Notes starting from May 31, 2009

Updated: June 24, 2009.

Models and Their Applications

I use a variety of models. They have many applications.

Models and Their Applications

New Normal?

Is the stock market behaving differently? Are we entering a period with a new normal?

My answer is no. The market is returning to its historical valuations. We could even see prices fall to one half of today’s levels.

For more on the market, visit Ed Easterling’s Crestmont Research web site and read Professor Robert Shiller’s S&P500 online data.

Crestmont Research web site
Professor Shiller’s web site

Single Year Predictions

Haven’t you heard single year predictions? Experts use the Gordon Model. Let me give you mine.

Using the Year 10 most likely return from the Stock Returns Predictor [Stock Returns button] and today’s valuations, I estimate a real, annualized, total return of 4.98%. My inner confidence limits for a single year are plus and minus 20%. My outer confidence limits are plus and minus 40%. That is, I expect a total return of stocks over the next year between a (15.02%) loss and a 24.98% gain (inner confidence limits). The total range of outcomes is between a (35.02%) loss and a 44.98% gain (outer confidence limits).

It doesn’t make a lot of sense, does it? Predicting a single year’s return is an item of light conversation. Prediction a single year’s return accurately is difficult, to say the least.

Balanced Fund Comparison Graphs

Here is a comparison of the Year 10 NOMINAL returns of a Balanced Fund and the S&P500 index.

Updated: June 5, 2009

Balanced Fund Comparison Graphs

Current Research O

I have added Current Research O: An Active Management Example.

Current Research O: An Active Management Example

Balanced Fund HSWR Comparison Graphs

Here is a comparison of the 30-year Historical Surviving Withdrawal Rates of a Balanced Fund and a 50%-50% S&P500-TIPS portfolio.

Balanced Fund HSWR Comparison Graphs

Current Research P: Balances and Time

I used the Scenario Surfer to give us an idea of how balances develop throughout the years. This shows the degree of predictability from early returns.

Update: A new graph shows that Valuation Informed Indexing holds up at a 5% withdrawal rate.

Current Research P: Balances and Time

Statistical Approximations

I have copied this part of a write up from Professor Peter Ponzo’s Gummy Stuff web site. From 2005.

Statistical Approximations

Beating the Market

How do you beat the stock market? One way is Valuation Informed Indexing. You vary stock and bond allocations according to major changes in valuations (Professor Robert Shiller’s P/E10 for example).

This is a form of long term timing. You vary your holdings infrequently. It almost always beats rebalancing by a large margin.

Why is it possible to beat the market? Because you are not always at the whim of the market.

Sensible investors do NOT make this an all-in or all-out decision. That is “Idiot Switching.” It works, but not as well as a more gradual approach.

You can practice Valuation Informed Indexing on the Scenario Surfer and on the Investment Strategy Tester [buttons on the left].

Index Fund Advocates

Too many Index Fund advocates go overboard. They make comparisons of INDEX FUNDS with SECTOR FUNDS, not balanced funds. Even worse, they identify fund sectors AFTER THE FACT. They label any shift in sectors STYLE DRIFT, not intelligent management.

I like index funds. They bring instant diversification, usually at a low cost. But let’s not go overboard.

Visit Rob Bennett’s Site

Read his write up of the Investment Strategy Tester. Read about our default page. Rob points out that a person who has $100000 and uses Valuation Informed Indexing will eventually do better than a person who starts out with $150000 and sticks with a fixed allocation. If you lost money during the meltdown, you can get it back and more, but not instantaneously.

Rob Bennett’s Investment Strategy Tester

A Revealing Article

Rob Bennett led me to this one. It was one of his “Today’s Passion” articles.

Dave Shafer Article

Passive Investing

Passive investing is a mistake. With it, you set a fixed allocation and maintain your allocation through rebalancing.

If you vary allocations according to valuations, you do much, much better. You avoid the heavy losses during a market meltdown.

Read this from July 2006.

Orders of Magnitude

Dividend Guidelines

I got a great Letter to the Editor: Accumulating dividend producing stocks. It motivated me to open a new Dividend Guidelines section. It has a button on the left. Thank you, David Shafer.

June 9, 2009 Letters to the Editor
Dividend Guidelines

Fabulous Letters

I have been receiving a flurry of outstanding Letters to the Editor. The latest draws out today’s savings requirement for retirees. It is $130000 to $170000 for each $10000 of income. This includes increases to match inflation.

This is a whole lot better than the old days. Prices matter. Stock prices have fallen to the point that you can retire earlier.

Retirees will do well to look at income investments such as REITS and Master Limited Partnerships (MLP). They can make a lot of sense. In particular, MLPs have tax advantages. The paperwork can be a nuisance. You may need to buy Turbo Tax.

If your investment does not grow its income stream, always be sure to reinvest enough to handle inflation.

Market prices may still fall. I think that they will. But the income streams are likely to be secure. My preference is to hold back about 50% of your funds to exploit future opportunities. But your situation is unique. Think everything through.

Double Your Income?

Should you invest for income now or wait for better prices?

I don’t know. It depends on your circumstances.

The odds favor another significant drop in stock prices. You shouldn’t have to wait beyond 5 years, 10 years at the most. You might double your retirement income for every dollar of capital that you preserve. That is what I expect.

But it isn’t guaranteed.

If you need income now, meet your needs. If not, protecting your portfolio balance may be a greater concern. A fifty percent stock allocation makes sense at today’s prices. I prefer holding more cash. It all depends upon how much income you actually need and how much cash you can place at risk.

Dividend Based Predictions

Dividend yields are great for predicting long term returns. They do not always tell us about the short term. This is well worth remembering.

From 2005, Refusing to See: Dividends:

“I read recently that dividend yields have no power to predict stock returns. That is ridiculous.”

“Here are my speculations as to how someone could reach such a conclusion. It is not easy.”

Refusing to See: Dividends

The High Yield Paradox

Is a high yield investment safer or more dangerous than another investment? Most people urge caution. High yields signal that other people expect bad things to happen.

But ElLobo at the Morningstar Income & Dividend Investing discussion board has a different take IF YOU DO YOUR DUE DILIGENCE. If the income stream is stable, supported by steady earnings and a reasonable payout ratio, a lower price means lower risk.

ElLobo first ranks companies by yield and then finds reasons NOT to purchase them. Then he does two other things that make sense. He diversifies widely and he reinvests part of his income to keep up with inflation.

ElLobo does not insist upon dividend growth from a company, just that his holdings grow their income stream after reinvestment. In fact, he considers a stable, predictable high dividend amount much safer than a growing dividend. He just makes sure that the earnings stream covers the dividend. This is less risky than depending on dividend growth, which is hard to predict, especially beyond two or three years out.

This is only a brief outline of his strategy. In fact, it is not even complete. He buys Vanguard’s High Yield bond fund as well.

Switching C

I optimized stock allocation switching for today’s valuations on the Investment Strategy Tester. I call this Switching C. I have now generated 30-year Historical Surviving Withdrawal Rates for sequences starting in 1923-1980.

Switching C

Switching D

I optimized stock allocation switching for today’s valuations on the Investment Strategy Tester. I call this version Switching D. I have now generated 30-year Historical Surviving Withdrawal Rates for sequences starting in 1923-1980.

Switching D

Notes Index Starting from November 23, 2007