Slowly Rising Earnings

Today’s market is expensive. P/E10=27.6.

There are lots of ways for earnings to return to historical levels. What if prices remained stagnant while earnings continued to grow?

Would it happen? Could it happen? What would be the consequences?

P/E10 Calculations

Today’s S&P500 index level (price) is very close to 1400. Since inflation has been 3% per year over the long-term, the real price at Year 10 would be 1400/(1.03)^10 = 1400/1.344. At Year 20, it would be 1400/(1.03)^20 = 1400/1.806.

From E10 = P / [P/E10], in January 1900, E10 = 7.848 real. In January 2000, E10 = 36.60 real.

The ratio of earnings is 4.66 and (1+earnings growth rate)^100 = the earnings ratio 4.66.

E10 earnings growth rate = 1.55% real (long term).

At Year 10, the compounded earnings growth would be (1.0155)^10 = 1.166. At Year 20, the compounded earnings growth would be (1.0155)^20 = 1.360.

The adjustment to P/E10 at Year 10 would be 1.344*1.166=1.567. Since today’s P/E10=27.6 and since we assume that P remains equal to 1400, P/E10=17.6.

The adjustment to P/E10 at Year 20 would be 1.806*1.360=2.456. Since today’s P/E10=27.6 and since we assume that P remains equal to 1400, P/E10=11.2.

To an adequate approximation, the dividend yield of the S&P500 index equals 63% of the earnings yield 100E10/P.

Today, using this approximation, the S&P500 dividend yield should be 2.3% since P/E10=27.6. The actual payout ratio is lower.

At Year 10, using this approximation, the S&P500 dividend yield should be 3.6% since P/E10=17.6.

At Year 20, using this approximation, the S&P500 dividend yield should be 5.6% since P/E10=11.2.

Dividend stocks from high quality companies typically yield 1.7 times as much as the S&P500 index. Using this approximation, today’s dividend yield from such companies should be 3.9%. At Year 10, using this approximation, the dividend yield of such companies should be 6.1%. At Year 20, using this approximation, the dividend yield of such companies should be 9.5%.

Could It Happen?

Using the Bull and Neutral Market Calculator of the “Simplified Retirement Trainer A” and “Simplified Retirement Trainer with Dividends A,” this is what I, starting today:

Calculated Today: P/E10=27.6
At Year 10, most likely = 0.97%
Upper bound = 7.0%
Lower bound = -5.0%

Calculated Today: P/E10=27.6
At Year 20, most likely = 2.48%
Upper bound = 6.5%
Lower bound = -1.5%

Calculated Today: P/E10=27.6
At Year 30, most likely = 5.27%
Upper bound = 7.3%
Lower bound = 3.3%

Notice that a 1.55% annual decrease in P/E10 would be reasonable at Year 10. It would be unusually pessimistic at Year 20, but only slightly so. I would expect a recovery well before Year 30.

Calculated ten years from today: P/E10=17.6
After another 10 years, most likely = 4.11%
Upper bound = 10.1%
Lower bound = -1.9%

Calculated ten years from today: P/E10=17.6
After another 20 years, most likely = 4.72%
Upper bound = 8.7%
Lower bound = 0.7%

A 1.55% annual decrease in P/E10 would seem reasonable after another 10 years, provided that we ignore mean reversion from the previous decade. I would expect a recovery well before another 20 years.

Could It Happen? Using the Bull and Neutral Market Calculator: the answer is Yes, at Year 10 and Just Barely at Year 20. Stock prices would recover well before Year 30.

Using the Bear Market Calculator of the “Simplified Retirement Trainer A” and “Simplified Retirement Trainer with Dividends A,” this is what I project, starting today:

Calculated Today: P/E10=27.6
At Year 10, most likely = -1.51%
Upper bound = 3.5%
Lower bound = -6.5%

Calculated Today: P/E10=27.6
At Year 20, most likely = 3.43%
Upper bound = 7.4%
Lower bound = 0.4%

Calculated Today: P/E10=27.6
At Year 30, most likely = 5.89%
Upper bound = 7.9%
Lower bound = 3.9%

Notice that a 1.55% annual decrease in P/E10 would be reasonable at Year 10. I would expect a recovery well before Year 20. I would expect a substantial recovery by Year 30.

