February 12, 2008 Letters to the Editor

Updated: February 29, 2008.

First Preserve Capital

I received this letter from Aaron.

Jonathan, you wrote, "If the stock market follows its normal course, P/E10 will fall to 8 at some time within the next 10 to 15 years. Those who have preserved their capital will face a glorious future."

I'm in this boat ~ concerned about preserving capital until stocks shed much of their price. I do not feel good about the stock market at these prices, yet I will need a sustained bull market at some point to realize a comfortable retirement. I'm 38, married, don't make a lot of money, and have managed to accumulate $167,000 in retirement funds to work with. I'd like to see this number grow into the millions over time, but it seems there's no reliable way to invest anymore.

I have some questions for you:

1. How did you arrive at 10-15 years?
2. 10-15 years is a long time. What do you recommend in the meantime?
3. Do you have any concern about the integrity of the US dollar? If so, how do you protect purchasing power?
4. Where can I find the current P/E10 figure?

I love your work, and you're a prince for sharing it with the world. That goes for Rob, too. You guys are great.

HERE IS MY RESPONSE

I believe that I am 40 and Worried addresses your primary concerns. You should be in a good position within 20 years. You will be in an excellent position as soon as Medicare kicks in. It terms of today’s dollars, your $167,000, will return a continuing income stream around $31,300 per year in 20 years, which is not too shabby.

I am 40 and Worried

In terms of my time table, I use two observations from Yale Professor Robert Shiller’s S&P500 database and one from a demographics study mentioned in “Bulls Eye Investing.” Professor Shiller’s spreadsheet includes a graph of P/E10 versus calendar year (Figure 1.3). It peaked in 1901, 1929, 1966 and 2000. The period between peaks was 28, 37 and 34 years. Anticipating a valley between the peaks, we would expect to see a low before 2020. Alternatively, the previous low was in 1982, eighteen years before the 2000 peak. Assuming symmetry, the low should occur in 2018. The low is more likely to occur a little bit earlier, judging from history. In the demographics study mentioned in “Bulls Eye Investing,” pages 22-24, there should be a dramatic reduction in price to earnings “in the next 20 years” (starting from 2002), which would be 2022.

Professor Shiller’s Web Site

I bonds and TIPS provide the needed protection from high inflation. High yielding (dividend paying) stocks can do so as well. I now prefer a minimum exposure of 20% to stocks as a result of using the Scenario Surfer. I used to recommend zero stocks at today’s valuations (P/E10=24). Be sure to purchase high quality companies with good credit ratings with dividends of 3% or more. You might purchase some of the new Exchange Traded Funds ETFs as an alternative. There are several good ones. But read the fine print. Increase your stock allocation gradually as valuations become more favorable.

Practice varying allocations with P/E10 on the Scenario Surfer. It doesn’t take long to develop a good amount of skill and caution as well.

I keep the P/E10 conversion in the Stock Returns Predictor up to date. You have to enter a P/E10 value (using the slider or typing it in) and then press “CALCULATE” to see the corresponding level of the S&P500 index.

A New Layer of Building Blocks

I received this letter from Rob Bennett.

I liked your article "Delayed Purchase Withdrawals" a lot. A chapter of a book could be written working through the implications of these words of yours: "With a delayed purchase concept, we must prepare for the worst case: failure to reach the threshold. We can do this by limiting early withdrawals, possibly to 4% (plus inflation). We can do this by easing into stocks (as with Valuation Informed Indexing). We need to be careful not to set the threshold too low. "

You may recall that in the early days of our investing discussions we often spoke of the concept of "building blocks." All learning is achieved through a building-block approach. First, a foundation is laid. Then floors of knowledge are added on top of the foundation.

The Efficient Market Theory is the foundation of the conventional investing advice of today. Even people who care not for theory and who have never bothered to learn what the theory says employ ideas that are the product of the Efficient Market Theory in their recommendations. These ideas are like air in investing circles. They are so ever-present that few even notice their presence at this point. But they influence just about everything that is said.

The foundation stone is gravely flawed. Thus, everything that follows from it is gravely flawed. We need a new foundation stone.

Your words above reflect a realistic assessment, in my view. Those words show the tensions that are present in real-world investing. One of the big flaws of the EMT is that it encourages mindless, dogmatic, simplistic "solutions" to problems. Those following the EMT can come forward with "optimal" stock allocations that apply for all and safe withdrawal rates that apply at all possible valuation levels. Of course no such things exist in the real world.

