The Real Returns Report, Feb 21 2012

8/3/2019 The Real Returns Report, Feb 21 2012

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The Real Returns ReportVOL. 1, No. 5 FEBRUARY 21, 2012

Contents Page

This Week 1

10% Stock Returns: Myth and Reality 4

Value Map 8

Contents Page

From the Archives 10

License/ Disclaimer 12

This Week

Adding the Russell 1000 I've added the Russell 1000 Index to our coverage in order to

fill out the data on 'Large-cap/ Broad Market' segment. Only

the P/E10 is available at this time I don't have the necessary

data to calculate the Equity q ratio, but I expect to obtain it

relatively soon.

What does this series tell us? In isolation, not that much -- it's

simply too short. However, I note with some satisfaction that

the current value (19.4) is within 9% of the S&P 500's P/E10.

Not altogether surprising since the S&P 500 represents

roughly four-fifths of the market value of the Russell 1000,

but it suggests our data is pretty consistent (our calculation

methodology for the two indexes is completely consistent, we

know that much for certain.)

More broadly, the broad market valuations we track (the U.S.

and India, for now) are roughly unchanged and remain, in my

estimation, dissuasive.

The ultimate currency This week, I watched part of an original and thought-

provoking science-fiction/ action movie, In Time. In a future

society, people only age until 25 (judging by the clothing they

wear, it doesn't look all that far into the future, with the business suit and the smoking jacket still in use.) Once they

reach 25, their life countdown begins with only a year on the

clock. People keep track of the time they have left on a digital

countdown that is displayed on everyone's forearm. However,

they aren't condemned to die at 26, as there are means to add

to your time amount. In fact, "life-time" (my expression, not

that of the movie, in which it is simply referred to as "time")


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has become this society's money. Goods, services and labor --

all are paid for in time, which also functions as a store of

wealth.

Not everyone is equal in this world, however. The world

(there is no indication that nation-states still exist) is divided

into "time zones" that correspond to different strata of wealthand rank in society. There are borders between the time zones

and one has to pay a toll in order to cross them. As you go up

the hierarchy of time zones, the toll increases. In order to

enter the most exclusive time zone, "New Greenwich" 1, the toll

is a full year. This ensures that no riff-raff can penetrate this

ultimate gated community; indeed, inhabitants of the lowest

time zone are literally living day-to-day (as the protagonist

says: "Just once, I'd like to wake with more hours [left] than

there are in the day.")

The film contains an element of stark social commentary: In

order to control world population, the plutocracy creates price

inflation. Rising prices ensure that some percentage of ghetto

inhabitants will quite literally run out of time. The plutocracy,

on the other hand can continue banking time (wealth) that is

created by those underneath them and live forever.

Meanwhile, one as one character explains to the protagonist,

"there's enough time for everyone."

I was less interested in the social commentary than in the

clever way in which the screenwriters imagined that using

time as a currency would affect behaviors and social mores.

For example, when the protagonist, who is from the ghetto,travels to the New Greenwich, it's impossible for him to hide

his origins a woman who waits on him in an expensive

restaurant explains: "You do everything a little bit too

quickly." In a world in which time is the currency, adopting a

leisurely pace is a privilege only the wealthy can afford.

While the film can function as a metaphor for inequality in

our society, it's also an interesting reminder that time is a

form of currency that has at least one egalitarian aspect.

Unlike the privileged few in the movie, there is a biological

ceiling on the amount of "time wealth" any one of us can

bank. It's true that access to better nutrition, healthcare etc will allow someone to increase their expected lifespan;

however, no-one, no matter how wealthy or powerful, can

avoid the clock ticking down to zero. Your time wealth is

1 The name was not chosen randomly. Greenwich, CT has become (along with London) the world hedge fund capital.Consequently, the concentration of wealth is extraordinary is extraordinary. With billionaire hedge fund managersrunning around buying and building pharaonic mansions, the price of real estate (and everything else) has shot up.


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finite, you won't be able to take it with you and you can't

bestow it to your children. Spend this wealth wisely.

In Time is based on an interesting and thought-provoking

premise and it's pretty entertaining -- check it out.

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Commentary

The Enduring Myths Surrounding U.S.

