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Strategies & Market Trends : Graham and Doddsville -- Value Investing In The New Era -- Ignore unavailable to you. Want to Upgrade?

To: Axel Gunderson who wrote (482)	7/9/1998 5:49:00 PM
From: porcupine --''''>	Read Replies (4) \| Respond to of 1722

Very interesting analysis, Axel. I probably should repeat more often that I am assuming that most of us have an investment time horizon of at least 20 years or so. And, I am also assuming that most of us are adding to our portfolios annually, thereby taking advantage of a dollar-cost-averaging-type effect. I don't think there is any 20-year span in stock market history when dollar-cost-averaging into an Index product would not have outperformed any other asset class -- even if one were to begin just before the onset of a major Bear Market. Further, given the narrowness of the leadership in the Index (only about 50 out of 500 stocks), it seems to me that the relative advantage of undervalued stocks is increasing in favor of enterprising investors, if they are patient (a big "if", I admit).

To: Axel Gunderson who wrote (482)	7/9/1998 8:42:00 PM
From: Freedom Fighter	Read Replies (2) \| Respond to of 1722

Axel your analysis was excellent. Here's some more thoughts! <<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<< Wayne, I agree with you that the market is overpriced. But something is missing in the above - the relative attractiveness of competing asset classes. Since the beginning of 1970, the differential between the implied return (6.3% growth + dividend yield) and the long bond yield has averaged 1.85%. As of the close Friday it was at 2.10%, i.e. >>6.3% (growth) + 1.4% (dividend yield) - 5.6% (long bond yield) = 2.10% <<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<< You make a very good point, but the way you are calculating the implied growth rate is incorrect. At least I do it differently. The 6.3 % was just a starting point for demonstration purposes for this business cycle. This cycle had relatively low inflation. In actuality profit growth tracks nominal GDP over the "long haul". So for most of the time in your sample, the implied growth rate of earnings was higher than the 6.3% you used, all else being equal. (inflation was higher and so was nominal GDP growth) So as a result, the difference between stocks and bonds was also higher than you calculated. You are certainly correct about the late 70's and early 80's though. This is where it gets a little complicated. There is substantial evidence that the risk premium between stocks and bonds changes with the level of inflation. At high and "rising" levels of inflation the risk premium narrows dramatically. The reason for this is that stocks offer some inflation protection due to their ability to raise prices if inflation continues to rise. New investment by companies can also be at ONLY higher expected returns to compensate for the higher cost of capital. Bond holders have no such luck and face much more serious loss of purchasing power if inflation keeps rising. A a result, bond holders insist on returns closer to those that stocks offer in periods of uncertain inflation. I find this logical. It is also verified by a couple of studies I have seen. On the other hand, as inflation declines closer to zero, the unexpected now includes DEFLATION, not just a lower rate of inflation (which benefits both stock holders and bonds holders). In a deflation, stock holders can get killed but bond holders make out like bandits. So as we get closer to zero inflation, the risk premium between the asset classes should expand. The 40's, 50's and early 60'are an excellent example of this. Deflation was still in people's minds in those days. The difference between classes was huge. Sometimes as high as 8%. This is also verified and logical. I hope this helps a little. My original post was mostly just using a very simplified model to make a point in my discussion. What we have now is very interesting. Inflation expectations are now 1.7% (it just dropped) and GDP growth estimates are between 2.5% and 3%. That means that nominal GDP growth is expected to be between 4.2% and 4.7% over the next 10 years. 4.2 +1.5 = 5.7% 4.7+ 1.5 = 6.2% Neither has much risk premium. Both offer less than high grade corporate bonds. Certainly this is below the long term average risk premium. Especially for a period when some people are taking about deflation. The one difference in this period is that companies are not paying out all their free cash in dividends like they used to. So if the highest ROE in history is sustainable, "profits per share" will grow faster than the above estimates by some small amount. (maybe 1%) The difference between stocks and bonds would still be very low and below historical relationships. I hope this helps or at least provokes some more thought. I prefer using the real rate method instead of the stock bond method for these reasons. The real rate on bonds also varies for other reasons that are too long for this discussion. Maybe next time. On the tax issue, I do always include it in my estimates of what to do. I never include it in my discussion because it is different for everyone. Check this out though. I live in NYC. That means 20%-28% federal capital gains tax (depending on holding period), about 8% state taxes, and about 5% city taxes. This brings my capital gains tax rate to between 33% and 41%. Government bonds are state and city tax exempt. My average capital gains tax bill is higher than my bill for bond interest. Wayne members.aol.com