Hi ACF Mike, I am still looking out for your interest ...
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The Investment Matrix (see crestmontresearch.com )Revelations
June 27, 2003
By John Mauldin
The Investment Matrix Revelations
When Can We Make Long Term Money In Stocks Again?
Death and Taxes
The Most Dangerous Threat to Your Retirement
How to Lose 20% in Five Years - Guaranteed
Paris, Geneva and Points Beyond
This week the Fed cut rates by 0.25% as I predicted, yet the long rates have risen by over 0.50% from the lows. The dollar rises, gold drops and the stock market declines. On Tuesday, I was a guest of Ron Insana and Sue Herera on CNBC's "Business Center." During the interview, Ms. Herera asked me, "What would you like to see the Fed do?"
Since I normally simply analyze Fed actions rather than prescribe them (I assume Greenspan does not really care about my opinions) I was brought up a little short, and answered that I would like to see the Fed tell us whether they are going to work to bring down long rates, instead of merely hinting or suggesting or threatening. The answer would give us a real indication as to whether we will have a recovery or at least a continuation of the Muddle Through Economy or will slide into a recession. They told us absolutely nothing, which in my opinion is a very risky option. The bond and stock markets seem to agree.
Since that interview, I have given a great deal of thought to that question. The answer is far more complex, and has to do with how a number of factors, much of which is beyond Fed control, interact. I started to write on this today, but realize I need to let this topic cook in my mind some more. The economy of the world and the US is at an "inflection point." Since next week is the beginning of the second half, we will also discuss if there is the hint of the elusive "second half recovery."
That will wait for next week. Today we will deal with a far more important matter than my thoughts on the Fed: What kind of returns can we expect from the stock market over the next 10-20 years? This week's letter will require you to put on your thinking caps, but will help you to be a better investor if you grasp the import of what we are saying.
(As a side note, I will be in Paris, Geneva, Boston, Halifax, San Francisco and New Orleans within the next few months. Already I am tired. Details below.)
The essay below is part two (of four parts) of a series from my upcoming book-in-progress. Warning: this letter is a little longer than most, but this section needed to be kept together. This section is co-authored with Ed Easterling of Crestmont Holdings. Ed Easterling is a colleague of mine in the world of hedge fund analysis. He is an expert on Texas based hedge funds. (Let's hear it for specialization.) His client list consists of institutions and high net worth individuals. He has been trying to develop a graphic way to show his clients what they should expect from simple stock market returns over the next decade.
This research into stock market and economic cycles will give us insight into how secular bear markets actually work. It will also give us a clue on how to invest in stocks even in a bear market cycle. (Note: when the pronoun "I" is used, it denotes a personal comment by John Mauldin.)
The Investment Matrix: The Real Truth about Stock Market Returns
(This section will reference charts available at www.CrestmontResearch.com. Click on "Stock Markets" and the graph called "Long Term Returns." We will provide large fold-out versions of the graphs in the book. Readers of this e-letter can hopefully get the sense of what we are saying without looking at the graphs, but if you have the time, we would suggest reviewing them. If you are not going to be able to look at them, you might skip the first sections which explain what you are looking at and go on to the analysis following the subhead: The Investment Matrix Revelations. [Note from John - you will need Adobe Acrobat. I prefer to greatly increase the viewing size. You can also get Kinko's (or other similar firms) to print these on large color graphs.])
The past 103 years have provided over 5,000 investment period scenarios-that is, the combination of investment periods from any start year to every year since that time. This provides an extensive history across which to assess the potential and likely outcomes.
Like the movie, The Matrix, this Investment Matrix slows down the fast-paced motion of the markets, letting us see the ebb and flow of the economic tides over long periods of time.
There are several versions of the chart on the web site. We call your attention to two of them: one, called "Tax-Payer Real" is the S&P 500 index including dividends and transaction costs adjusted to reflect the net return after inflation and taxes (see details on taxes below). You will not see this one in a mutual fund sales presentation. The second is called "Tax-Exempt Nominal." It assumes your money is all in tax sheltered retirement accounts, there is no inflation (thus "nominal"), and you don't pay taxes when you take out your money. This is the "long run" numbers you are most likely to see in marketing brochures. (You can view other versions of the chart which show "Tax-Payer Nominal" and "Tax-Exempt Real" at www.CrestmontResearch.com)
Let's take a moment to explain the layout of the charts. There are three columns of numbers on the left hand side of the page and three rows of numbers on the top of the page. The column and row closest to the main chart reflect every year from 1900 through 2002. The column on the left side will serve as our start year and the row on the top represents the ending year. The row on the top has been abbreviated to the last two numbers of the year due to space constraints. Therefore, if you wanted to know the annual compounded return from 1950 to 1973, look for the row represented by the year '1950' on the left and look for the intersecting column designated by '73' (for 1973). The result on the version titled "S&P Index Only" is 6, reflecting an annual compounded return of 6% over that 23 year period. Looking out another 9 years the number drops to 2% for an after tax, inflation adjusted return over 32 years.