Stock Returns (Part 2)

I spent a lot of time working through the data this week and

I'm not quite ready to describe my methodology for

estimating future U.S. equity returns, but I'll give some more

examples to show why the Ibbotson-Chen (IC) method is very

useful on a conceptual level, but falls down in terms of its

implementation and the universal value of its results. Stock

investors should not expect to earn IC's 10.70% annual

average return starting in any given year and certainly not

in the current market.

Using a different data set (that of Professor Robert Shiller of Yale), I found a 10.90% annual return, comparable to IC's.

The breakdown of the different return components I obtained

is nearly identical (the figures are contained in the two charts

that follow the text.)

Maybe you're wondering where the problem is since I've

confirmed their result? The trouble is that, despite the fact

that we're looking at a seventy-five year period, those figures

are less stable than you might imagine. Take a look at the

table on the next page that shows the annual average return

for ten different 75-year periods that followed the one IC

looked at.

Two remarks:

Given that these periods are long quite a bit longer

than an individual investor's holding period and

very largely overlapping, the range of average returns

is remarkably high. The difference between the lowest

and highest return is almost two full percentage

points. Compounded over seventy-five years, that

makes a heck of a difference!

Why are the returns so volatile? Because the range of

starting and ending years cover the Great Depression,the Internet stock market bubble and the credit crisis.

Although you can't see this in the table or the charts,

the P/E multiple expanded over all eleven of the

seventy-five year periods every one! P/E growth

contributed between 15 to 196 basis points to total

returns (a basis point is one-hundredth of a


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percentage point.) This return component is what

Vanguard's Jack Bogle refers to as "speculative

return."2

Next week, I'll discuss another way to derive the contribution

of P/E growth. It's critical to isolate that contribution since it

is the most volatile total return component. I think IC'scalculations underestimate it and I'll show why investors

shouldn't hold out for this speculative return over the next ten

years and why this is consistent with the constant hype

from commentators and analysts about stock multiples being

at multi-year lows.

Period

Annualized totalreturn, U.S. stock

market

1926-2000 10.90%

1927-2001 10.52%

1928-2002 9.72%

1929-2003 9.62%

1930-2004 9.82%

1931-2005 10.27%

1932-2006 11.24%

1933-2007 11.54%

1934-2008 10.24%

1935-2009 10.62%

1936-2010 10.26%

RANGE 9.62% - 11.54%

Source: Robert Shiller, The Real Returns Report

Next week: Look for part three of our discussion concerning

expected stock returns. 1

2 See, for example,The Policy Portfolio in an Era of Subdued Returns, June 5, 2003.
http://www.vanguard.com/bogle_site/sp20030605.htmlhttp://www.vanguard.com/bogle_site/sp20030605.htmlhttp://www.vanguard.com/bogle_site/sp20030605.htmlhttp://www.vanguard.com/bogle_site/sp20030605.html


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Source: Ibbotson & Chen (2002)

Note

CPI Consumer Price Index

g(REPS) Real EPS growth

g(P/E) P/E growth

INC Income return (i.e., dividends)

INC, 4.28

g(P/E),1.25

g(REPS),1.75

CPI, 3.08

0

2

4

6

8

10

12

PERCE

NTAGE

POINTS

Historical Average Equity Return Breakdown(Ibbotson-Chen)

1926 - 2000


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Source: Robert Shiller, The Real Returns Report

Note

CPI Consumer Price Index

g(REPS) Real EPS growth

g(P/E) P/E growth

INC Income return

INC, 4.38

g(P/E),

1.31

g(REPS),1.90

CPI, 3.08

0

2

4

6

8

10

12

PERCE

NTAGE

POINTS

Historical Average Equity Return Breakdown(Robert Shiller data set)

1926 - 2000


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Value Map Feb. 17, 2012

INDIA - Broad market/ Large-caps

Currentvalue

(02/17)Serieslength

Percentilerank

% Above(below)

geometricmean

% Above(below)

arithmeticmean

Standarddeviation

SENSEX

Equity q ratio 1.07 1991-2012 45% (2%) (7%) 0.37

P/E10 21.8 1991-2012 46% (5%) (10%) 8.56

BSE-100

Equity q ratio 1.11 1991-2012 54% 3% (2%) 0.37

P/E10 21.2 1991-2012 39% (7%) (12%) 7.9

S&P CNX

Equity q ratio 1.06 1991-2012 57% 5% 1% 0.32

P/E10* 21.7 1991-2012 26% (9%) (10%) 3.2

*This item is not meaningful as the series is simply too short. Source: BSE Ltd., MOSPI, The Real Returns Report


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Value Map (cont.)

