May 1, 2007 Letters to the Editor

Updated: May 24, 2007.

GMO's Return Predictions

I received this letter from Rob Bennett.

The article by John Hussman linked to at your Notes section ("Double Counting") makes reference to the 7-year stock-return predictions put forward by Jeremy Grantham at the GMO.com site. Are you able to comment on these predictions, comparing and contrasting them to the predictions set forth in the Stock-Return Predictor?

HERE IS MY RESPONSE

Thank you.

Jeremy Grantham’s predictions are the best that I have seen. He includes confidence limits, which range from plus and minus 6% to 7% for US equities. Very few people do this. In addition to Jeremy Grantham and myself, Ed Easterling estimates the range of likely outcomes at Crestmont Research (when applying his “Financial Physics”).

Jeremy Grantham appears to make a bottom up estimate using the Gordon Model. The Gordon Model works well between 5 and 15 years. Jeremy Grantham estimates are for Year 7.

I classify Jeremy Grantham’s approach as a refinement. As such, he is able to make more precise predictions than we can with the Stock Returns Predictor, but only as a result of making more assumptions. His estimate for the S&P500 at Year 7 is slightly more pessimistic than our estimate at Year 10. It is within the inner confidence interval (between Lucky and Unlucky).

On a similar note, when I investigated the effect of accelerated earnings, I found that the refinement would increase the Most Likely return slightly. It too was within the inner confidence limits. Each refinement requires additional assumptions.

To the extent that those assumptions are accurate, the refinement is more accurate.

Jeremy Grantham predicts a Year 7 real, annualized, total return for the S&P500 index of -1.5%. We currently calculate a Year 10 Most Likely return of +0.7%. Our inner confidence limits range from -2.3% (Unlucky) to +3.7% (Lucky). Our outer confidence limits range from -5.3% to +6.7%.

Here is a link to Jeremy Grantham’s GMO Web Site. Registration is required, but it is free.

Jeremy Grantham’s GMO Web Site

What is P/E10?

Mary asks, “What’s P/E10?”

HERE IS MY RESPONSE

Thank you, Mary. You have asked a good question.

P/E10 is the current price of the S&P500 divided by the average of previous ten years of earnings. All values are adjusted for inflation. It was invented by Professor Robert Shiller of Yale.

You are not the first to ask this question. Frank asked it in last November's Letters to the Editor. Perhaps, my best answer is in the “Valuations” section of “Building Blocks: Edited.”

November 7, 2006 Letters to the Editor
Building Blocks: Edited
Building Blocks

Price Drops

I received this letter from Rob Bennett.

I have on numerous occasions cited Robert Shiller's finding (from Irrational Exuberance) that, on the three earlier times when prices went to the sorts of levels where they reside today, stock investors experienced an average price drop of 68 percent.

My understanding is that Shiller's finding is not inconsistent with yours in that he was looking only at what happened at the three times of extreme valuations while you are taking into consideration the entire historical record.

My question is -- Do you think it would be better for me to cite your finding, that a drop in purchasing power of only 40 percent is the most likely scenario (although loss percentages either larger than that or smaller than that are of course also possible)?

HERE IS MY RESPONSE

Thanks, Rob.

Use both. Both are true.

Professor Shiller’s finding is about price drops independent of dividends. My numbers show what happens if you reinvest all of your dividends.

Here is a listing of REAL price decreases (January values only) of the S&P500 index.

1881-1885 prices fell to 78%, a drop of 22%.
1906-1921 prices fell to 32%, a drop of 68%.
1929-1933 prices fell to 38%, a drop of 62%.
1937-1942 prices fell to 46%, a drop of 54%.
1966-1982 prices fell to 42%, a drop of 58%.
2000-2003 (so far) prices fell to 58%, a drop of 42%.

I suspect that Professor Shiller included only the 1906-1921, 1929-1933 and 1966-1982 series, but that he included all months.

Here is a listing of all of the minimum balances below $70000 when starting from $100000 with all dividends reinvested. All of these lows occurred within the first decade:

1912 $67200
1913 $67298
1916 $60701
1917 $62917
1929 $53775
1930 $58578
1931 $68379
1937 $64764
1966 $65267
1968 $64459
1969 $60987
1971 $69316
1972 $63085
1973 $55752
1999 $69007 (so far)
2000 $61436 (so far)

Keep in mind that I am projecting a drop of 40% (plus and minus 30% at the outer confidence limits) from today’s purchasing power, not from that of the Year 2000.

Price Drops

Price Peaks

I received this letter from Rob Bennett.

Here are three sentences from your article on "Price Peaks":

"Today's holder of the S&P500 index can expect his balance to remain below 228.8% of its current purchasing power throughout the next decade even with dividends reinvested. The likely range of outcomes is below 153.5% (80% probability). The most likely outcome is a loss throughout the entire decade."

Price Peaks

I've long had an interest in learning more about which sorts of returns sequences are best and which are worst, given the valuation level that applies at a given time. Do you have any sense of what sort of returns sequence we should be "rooting" for today?

My guess (that's all it is) is that in an overall sense it would be best to have a sharp price drop soon. I would think that would usher in more healthy emotional takes on the part of investors, and we might see a positive return by the end of the decade. I see it as more likely that we will see a negative outcome for the decade beginning today if the slow leak we have seen since the year 2000 continues (a period in which stocks have provided smaller real returns than TIPS).

My sense is that some sorts of returns sequences are better for certain types of investors and other sorts of return sequences are better for other types of investors. Perhaps the slow leak scenario is best for retirees while an immediate sharp price drop would be better for younger investors. I'm only putting forward tentative thoughts here. It would be nice to gain a better grasp of the issues at play in a determination of what sort of returns sequences to "root" for.

HERE IS MY RESPONSE

Thank you, Rob.

For the investor who ignores valuations, the answer is found in “An Illusion of Numbers.” In essence, you want prices to rise sharply when you have the most money. You want sharp price decreases to occur when you have little money.

Assuming that only the sequence of returns varies:

For a retiree who ignores valuations, it is best for the worst years to occur as late as possible. For the accumulator, it is best for the worst years to occur as soon as possible.

An Illusion of Numbers

For the investor who changes allocations in accordance with valuations, it is best for any price drop to come as soon as possible. Both the retiree and the accumulator should root for an early price drop. And, surprisingly, the retiree as well as the accumulator should desire a delay in price increases.

A sharp price drop would cause the dividend yield of stocks to rise. Retirees with cash (equivalents) to invest would be able to purchase high quality dividend paying stocks without ever having to sell. The dividends would provide a continuing income stream that typically grows faster than inflation. The retiree’s inflation adjusted balance at Year 30, typically, would be higher than the original balance.

Not only that, but if the retiree were able to reinvest part of his dividend income back into high quality dividend paying stocks, he would be able to buy more shares if stock prices were to remain low. Only when he needed a large amount of cash would he sell shares. Only then should he look forward to a sharp price increase.

As a practical matter, we all look forward to price increases even when it lowers our returns from stocks. We like to have the ability to take money off the table, even when we don’t have the need.

From a purely rational standpoint: an investor who takes valuations into account prefers price drops to occur early and price increases to occur much later.

Letters to the Editor in 2007

Letters to the Editor in 2006

Letters to the Editor in 2005