasting) Bull Markets and secular Bear Markets.

Upon further review, I eliminated the special Bull Market predictor. It failed to produce reasonable results.

You can read further details about this in the “SWR Calculators” section in reference to my Retirement Trainers.

SWR Calculators Starting September 5, 2006

The BEAR MARKET STOCK-RETURN PREDICTOR is more accurate provided that we really are in a long lasting (secular) Bear Market. The regular Stock-Return Predictor makes no assumptions as to whether we have reached the turning point, from a secular Bull Market to a secular Bear Market.

To get a better prediction, we needed to include an additional assumption. If we are not in a secular Bear Market, the BEAR MARKET STOCK-RETURN PREDICTOR will be in error.

When we look at Ed Easterling’s procedures, we notice that he did not address confidence levels directly. Instead, he generated an Outcome Matrix (Figure 6), which converts a series of assumptions (related to earnings, inflation and the single-year price-to-earnings ratio) into (nominal) annualized, price-only returns.

Ed Easterling did discuss which outcomes are most reasonable. He did mention the need to adjust for dividend yields, which are very low by historical standards.

To a certain extent, a reader could provide his own confidence estimates. The evidence supporting Ed Easterling’s key assertions is overwhelming.

For our purposes, the primary value of his research is to track how well our Year 10 predictions are developing. We can compare actual developments and Easterling’s Outcome Matrix to make adjustments as we go along. We know what to look for. We can refine our estimates as we approach Year 10.

Summary

The Stock-Return Predictor makes the basic estimate of what will happen at Year 10. If we include the additional assumption that we are already in a secular Bear Market, then the BEAR MARKET STOCK-RETURN PREDICTOR will give more accurate predictions. Both Stock-Return Predictors provide a full set of confidence limits.

We can compare the actual behavior of the stock market and the economy with Ed Easterling’s Outcome Matrix to refine estimates later on. The Outcome Matrix does not include confidence limits directly, but it does bound the range of likely outcomes. It is helpful. It allows us to make short-term adjustments along the way.

Have fun.

John Walter Russell
November 22, 2006