U.S. - Broad market/ Large-cap/ Small-cap stocks

Currentvalue (02/17)

Serieslength

Percentilerank

% Above(below)

geometricmean

% Above(below)

arithmeticmean

Standarddeviation

Aggregate U.S.equities, Equity qratio

0.85 1945 2011 72% 28% (3%) 0.26

S&P 500, Equity qratio

0.72 1871 2012 52% 12% 4% 0.25

S&P 500, P/E10 21.3 1871 2012 82% 40% 30% 6.6

Russell 1000, P/E 10 19.4 1994 - 2012 38% (5%) (7%) 4.08

Small-caps:Russell 2000, P/E10

32.4 1993 - 2012 54% 8% 6% 5.0

Source: Federal Reserve Board of Governors, Robert Shiller, Russell Indexes, Standard & Poor's, The Real ReturnsReport

Notes

Equity q = Market value / Net worth (estimated at market prices)

This is a variation on Tobin's q. When it is calculated over all U.S. equities, it is a quarterly series since it depends on

data from the Federal Reserve's Flow of Funds report. However, it's possible to calculate the ratio mid-quarter, as I

have done, by adjusting the market value to reflect changes in equity market indexes. Here, I used the Wilshire 5000

full capitalization index, which is the broadest measure of U.S. equities' market capitalization and performance.

P/E10: Also known as the cyclically-adjusted PE (CAPE) or "Shiller PE" after Robert Shiller of Yale. The P/E10 uses

the average of the prior ten years' earnings, on an inflation adjusted basis, as its earnings input. The rationale behind

this is the observation that earnings are too volatile on a year-to-year basis to provide reliable information on a

company's (or a market's) true earnings power. By using a ten-year average, the P/E10 smoothes out earnings

volatility and allows investors to better identify legitimate changes in risk premiums. The figures in this table are

derived from Professor Shiller's data (available from his web page), which include series of monthly average prices

for the S&P 500/ S&P Composite Index.


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From the Archives: Rotten Finance (Nov. 27, 1907)


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From the Archives (cont.)

This cartoon is on the cover ofPuck,"America's

first successful humor magazine of colorful

cartoons, caricatures and political satire of the

issues of the day... published from 1871 until

1918" (Wikipedia). Interestingly, although it was

an American publication, the English-language

edition only appeared in 1877 the original was

in German.

The nursery rhyme below the cartoon reads:

Humpty-Dumpty Sat on a Wall,

Humpty-Dumpty Had a Great Fall,

All the Street's Horses and All the Street's

MenCan't Put Humpty Back Again.

This issue ofPuck is dated Nov. 27, 1907 -- the

tail end of the Panic of 1907, which was also

known as the 1907 Banker's Panic. Humpty

represents the lost confidence of depositors,

which triggered bank runs. The origins of the

crisis were a failed attempt to corner the stock of

the United Copper Company financed by

banks and trusts. This led to the collapse of the

Knickerbocker Trust Company, New York City's

third-largest trust, which triggered an

nationwide banking panic.

Despite the last two lines of the doctored rhyme,

it was indeed a "Street man", John Pierpont

Morgan, who restored confidence by pledging a

significant portion of his personal wealth to

strenghthen the banking system and coaxing

other bankers to do the same.

Among the faces that are represented on thestone wall are those of J.P. Morgan, John D.

Rockefeller and Edward Harriman (Harriman

ultimately controlled multiple railroads,

including the Union Pacific, as well as the Wells

Fargo Express Company.) Harriman is the

bespectacled face on the right of the page.

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The Real Returns Report byAlex Dumortieris licensed under aCreative Commons Attribution-

NonCommercial-NoDerivs 3.0 Unported License.

Permissions beyond the scope of this license may be available atlongrunreturns.blogspot.com .

Disclaimer: This research is based on current public information that we consider reliable, but we donot represent it is accurate or complete, and it should not be relied on as such.

This research does not constitute a personal recommendation. The price and value of theinvestments referred to in this research and the income from them may fluctuate. Past performanceis not a guide to future performance, future returns are not guaranteed, and a loss of original capitalmay occur. Certain transactions, including those involving futures, options, and other derivatives,give rise to substantial risk and are not suitable for all investors.
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The Real Returns Report, Feb 21 2012

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