May 21, 2017

Last week I mentioned the 20 year CAPE ratio, a modification of economist Robert Shiller’s 10 year CAPE ratio used to evaluate the stock market. This week I’ll again look at equity valuation from a different perspective. The results surprised me.

The date of our birth is circumstance. When we retire is guided by our own actions and the circumstance of an era. We have no control over market behavior during the twenty year savings accumulation phase before we retire or the distribution of that savings during our retirement. Let’s hope that we live long enough to spend twenty years in some degree of retirement.

The state of the market at the beginning of the distribution phase of retirement can have a material effect on our retirement funds, as many newly retired folks found out in 2008 and 2009. Some based their retirement plans on the twenty year returns prior to retirement.

I’ll use the SP500 total return index ($SPXTR at stockcharts.com or ^SP500TR at Yahoo Finance) to calculate the total gain including dividends. The twenty year period from 1988 through 2007 began just after the stock market meltdown in October 1987 and ended just as the 2007-2009 recession was beginning in December 2007. The total gain was 742%, or 11.3% annualized. Sweetness! Sign me up for that program. Those high returns led many older Americans to believe that they didn’t need to accumulate more savings before retirement. Then came the double shock of zero interest rates and a 50% meltdown in stock market valuation.

Now let’s move that time block one year forward and look at the period 1989 through 2008. Still good but what a difference one year makes. The total gain was 404%, or 8.4% annualized. That’s a drop of 3% per year! Investors missed the 16% bounce back in 1988 after the October 1987 crash, and the time block now included the 35% meltdown of 2008. There was even more pain to come in the first half of 2009 but I’ll come back to that.

1995 through 2014 was a good period with total gains of 550%, or 9.8% annualized. Shift that time block by two years to the period 1997 through 2016 and the gains fall off significantly. The total gain was 340%, or 7.7% annualized.

We can make a rough approximation of total returns during the late 1970s and into the 1980s, an ugly period for equities. In 1980, someone quipped “Equities are dead.” Twenty year periods ending during this time did not fare so well but still notched gains of more than 6%. Bonds, CDs and Treasuries were paying far more than that at the time. In today’s low interest environment, 6% seems a lot better than it did during the double digit inflation of 1980.

In past weeks I have written about the overvaluation of today’s stock market based on trailing P/E ratio and the smoothed 10 year CAPE ratio. Let’s look at the current valuation from the perspective of this twenty year return. It would come as no surprise that the total twenty year gain hit a low at the end of February 2009 when the market was about a 1/4 of its current valuation. That 20 year annualized gain was 5.7%. What surprised me was that the current valuation shows the same 20 year gain! Using this metric as an evaluation guide, the market sits at a relatively low level just like it was in 1988 and 1989.

The historical evidence shows that stock returns may be erratic but consistently make over 5% over a twenty year retirement period. Those who are newly retired or about to retire might understandably desire more safety. The safest approach is not to suddenly shift one’s portfolio entirely to safe assets.

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**Income Inequality
**

Much has been written about the growth of income inequality. The GINI coefficient is the most popular but there are other measures (for those who want to get into the weeds of inequality measures). The Social Security Administration offers a simple indicator of the trend. They track the average and median incomes of millions of earners every year.

When the median and average are fairly close to each other, that indicates that the numbers in the data set are uniformly distributed. As the ratio percentage of the median to the average falls, that indicates that a few big numbers are raising the average but do not raise the median.

Here’s a simple example of an evenly distributed set. Consider a set of numbers 1, 2, 3, 4, 5, 6. The average is 3.5. The median is also 3.5 because there are three numbers in the set below 3.5 and three numbers above 3.5. The percentage of the median to the average is 100%.

Let’s consider an unevenly distributed set: 1, 2, 3, 4, 5, 12. The median is still the same value as the earlier example: 3.5. But the average is now 4.5. The ratio of the median to the average is 3.5 / 4.5 = about 78%.

The ratio of the median to the average income has fallen from 71% in 1990 to 64% in 2015. This indicates that there is a growing number of large incomes in our data set.

Here’s the data in a graph form

Median wages have doubled, or grown by 100%, while average wages have grown by more than 150% in the last quarter century.

Next week I will look at a hypothetical income tax proposal based on income. It might just blow your mind.

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**Dividend Payout Ratio
**

FactSet Analytics grouped dividend paying stocks in quintiles (20% bands) by the dividend payout ratio (Chart). This is the percentage of profits that are paid to shareholders in the form of dividends. Over the last 20 years of rolling one month returns the stocks that had the highest and lowest payout ratios had the lowest total return. Think about that. Both the highest and lowest quintiles did the worst. What performed the best? Those stocks that were in the middle quintile, the companies who balanced their profit distributions between investors (dividends) and investment (future sales and profits).

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**CWPI
**

Each month I compute a Constant Weighted Purchasing Index built on a combination of the two Purchasing Manager’s surveys (PMI) each month. For the six month in a row, this composite has shown strong growth and the three year average first crossed the threshold of strong growth in January 2015.

A sub-index composite that I build from the new orders and employment components of the services survey (NMI) shows moderate growth. Its three year average has shown moderate growth since early 2014.

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