October 2, 2007 Letters to the Editor

Updated: October 13, 2007

Data to calculate P/E10

I received this letter from Erwin.

I read with interest your website, and I agree with you that rebalancing is not the ideal tool to optimize return, however I do not think that it was intended for that.

I use it exclusively to control risk and then I only rebalance to my original total stocks %.

I have a few questions that I hope you can help answer.

1. I understand from your information that P/E10 of about 14 is the fair value for S&P500. Where does 14 come from?

What about the other markets, such as REITs, Developed World (i.e., ETF symbol: EFA), Emerging Markets (i.e., ETF symbol: EEM) What P/E10 would be the right one?

2. Where do I get the data to calculate earnings for the past 10 years for all the above markets?

Thank you for your comments.

HERE IS MY RESPONSE

Thank you.

You are right. Rebalancing is meant to control risk, not to optimize returns.

Having said that, I point out that the theory behind rebalancing depends on the assumption that we cannot measure valuations meaningfully. Repeatedly, I find that rebalancing offers a little protection at a great cost.

From Gummy Slices:

"I found that all of the portfolios behave in the same way with respect to rebalancing. Rebalancing is helpful during times of high valuations. Rebalancing is harmful during times of normal valuations. Rebalancing is very bad when valuations are low."

Gummy Slices

From More on Rebalancing: Edited:

"During the distribution phase, only a few conditions show a rebalancing bonus. Those with a bonus show only a small improvement. The sequences with a rebalancing bonus are those associated with high valuations and times of severe portfolio stress: a few years around 1929 and the entire decade of the 1960s."

"Typically, there was a penalty for rebalancing. Typically, it was huge."

More on Rebalancing: Edited

From Automatic Rebalancing Examples:

"If you have ever doubted the folly of automatic rebalancing, look at these retirement portfolio examples."

Automatic Rebalancing Examples

Professor Robert Shiller supplies the S&P500 database that I use in my calculators. Sometimes, the most recent data are in his “Online Data” section. At other times, the most recent data are in his “Irrational Exuberance” section.

Professor Shiller’s Web Site
Professor Shiller's Irrational Exuberance Web Site

Professor Robert Shiller invented P/E10 for the S&P500, building upon Benjamin Graham’s approach with individual stocks. He includes P/E10 in his database.

In terms of the typical value of P/E10, I have forgotten the details such as which years that I used and how the mean and the median values compared. I did use January values. You can download Tables of the January values of P/E5, P/E10, P/D5 and P/D10 (and their reciprocals) from my Yahoo Briefcase. My username is jwr19452000.

Yahoo Briefcase

I believe that I emphasized the median of 100E10/P (=100/[P/E10]), the percentage earnings yield.

In terms of stocks, P/E10 (actually, the reciprocal 100E10/P) has quite a bit of generality. From my Notes through November 29, 2005:

Notes through November 29, 2005

Scroll down to Calculator Results Using Gummy's Database.

"14. We have found that P/E10, which is calculated on the S&P500 index as a whole, also works very well for the Large Capitalization Growth, Small Capitalization Growth, Large Capitalization Value and Small Capitalization Value slices as well. You do not need a separate indicator."

I imagine that P/E10 can be extended to other markets, but I am not aware of any data source. I am not aware of what a reasonable time period would be. That is, whether ten years would still be the best choice for smoothing earnings data.

I believe that it would be possible to construct useful equivalents to P/E10 for all of the major indices. However, I do not have such measures. Nor do I have the data needed to construct them. It would be a major undertaking.

Free Lunches for Everyone

I received this letter from Rob Bennett.

Your article "Free Lunches for Everyone" makes numerous important points, John.

It conveys some of the outrage that I feel toward the irresponsibility engaged in by those who endorse the Efficient Market Theory. This theory is wildly implausible and wildly irresponsible and responsible investing analysts should be saying that regularly so that the thought penetrates the public consciousness.

You mention in your article the "studies" that pretended to determine whether valuation-informed investing works by seeing whether it produces a 5 percent gain each year or not. You have referred to these studies before. Could you provide a bit more detail about them for those of us who did not pay sufficient attention the first time?

The idea of requiring a 5 percent annual gain is obviously absurd. Is it one study that did this or more than one? Are you able to provide a link to the study that did this? I would like to be able to refer to it to demonstrate the absurd lengths to which some will go to prop up the discredited Efficient Market Theory. It is a scandal that such a study exists and is not routinely called out by all investing "experts."

HERE IS MY RESPONSE

Thank you, Rob.

My reference is David Dreman’s Contrarian Investment Strategies: The Next Generation, Part V, “Psychology and Markets.”

From pages 382 and 383: “On closer examination, the efficient market victory vanished. Studies..demonstrated that the standard risk adjustment tools researchers used were too imprecise to detect even major fund outperformance of the averages..”

“Even to be flagged on the screen, the manager had to outperform the market by 5.83% annually for 14 years. When we remember that a top manager might beat the market by 1.5% or 2% a year over this length of time, the returns required by Jensen to pick up managers outperforming the averages were impossibly high..One fund outperformed the market by 2.2% a year for 20 years, but according to Jensen’s calculations, this superb performance was not statistically significant.”
“..”
“In spite of this and other evidence, the conclusions of Jensen’s mutual fund study are still used to support the main premise of efficient markets. “There is very little evidence,” wrote Jensen at the time, “that any individual fund was able to do significantly better that that which we expected form mere random chance.”

Such nonsense led me to write “Refusing to See the Obvious,” which addresses valuations and Safe Withdrawal Rates. I wrote “New Standards for Financial Reporting” to address related issues.

Edited: Refusing to See the Obvious
Refusing to See the Obvious
New Standards for Financial Reporting

Valuations

I received this letter from Richard.

Do you agree with the valuations of the total market as shown on the Morningstar website?

Based on those numbers, it seems as though Morningstar believes that the total market is roughly fairly valued or a little undervalued and that wide moat and below average risk stocks are undervalued.

Thanks.

HERE IS MY RESPONSE

Thank you, Richard, for an excellent question.

I strongly disagree with Morningstar. They use single year price to earnings ratios. I do not.

Valuations of the S&P500 index and the Total Market Index are almost identical. That is not an issue.

The problem with a single year price to earnings ratio is that the earnings are volatile. Smoothing over several years provides an accurate measure.

I use smoothed earnings. I prefer to use Professor Robert Shiller’s P/E10, which uses the most recent (inflation adjusted) price divided by the average of the past decade of (inflation adjusted) earnings. P/E10 does substantially better than the standard, single year, price to earnings ratio.

I have examined this several times in the past. I have found P/E10 to be the best measure of valuation. P/D5 and P/D10 have done well since 1950. Tobin’s q is another excellent measure of valuation.

For an outstanding discussion of single year price to earnings ratios and how they should be adjusted in today’s market, I recommend Ed Easterling’s article “The Truth About P/Es.”

Crestmont Research
Crestmont: The Truth About P/Es

Letters to the Editor in 2007

Letters to the Editor in 2006

Letters to the Editor in 2005