There's a sense in which real-world investing is more complicated. It is indeed less simplistic. I think it uses up less mental energy, though. Huge amounts of mental energy are directed to rationalization under the EMT model. Under a more realistic model (it might be called a Realistic Buy-and-Hold model or an Investing for Humans model or a Behavioral Finance model), less surface certainty is provided. But the measure of security that is provided is real and lasting. That makes a big difference when buy-and-hold comes to be tested.

There are all sorts of tensions that need to be explored but that never yet have been explored because the conventional approach causes "experts" to brush aside the questions as meaningless under the EMT. At several times during our discussions, I have seen evidence that one layer of building blocks was being completed and the mental energies of all those participating constructively in the discussions was shifting to a new layer of building blocks. I have that feeling reading the words quoted above.

The question that I am asked most frequently in e-mails is "Well, what specifically should I do, at what P/E10 levels should I make shifts?" We have both of course given guidance on this question. But we have also both refrained from giving specific statements as to the "right" thing to do. That's because there is no one right thing to do. The question itself is a product of EMT thinking. People need to stop thinking that they are going to find definitive answers to these sorts of questions. Analysis can be used to point out pros and cons of various approaches for those in various circumstances. But one-size-fits-all recommendations are always misleading and dangerous.

I see tensions everywhere I look today. If I were to write down my descriptions of all of them, I wouldn't have time to do anything else. My hope (and my belief) is that over time we will have more and more people contributing to the discussions needed to explore the many tensions in depth. By getting off the wrong path and onto a right one, we have changed the nature of the discussion. We are today discovering questions that couldn't have occurred to us in earlier times because we were too confused in our thinking as a result of our earlier willingness to give more credit to the EMT model than it merited.

Thanks for putting another significant building block in place.

HERE IS MY RESPONSE

Thank you for your kind words. Thank you for an insightful analysis.

My observation agrees with yours: Efficient Market jargon interferes with clear thinking. Trying to force fit ideas into an EMT template just doesn’t work. You need to toss that template away. You need go back to basics.

Delayed Purchase Withdrawals

My Mom's retirement portfolio

I received this letter from Lisa.

I've followed your posts on Morningstar, in particular a back and forth between you and Bill Perkins. My sister and I need to invest our mother's financial assets. She's 85, and in good health. We've been researching this for months, not coming to a conclusion.

My questions: Do you provide portfolio assistance as a business? I would love to be able to consult with you. Neither my sister nor I have been impressed with a financial advisor my mother has consulted, and she will take our suggestions.

Any help would be appreciated.

Thank you.

HERE IS MY RESPONSE

Thank you.

No. I do not provide financial advice as a business. I am a retired Electronics Engineer. I conduct my financial research as a volunteer. My services are free.

I do not claim to have any special expertise in securities selection. I focus on the overall strategy, the structural framework, of retirement portfolios.

That having been said, I will point out a few things that are relevant to an older investor:

1) Consider purchasing Treasuries as alternatives to some of her Certificates of Deposit. Treasuries are even safer than CDs and they have no limits on how much is guaranteed. [NOTE: here is a fine grained technical point. FDIC is an agency of the US Government. The Treasury Department is the US Government itself.] Sometimes, but not always, Treasuries offer a higher interest rate.

Treasury Direct Web Site

2) Today’s stocks are dangerous. Overall stock prices are likely to drift downwards. Today’s valuations are almost as high as those in 1929 and 1965-1966 but well below those of 2000.

3) Dividend amounts are likely to rise a little faster than inflation, although increases can be erratic.

4) Judging from S&P500 historical performance, the absolute worst case downside risk in dividend amounts would be a momentary cut of 25% (in terms of buying power) if you have a diversified portfolio. In terms of market sectors, I do not expect to see anything worse than we have seen already in financials with subprime loans. Some companies had big write downs. Others are purchasing those holdings at bargain prices. The overall financial sector has taken a big hit, but a diversified portfolio should do OK.

5) Because of today’s low payout ratios, I do not expect to see widespread dividend cuts.

6) You will do well to read what Morningstar contributors Sirschnitz, Justin and Copie are doing. I am most comfortable with Sirschnitz’s approach. [I like ElLobo’s approach, but it takes a lot of time, effort and care. It would not be appropriate.]

Letters to the Editor in 2008

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