November 21, 2008 Letters to the Editor

Updated: November 27, 2008.

Thanks for your website!

I received this letter from Wayne. He had written earlier. Refer to the October 8, 2008 Letters to the Editor.

I have always believed valuations matter. I sincerely appreciate your work in this area because your thoughts gave me the strength to stick to those beliefs even when it didn't feel wise at times.

I started buying some quality blue chip type funds today at SP500 of 752. I might still be early but I am looking to dollar cost average into further declines.

Let Rob know he was right. I hope those jerks who have been giving you guys a hard time are enjoying their own cooking!

Keep up the good work.

HERE IS MY RESPONSE

Thank you. You are doing exceedingly well.

Don’t worry about being early. Easing into a high stock allocation makes a lot of sense at these valuations. Dollar cost averaging at even better prices also makes a lot of sense.

Congratulations. You have shown a lot of character.

Is there a risk of dividend cut greater than history would indicate?

Hi John, Michael here.

I have seen in some Notes here that you cite the historical worst case dividend cut across a broad spectrum of stocks as something like 25%. Is there an argument to be made that given the current financial crisis that number could well go much higher? My thinking is that historically companies that are in trouble are the ones that cut dividends and the same will be true now. But is there a chance that given the extreme lack of risk taking and lending by banks that even healthy companies may cut dividends simply as a risk management mechanism to save capital in case their banks/debt holders are so risk averse that they do not roll over existing debt? For my argument to hold merit obviously the condition of the debt markets would have to be worse than historical precedent which by virtually any standard seems to be the case.

Thoughts?

HERE IS MY RESPONSE

Thank you. You have voiced a legitimate concern.

I would focus on two aspects of the problem. The first is dividend payments in the market as a whole. The other is financial stocks and their prominence as dividend payers.

I anticipate that the current slowdown will be worse than those of the last two decades. Those recessions were very mild. But I do not anticipate anything outside typical historical norms. In terms of the effect on dividends, I do not believe that we are facing anything unusual in the overall market.

Do not be overly concerned about temporary earnings disappointments. Expect companies to charge off everything questionable on their balance sheets while they can blame it on overall conditions as opposed to their own doing. Pay attention to smoothed earnings and the growth of smoothed earnings.

Dividend oriented investors are likely to overweight financial stocks. They have looked especially attractive until the last few weeks. DVY, a dividend oriented Exchange Traded index Fund, has had a 40% allocation in the financial sector. The outlook for dividends from many of these companies has worsened considerably because of the demands of the Treasury Secretary and TARP (Troubled Asset Relief Program).

Even then, a high percentage of financial companies are in fine shape.

I believe that the Treasury and the Federal Reserve will succeed at avoiding deflation (i.e., a general decrease of prices for reasons other than improved productivity). I believe that there is considerable risk of their overdoing it and ending up with a strong bout of inflation. All of this has elements of the great depression (contending with deflation) and the great Stagflation of the 1960s and 1970s. Officials know what to do (or, at least, they believe that they know what to do) in both instances. Whether they choose to do so is likely, but it is yet to be seen.

Mitigating against these factors are the low payout ratio of the market as a whole and the income demands of baby boomers as they retire.

Normally, I would have placed the lower extreme around 10% because of the low payout ratio. But because of other factors, it becomes prudent to prepare for a worst case temporary drop in buying power of 25%.

Consider holding some TIPS along with dividend paying stocks. They are losers if deflation continues. They are big winners if inflation roars strongly. They are a bargain if inflation continues at a moderate pace, considering that the yield to maturity has risen above 3% (at 10, 20 and 30 years) plus inflation.

October 8, 2008 Letters to the Editor

TIPS [Ladders]

I received this letter from Bill.

Are there any publications that can explain exactly how to set up a TIPS ladder using Vanguard IRA, ROTH & Rollover IRA? Also what would I do with money in taxable account?

I am really leery of going into equities.

I am 59 just retired.

Taxable 30%
Rollover 48%
Roth 12%
IRA 10%

HERE IS MY RESPONSE

Thank you.

Larry Swedroe has written an excellent book on bonds. It may have the answers to your questions. I will supply such information as I can.

A bond ladder consists of “rungs” of bonds that mature at different dates. The idea is that, after a rung matures, you purchase new bonds at the maximum length of the ladder. That way, you get the long term interest rate on all bonds, but a new rung matures every year or two.

Normally, you would establish a bond ladder over a series of years. In your case, you need to buy all of the rungs from the start.

Your biggest problem is that TIPS have not been around long enough for all rungs to be available. Still, enough rungs are available for you to make meaningful purchases. You can do so on the secondary market. Your IRA custodian or custodians can do this for you. [You mentioned Vanguard.] So will your contact for your taxable account. They will make offers (that is, they will state their asking prices) at their bond desk. You may have to be patient to get a reasonable price, however, since different investment brokers offer different rates depending upon their inventory.

Refer to Bloomberg’s web site to know what prices and yields are reasonable. Currently, the 5-year TIPS provide a 2.5% real interest rate and the 10-20-and-30-year TIPS offer more than 3.0%.

Bloomberg Interest Rates

If all of your ladder rungs extended to Year 25, you would receive 4% (plus inflation) from the maturing of the longest rung and you would receive the coupon interest from all of the rungs. You would withdraw your desired amount and reinvest the remainder.

Beyond that, the details can become quite complex. They depend on your unique circumstances.

TIPS are a nuisance in a taxable account because you must pay taxes on the increase in principal (the inflation adjustment) each year, not at maturity. I prefer alternative investments in a taxable account.

Ibonds are no longer attractive. The purchase limit has been reduced from $30000 per social security number to $5000. [I do not know whether you are still able to double the total amount by having bonds in both paper form and electronic form.]

It makes sense to be leery of stocks at this time, especially if you have not owned them in the past. I generally recommend holding 20% minimum, but not in your case. Consider setting aside UP TO BUT NOT MORE THAN 20% of your balance to buy stocks IF P/E10 FALLS BELOW 10. This corresponds to an S&P500 index level of 580. At such prices, you should be able to buy many high quality (blue chip) stocks at extremely attractive dividend yields. You would want to buy very slowly, just in case prices were to drop even farther. The odds of even lower prices are about 50%-50%. In this case, the dividend income and its growth would compensate for the price risk. You might wish to purchase a dividend oriented index fund or Exchange Traded index Fund instead.

The likely return at Year 10 is compelling when starting from P/E10=10. Press the Stock Returns button to bring up the Stock Returns Predictor. Put in P/E10=10 and press calculate. The most likely return is almost 11% per year (plus inflation). The worst case confidence limit is still 5% per year (plus inflation). These numbers are attractive enough for a small investment even for the most cautious investor.

Valuation Based Investing

I received this letter from Wayne.

Have you read this?

The Kitces Report

The Financial Planning thinking is finally getting around to valuation based investing?

HERE IS MY RESPONSE

Yes! Slowly, but surely, the word is getting around.

Rob Bennett has exchanged several emails with Michael Kitces. For a summary, visit Rob Bennett’s “A Rich Life” blog and listen to his RobCast audio #34: “My Conversations with Michael Kitces” on page 5.

Rob Bennett’s RobCast page 5

Early last year, Ed Easterling wrote a valuation based Safe Withdrawal Rate study at his Crestmont Research web site.

Destitute At 80: Retiring In Secular Cycles

Thank you kindly. Your continued support is greatly appreciated.

Letters to the Editor in 2008

Letters to the Editor in 2007

Letters to the Editor in 2006

Letters to the Editor in 2005