January 3 2008 Letters to the Editor

Updated: January 10, 2008.

When P/E10 Equals 8

I received this letter from Rob Bennett.

Thanks for your article entitled "When P/E10 Equals 8." That's interesting stuff.

I wanted to comment on your observation that: "I sought to find out what would happen if I cut the stock allocation to 20% whenever P/E10=20 and higher. I found that my threshold was too high to make much of a difference. "

I have done a good number of runs in which I went with a 100 percent stock allocation up to a P/E10 of 20 and achieved shockingly good results. The difference is that in the runs I was doing I was not making any withdrawals (I was checking to see how this allocation rule works in the accumulation stage of the investing life cycle rather than in the distribution stage).

It's of course no surprise that making withdrawals changes things. But I find it compelling to see how great a difference it makes (of course, a big factor here is the size of the withdrawal you were testing in your runs). The moral is one we've heard before but one that bears highlighting: Drawing down from a portfolio with a high stock allocation is inherently a dangerous business.

There are things that can be done to reduce the danger; your site explores many good strategies. I think it's important, though, to frequently return to the basics and make the most important points as clear possible for those who have not heard them or digested them properly before. Drawing down from a portfolio with a high stock allocation is inherently a dangerous business. Most retirees of today have no idea what sort of risks they are taking on when that make that shift from the accumulation stage to the distribution stage.

Responsible investing experts need to make this point one time, two times, three times, four times. The change itself is what one would intuitively expect. But the extent of the change is counter-intuitive. I am strongly convinced that most of today's retirees have little idea what they are getting into when they make the shift.

It is not hard to put together a safe retirement plan using the information publicly available today. But it is very, very, very, very hard to do so using only the information available from the big-name "experts." The conventional advice leads people into traps for the unwary. The conventional retirement advice of today is highly dangerous and irresponsible stuff, in my assessment. It regularly stuns and amazes and horrifies me what passes as "wisdom" in the investing field. Holy moly!

HERE IS MY RESPONSE

Very well said.

Thank you.

NOTE: I have added an article for accumulators.

When P/E10 Equals 8
When P/E10=8: Accumulators

An idea

I received this letter from Wayne.

Hi,

I've read your website on and off for several years now. I also have read Rob's stuff.

I am in a situation where I have accumulated enough money to retire early, I'm 53. I have fears about the same thing as you discuss, how much can I safely withdraw and where should I be invested.

I read with great interest your recent work on the Dividend Strategy. I think it is a good plan but I have a few issues with it. For instance, it is possible that current dividend stocks are overpriced right now due to the recent cut in the tax rate for dividends. If the favorable tax rate were to go away there could be some significant selling in those stocks. Another concern is "are dividends really safe and stable"? Since many of the dividends paid by the SP500 come from Financials, and the Financial companies obviously are involved in a huge mess, the dividends could be cut severely.

I have felt that valuations matter and have been mostly out of stocks for quite awhile. I cannot take the risk of losing 20% or much more, it would ruin my plans. I realized that valuation matter many years ago, long before the "great old school/new school" debate. I do not know why there needs to be disagreement on that issue. Valuations have to matter, common sense.

One idea I have is that rather than staying in TIPS and knowing that my account balance "will decline" while I wait for a PE/10 to decrease to 14 or so (which might not happen in my lifetime) it might be better to look at getting yield from Preferred Stocks, REITs, MLP's or maybe even High Yield Bonds. Have you done any research in that area?

The idea that I would like to present here however is different. I see that the possibility of being "locked out" of stocks completely for a long time, due to high valuations, is large issue. As I read your info I see that some of your recent work is attempting to find a way to be in stocks (to some degree) even at these valuations. My idea to be partially invested in stocks is this, what about screening "individual stocks" for candidates that meet a PE/10 of less than 10 (or whatever one chooses) and building a partial position in those stocks, maybe only a 30% position but at least a position? I do not have a screener that does that but I am sure it can be done. This might be a low risk way to avoid being locked out for years. I'd appreciate your thoughts.

HERE IS MY RESPONSE

You are hitting all of the major points. Consistent bulls eyes. Outstanding.

Be sure to read Taken At Face Value. It uses high yield investments as part of a Dividend Blend. There is only a small allocation to the traditional stock portfolio (high dividend growth rate, lower initial yield). It is well inside of your comfort zone.

Taken At Face Value
Taken At Face Value: Upside

Because you do not sell any shares, a price drop does not adversely affect the income flow. I include TIPS in order to be able to make calculations. You are likely to do better if you use your surplus funds in the early years to buy income producing investments.

Income Stream Insights gives a good overview.

Income Stream Insights

As for your solution: it works. Even without the fast growing component, it is a great idea.

When using it, consider reinvesting part of the income stream to overcome the effect of inflation. From what I have read (by a poster named ElLobo), the sweet spot is to reinvest about 30% of the yield and live on 70%. Your withdrawal rate would be 5.0% if your investments deliver 7.1%, which is obtainable.

Be sure to diversify. Diversification helps most with little followed and not so well known investments.

As for dividend stocks in general: although their prices vary, they are usually less volatile than other stocks. Dividend amounts are usually secure. Although dividends sometimes rise erratically, they usually grow faster than inflation. In the case of the S&P500 the largest drop in real dividend amount was 25% (in terms of buying power). This gives an idea of what happens with a well diversified, all-stock portfolio.

Tracking the quality of dividends is easier than estimating price appreciation. Look at the latest decade of earnings and the latest three years (to use Benjamin Graham’s technique). Look for average earnings to be growing (latest three years versus the previous decade). Look for the decade long earnings to cover the dividend amount with a reasonable cushion. Check other factors as you would any other stock purchase. Be sure to look at the credit rating of a company’s bonds. Most of the time, this lets you know whether a company is financially sound.

