Dow record highs? Almost, but don't be fooled by the news

There's a lot of attention being put on "record highs" for the Dow lately, but if you're an investor you should ignore this fundamentally flawed way of looking at things.  A recent example of this is this article, which gives lots of seemingly wise, yet useless, advice like "investors should proceed, but with caution".  What does that mean exactly?

Anyway, the reason to ignore this type of analysis is that the level of the Dow is not normally adjusted for inflation, nor for dividends, which matter to you as an investor.

Instead of looking at it this way, I've been keeping track of the level of the S&P500 adjusted for inflation and assuming re-invested dividends.  The last peak for this was in September 2000 (not 2007!  See here for a set of past articles talking about this).  Based on the value of the S&P500 today, it is still 1.2% away from that record high.

What this means is that an investor who put money into stocks more than 12 years ago, and dutifully re-invested dividends the whole way, is close to breaking even in real terms.  Not great, but it's interested to note that the only time in the past ~80 years that this has happened was from January 1973 to January 1985 - 12 years, and only a little bit shorter than this time around assuming the 1.2% is crossed soon (no guarantee of that of course!).

Buffett on CNBC

http://www.cnbc.com/id/100515743

Interesting article about Shiller's PE ratio (or CAPE)

http://seekingalpha.com/article/798701-shortcomings-of-the-shiller-pe10-ratio-why-stocks-aren-t-overpriced

Deriving the 4% safe withdrawal rate for retirement planning

In a recent article I linked here, the infamous 4% withdrawal rate set out in a 1994 study by Bengen was mentioned.  In thinking about a way to derive more fundamentally where that number comes from I came up with an interesting way to look at it.  I have not verified that this is an original contribution, but here it is nonetheless:

When coming up with a safe withdrawal rate, the most conservative goal is to maintain the real value of the portfolio while spending X% of it to support retirement.

To derive what X should be, consider an all-stock portfolio, where:

• Y is the total earnings yield of the portfolio (specifically, Y = earnings / market_cap of the portfolio).
• D is the fraction of the portfolio that are distributed instead of re-invested (D usually comes from dividends but also things like stock buybacks).  Basically any part of the earnings that aren't added to book value through retention count toward D.
• Let the expected inflation be I.
• Let E be the "return on equity" (ROE) of the portfolio (ROE is earnings divided by book value).  One assumption that I am making is that the ROE is fairly constant - Warren Buffett wrote an article in 1977 showing that US stocks tended to have an ROE of 12% (link), and interestingly the S&P 500 recently has been in the ~14% range.  So let's assume E=12%.
• Let B be the price-to-book value.

For this portfolio, to meet the definition of safe withdrawal rate above, the portfolio's growth in earnings must match inflation (I).  Assuming no withdrawals, the growth in earnings is equal to:

          1) Portfolio earnings growth = (D*(E/B))+((Y-D)*E) / Y

If spending (X) is less than D, the growth is:

          2) Growth if X<D = ((D-X)*(E/B))+((Y-D)*E) / Y

If spending (X) is bigger than D, the growth is:

          3) Growth if X>D = ((Y-X)*E) / Y

In either of #2 or #3 above, to make X safe you need to have it match inflation, or I (thereby making sure that the growth in earning power of the portfolio matches the growth in inflation).

For #2:

          4) X = D - DB + YB - ((IBY)/E)

For #3, it's a bit simpler:

          5) X = (Y * (E - I)) / E

Plugging in some sample values, Y = 6%, I estimate D to be ~4% even though only half of that comes from dividend yield (the rest I believe is from stock buyback although I can't prove it perfectly yet), I = 3%, E = 12% as I said above, and B = 2.2 right now.

For these values, #5 gives X = 4.5%... Since X > D I don't need to compute the more complicated #4, but for smaller spend it would matter (since companies can only re-invest at book value the money they actually retain, not dividends or repurchased stock).

4.5% is the typical safe withdrawal rate!  But now by plugging in different values for the key assumptions, you can work out what other safe rates could be.

Closing the Gap

In a post in September 2012 (link) I continued updating where the S&P500 is relative to the last peak (when factoring in re-invested dividends).

The S&P500 today (Feb 2013) is now only 3% away from that peak - another 3% upside and the previous peak of September 2000 will finally be crossed after a record 12+ years!

The 4% Rule: The Easy Answer to “How Much Do I Need for Retirement?” | Mr. Money Mustache

http://www.mrmoneymustache.com/2012/05/29/how-much-do-i-need-for-retirement/

Strong Long-term Dividend Growth Rate

Here's a graph I was surprised by.  It shows the annual growth rate for the real dividends on the S&P 500 index over the past 10-years.  Recent numbers are approaching 4% (ie. real dividends today are 4% per year higher than 10 years ago).

Aside from the big dip during the Great Recession in 2008/2009, the rate had been trending this way since the dot-com-bust.

Has U.S. Economy Bottomed Out? Census Suggests Yes

Has U.S. Economy Bottomed Out? Census Suggests Yes

http://feedproxy.google.com/~r/timeblogs/curious_capitalist/~3/GnL-qgIkAQQ/

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Factory data sends China stocks to nearly 4-year low

Factory data sends China stocks to nearly 4-year low

http://rss.cnn.com/~r/rss/money_markets/~3/xS7ekYmCu90/index.html

Sent from Read It Later.

Mason Hawkins of Longleaf Partners Interview with GuruFocus

Mason Hawkins of Longleaf Partners Interview with GuruFocus

http://www.gurufocus.com/news/190224/mason-hawkins-of-longleaf-partners-interview-with-gurufocus-

Sent from Read It Later.

Oakmark's Bill Nygren Says Banks Are Undervalued

Oakmark's Bill Nygren Says Banks Are Undervalued

http://www.gurufocus.com/news/190235/oakmarks-bill-nygren-says-banks-are-undervalued

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The Drought Continues

In a previous article (link) I talked about how the S&P 500 was near the biggest drought ever in real terms (with dividends re-invested).  Since then, we crossed the record and have now had 144 months without a new high (12 years!), in contrast to a 143-month drought that ended in January 1985.

However, the S&P has been on somewhat of a run lately, so it is only 8% away from reaching the previous high set 12 years ago.  It will be interesting to see how much higher this 144 goes before resetting the count to 0.  I'm bullish that it will be soon, but we'll see!

Another update on US and Canadian Equities

In September 2011, I posted a graph on the ratio of EWC (Canadian equities) and SPY (S&P 500)... see here.  In March 2012 I posted an update showing the ratio had moved from 0.225 to 0.203.  Today (August 12, 2012), the ratio is down to 0.193!

Equities: Now As Cheap As They Were In 1974?

Equities: Now As Cheap As They Were In 1974?

http://seekingalpha.com/article/653311-equities-now-as-cheap-as-they-were-in-1974?source=feed

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GMO whitepaper: Profits for the Long Run: Affirming the Case for Quality

http://feedproxy.google.com/~r/ValueInvestingWorld/~3/ltsvfrMEyAw/gmo-whitepaper-profits-for-long-run.html