Calculated ten years from today: P/E10=17.6
After another 10 years, most likely = 0.92%
Upper bound = 5.9%
Lower bound = -4.1%

Calculated ten years from today: P/E10=17.6
After another 20 years, most likely = 4.57%
Upper bound = 8.6%
Lower bound = 1.6%

A 1.55% annual decrease in P/E10 would seem reasonable after another 10 years, provided that we ignore mean reversion from the previous decade. I would expect a recovery well before another 20 years.

Could It Happen? Using the Bear Market Calculator: the answer is Yes, at Year 10, but No at Year 20. Stock prices would recover before Year 20.

Retirement Income Streams

There you have it. Lots of numbers. But the messages are simple.

Can prices remain stagnant (S&P500=1400) for another 20 years while E10 earnings growth brings valuations back into line? Answer: no, not if we are currently in a secular (long lasting) Bear Market. Otherwise, yes, just barely.

NOTE: I believe that we have been in a secular Bear Market since 2000.

Keep in mind that there is always about a 10% chance that history will fail to remain within its statistical bounds.

Assuming that prices stagnate anyway, what does this mean to investors?

I brought up “The Big Project Super Variable Terminal Value Rate SVTVR Calculator L” to see what would happen if you varied allocations with P/E10.

To those who vary allocations in accordance with P/E10, your 30-Year Safe Withdrawal Rate will be 4.28% if you leave allocations unconstrained (between 0% and 100%) and 4.12% if you constrain stock allocations to 20% to 80%. If you withdraw 4.0% of the original balance (plus inflation), in the unconstrained case, you have a reasonably high probability (about 80%) of having 40% of your initial balance (plus inflation) at the end of 30 years. At 4.0% (plus inflation) withdrawals, with the constraint, you have a reasonably high probability (about 80%) of having 25% of your initial balance (plus inflation) at the end of 30 years.

With a fixed 50% S&P500 allocation, the Safe Withdrawal Rate would be 3.56%. The Reasonably Safe (80% chance of success) rate would be 3.96%. With an 80% stock allocation, the Safe Withdrawal Rate would be 2.96%. The Reasonably Safe (80% chance of success) would be 3.56%. The odds of reaching Year 30 with an 80% stock allocation and 4.0% (plus inflation) withdrawals would be just under 60%.

For those using a dividend based strategy, the outlook is excellent. Dividends continue indefinitely. They usually grow faster than inflation.

Consider what happens if you keep 50% of your holdings in 2% (real interest rate) TIPS. From What If There Is A Bubble?, you can withdraw 4.0% (plus inflation) from 2% TIPS for 20 years and still have 51.4% of your original balance (plus inflation).

At Year 20, assuming the 63% payout approximation, the S&P500 dividend yield should be 5.6% since P/E10=11.2. The dividend yield from high quality companies that pay high dividends should be 9.5%. Using your remaining principal, your income stream would be 0.516 times the 9.5% yield or 4.9% of your original balance (plus inflation).

Even at Year 10, the outlook for dividend investors is good. Using the 63% payout approximation, the S&P500 dividend yield should be 3.6% since P/E10=17.6. The dividend yield from high quality companies that pay high dividends should be 6.1%.

At Year 10, the remaining principal from 2% TIPS after withdrawing 4.0% (plus inflation) is 78.1%. Your income stream would be 0.781 times the 6.1% dividend yield or 4.76%.

Even if you started with 100% stocks, assuming the 63% payout approximation, your dividend income stream would be 3.9%. Most likely, your dividend growth would allow you to catch up and exceed 4.0% of your original balance (plus inflation) within two or three years.

Summary

Assuming that prices stagnate for 20 years, dividend investors will do well. If they start out entirely in high dividend paying stocks from high quality companies, they will be able to start withdrawing close to 4.0% (of the original balance plus inflation) immediately from dividends alone and exceed 4.0% (plus inflation) within two or three years. They can do better if they start with some of their money in 2% TIPS, switching to dividend paying stocks when yields are attractive.

Those who vary stock allocations in accordance with valuations (P/E10) will do reasonably well. They will be able to withdraw more than 4.0% (plus inflation) for at least 30 years.

Those who maintain a 50% or 80% fixed stock allocation will not be nearly as safe. When withdrawing 4.0% of the original balance (plus inflation): with a 50% fixed stock allocation, the probability of reaching Year 30 is about 80%. With an 80% fixed allocation, it is less than 60%.

Have fun.

John Walter Russell
December 2, 2006