I prefer individual stocks. Others prefer funds. If you are concerned about company specific problems, such as with today’s financial institutions, consider a broad based dividend focused Exchange Traded Fund (ETF). There are several. DVY is the oldest. But be careful. Some ETFs favor capital appreciation as opposed to providing steadily rising income.

You do not have to choose a Delayed Purchase approach. Today’s Alternatives gives you a look at the big picture. Interestingly, if you do include a Delayed Purchase, the initial stock allocation does not matter too much. Dividend payments may well compensate for a future price drop.

Today’s Alternatives

Valuations Before The Great SWR Debate

Rob Bennett sent in these additional remarks.

I'd like to send my regards to Wayne, who recently posted a Letter to the Editor and who said that he has been reading your stuff and my stuff for some time. Best of luck to you, Wayne!

I'd also like to comment on a point that he made that was not his core point (which you addressed). Wayne said:

"I realized that valuations matter many years ago, long before the "great old school/new school" debate. I do not know why there needs to be disagreement on that issue. Valuations have to matter, common sense. "

Wayne is of course correct that there is nothing "new" about the idea that valuations matter. This idea has been around since the first stock market opened for business. The idea that valuations do not matter defies common sense. Wayne is correct that there should be no controversy over this.

The reality is that there are two very different things that influence stock prices -- economic realities and human emotions. The extent to which one or the other is responsible for the price that applies at a given time varies from time to time. In both 1982 and 2000, the influence of the emotional effect overwhelmed the influence of the economic effect; the price levels that applied at those times were absurd. The emotional effect never entirely goes away. Even at a time when prices are at fair value levels, the influence is there in a hidden away in that the emotions that investors have experienced in recent years are likely to cause the next big move to be in one direction rather than the other (when we next get to a P/E10 of 15, the odds of us going down to a P/E10 of 8 will be greater than they would be if we had reached a P/E10 of 15 on the way up from a P/E10 of 8). But at times of fair value, the economic realities are dominant. It can be said that the average long-term value proposition of stocks to a large extent applies at such times.

The Great Safe Withdrawal Rate Debate is the product of three recent developments. One, we have more access today to statistical data on the long-term performance of stocks than we have had in the final years of any earlier out-of-control bull market. Two, middle-class participation in the stock market is greater today than it was in earlier out-of-control markets (because we now provide for our own retirements, and such). Three, the internet discussion-board communications medium permits sustained questioning of arguments and methodologies to an extent that earlier communications mediums do not.

There is more worry about about this out-of-control market than there was over any of the earlier ones because there are more middle-class workers invested in it; the middle-class worries more about big losses of accumulated wealth than the rich because such losses hurt the middle-class more. Also, we now have the data needed to show the effect of valuations in far greater detail than was possible at the tail end of the earlier huge bull markets. And we have a communications medium that permits sustained questioning of the rationalizations and evasions we use to avoid thinking about how much harm our bull market illusions do us. Combine those three factors and you produce an explosion the like of which has never been seen before in discussions of personal finance (I sincerely do not think that this is an exaggeration of the reality that we have seen play out before our eyes).

There has never been any legitimate controversy. The Old School SWR studies are OBVIOUSLY wrong. We OBVIOUSLY should be providing people planning their retirements with accurate reports of what the historical data says. The third "obvious" is the killer. The school of thought that produced the Old School SWR studies OBVIOUSLY has a lot else wrong with it if it could generate such obvious nonsense in the retirement area. People don't want to face that. There are a lot of "experts" who have been giving very, very, very bad investing advice for a long time now. Given that they have been shown to be wrong, they need to begin giving better advice. The first step to getting on a better path is saying the words "I" and "Was" and "Wrong." That's a big hurdle for a good number of humans.

Think about this the way you would think about an alcoholic. You don't need an I.Q. of 140 to know that a guy whose drinking has cost him his wife, his job, his health and his self-respect needs to make some changes, do you? It doesn't follow, though, that the guy is going to find it easy to follow the steps he needs to follow. The reality that valuations affect long-term returns is as obvious as can be. Getting people to accept the implications of that reality is as hard as hard can be. There is a great, great, great, great, great resistance to the idea of accepting that reality and the obvious implications that follow from it.

The good news is that people recover from alcoholism. It happens all the time. And people recover from huge, out-of-control bull markets too. We've seen that happen three times in the history of the U.S. stock market. It will happen this time too. The only other option is for the entire thing to go down. If prices never return to reasonable levels, stocks can never again provide a strong long-term return. Ifstocks never again are able to provide a strong long-term return, people will give up on stocks and invest in more appealing asset classes. But if they do that, prices will go down! Do you see?

Prices cannot remain indefinitely at absurd levels. It is a logical impossibility. Prices can no more remain indefinitely at today's levels than a guy can indefinitely hold a job while getting drunk every night. It catches up to you. It takes longer in some cases than in others. But it always catches up to you.

What's important about The Great SWR Debate is that we got to see this all play out in real time. We have Post Archives recording all of the evasions and rationalizations and deceptions and word games and all this sort of thing. Having a record of it all helps us to figure out what needs to be done to see that it never happens again, just as it helps doctors trying to protect our health to see what sorts of things have caused illnesses in the past. The discussion-board medium has provides us a means to learn things about how investors think and feel at bull market tops that was not available to us during earlier bull market tops.

We are learning the same lesson as before, but in a different way. History repeats, but it doesn't repeat exactly. There are changes, some good, some bad. This bull market was more out of control than any of the earlier ones. That's bad. We today possess communications tools that permitted us to study what was going on in this one in greater depth. That's good.

Letters to the Editor in 2008

Letters to the Editor in 2007

Letters to the Editor in 2006

Letters to the Editor in 2005