There is a thin black diagonal line going from the top left to the lower right. This line shows you what the returns are 20 years after an initial investment. This will help you see what returns have been over the "long run" of 20 years.
Also note the color of the cell represents the level of the return. If the annual return is less than 0%, the cell is shaded red. When the return is between 0% and 3%, the shading is pink. Blue is used for the range 3% to 7%, light green when the returns are between 7% and 10%, and dark green indicates annual returns in excess of 10%. This enables us to look at the big picture. Whereas, long-term returns tend to be shaded blue, shorter-term periods use all of the colors.
As well, note that our original number 6 mentioned above was presented with a black-colored font, while some of the numbers are presented in white. If the P/E ratio for the ending year is higher than the P/E for the starting year-representing rising P/E ratios-the number is black. For lower P/E ratios, the color is white. In general, red and pink most often have white numbers and the greens and blues share a space with black numbers. The P/E ratio for each year is presented along the left side of the page and along the top of the chart.
Lastly, there's additional data included on the chart. On the left side of the page, note the middle column. As well, on the top of the page, note the middle row. Both series represent the index values for each year. This is used to calculate the compounded return from the start period to the end period. Along the bottom of the page, we've included the index value, dividend yield, inflation (Consumer Price Index), real GDP, nominal GDP, and the ten-year annual compounded average for both GDP measures. For the index value, keep in mind that the S&P 500 Index value for each year represents the average across all trading days of the year.
Along the right, there's an arbitrary list of developments for each of the past 103 years. In compiling the list of historical milestones, it's quite interesting to reflect upon the past century and recall that the gurus of the 1990's actually believed that we were in a "New Economy" era. Looking at the historical events, it could be argued that almost every period had a reason to be called a "New Economy." But that's an argument for another chapter.
The Investment Matrix Revelations
As we consider the story that the matrix begins to tell, several observations are initially apparent. There are clear patterns of returns relating to the secular bull and secular bear cycles. The periods of red and pink alternate with periods of blue and green. Once the new period starts, it tends to persist for long periods of time. Though the very long-term returns have been positive and near average, investment horizons of ten years, twenty years, and even longer aren't long enough to ensure positive or acceptable returns.
Note also that we've recently completed the longest run of green (very high market return) years in the past century. Though we've had a couple of down (red) years lately, it has hardly helped to restore the long-term average to "average." We have quite a distance to go to complete what the mathematicians refer to as "regressing to the mean." As you look back over the past 100 years, there has never been a period where "the red bear" stopped after a few short years and morphed into a "green bull."
Secondly, when you look at the Taxpayer Real, which is what you experience in your actual accounts, you will notice that the returns tend to be in the 3-5% range after long periods of time. Often real returns are 2% or less over multiple decades. Again, the charts clearly show the most important thing you can do to positively affect your long term returns is to begin investing in times of low P/E ratios.
The Matrix assumes an estimate of each year's taxes at the then current rates over this period (details below). We are aware that the income tax did not exist in 1901. This was a tricky number to assume, as taxes on stocks are comprised of both long term and short term gains, and are taxed at different rates for different times. Some of you pay additional state taxes. While we estimated taxes for each individual year, the average over time was about 20%.
Why not just assume all long-term gains? If you buy your stocks through mutual funds, as most individuals do, then you are probably seeing a lot of turnover in your portfolio. Remember Peter Lynch of Magellan fame? His reported average holding period was about 7 months during the 70's. Some of you will pay higher taxes, and some of you will pay lower, depending upon your investment styles. The recent average we assume is around 20%.You can adjust your expectations accordingly.
Now, what can we learn from these tables?
First, there are very clear periods when returns are better than others. These relate to secular bull and bear markets. No big insight there. But what you should notice is the correlation with P/E ratios. In general, when P/E ratios begin to rise, you want to be in the stock market. When they are falling, total returns over the next decade will be below par. (More on that phenomenon below.)
With the exception of WWII, when these periods of falling P/E ratios start, they just keep going until the P/E ratios top out. Generally, this topping period comes prior to a recession.
Can you use the P/E ratios to signal a precise turn from a secular bull to a secular bear? No, but you can use them to assist you in confirming other signals. And once that turn has begun, the historical evidence is that the trend continues. Investors are advised to change their stock investing habits. As noted above, there will be bear market rallies which will momentarily halt the decline of the P/E ratios. These always end as reversion to the mean (trend) is simply too strong a force.
Second, the Investment Matrix shows the high probability that a secular bear is currently in progress. High and falling P/E ratios, along with negative returns, are always associated with the beginning of such markets. When you let your eyes follow along the tables, you can see those "red" periods when annual gains were negative. Look at the corresponding P/E ratio. If it is high, it historically has correlated with the beginning of a secular bear, which always takes years to work itself out. Fighting this trend is frustrating at best.
Continued ... |
