Archive for the ‘Uncategorized’ Category

Stocks With Strong Potential Earnings Boost From Trump Tax Plan

Friday, December 9th, 2016
  • Companies that have low effective tax rates due to current “tax loop holes” may find their effective tax rate rise (and profits decline), even if nominal corporate tax rates decline, because “tax loop holes” may be closed to pay for the tax rate change
  • Companies that have effective tax rates near the nominal rates, would likely see their effective tax rate fall (and profits rise), if nominal corporate tax rates decline
  • Searching for companies that may benefit from a tax rate decline, and are otherwise potentially attractive is a useful exercise
  • We found 22 stocks among all listed with favorable yield and valuation attributes that may provide interesting Trump tax plan return potential
  • We found 100 stocks in the S&P 500 with effective tax rates from 30% to 35% that would like benefit significantly from a corporate tax reduction
  • 34 of those 100 S&P 500 stocks are in current up trends.

Our search for stocks with favorable yield and valuation was of all listed US stocks, for those with these characteristics:

  • 7-year cumulative effective tax rate greater than 30% and less than 36%
  • 12-mo trailing dividend yield greater than 2%
  • PEG ratio less than 2
  • 12-mo trailing shareholder yield (dividend yield + buyback yield) is no less than dividend yield (no share issuance).

There are companies with tax rates  much higher than the nominal rates.  Those cases are too complicated for this simple search, and that is why we limited the effective tax range to less than 36%.   The 30% minimum is to find those with a substantial potential benefit from a corporate tax rate reduction.

These are the 22 companies that came through the filter criteria:

DE Deere & Company
HMC Honda Motor Co Ltd (ADR)
ETH Ethan Allen Interiors Inc.
PII Polaris Industries Inc.
HOG Harley-Davidson Inc
AFL AFLAC Incorporated
LM Legg Mason Inc
PDCO Patterson Companies, Inc.
IPG Interpublic Group of Companies
TEO Telecom Argentina SA (ADR)
AMX America Movil SAB de CV (ADR)
HRB H & R Block Inc
GATX GATX Corporation
IX ORIX Corporation (ADR)
AEO American Eagle Outfitters
M Macy’s Inc
PAG Penske Automotive Group, Inc.
BBY Best Buy Co Inc
MINI Mobile Mini Inc
NSC Norfolk Southern Corp.
CPPL Columbia Pipeline Partners LP

These are the metrics for each company, along with the Standard and Poor’s Capital IQ ratings for 12-months forward (“stars”) and fair value:

(click image to enlarge)





This table presents the trend condition of those 22 stocks, using the QVM 4 Factor monthly trend indicator.

A rating of 100 is for the leading end of the major trend line moving up.  A rating of zero is for the leading end of the major trend moving down. A rating of 50 is for the leading end of the major trend line in transition between trend directions.  At the bottom of this article, there is an explanation of how the QVM 4 Factor indicator works.



The median tax rate among S&P 500 stocks that have positive 7-year cumulative tax rates is 30%, and the average is 24%.

Our search among S&P 500 stocks simply eliminated those with 7-year cumulative effective tax rates below 30% and greater than 35%.  We found 100 such stocks shown in this table:


Thirty-four of those 100 stocks are currently in up trends as measured by the QVM 4 Factor monthly trend indicator, as follows



Companies currently with effective tax rates below the 20% rate that is often mentioned in Washington for the next Congress, may find their effective tax rate rising and profits declining, if the “tax loopholes” they have relied upon are repealed to pay for a new lower corporate tax rate.  Companies with rather full effective tax rates (such as those in between 30% and 35%) in our filter, would likely find their effective tax rate dropping and profits increasing under a new lower corporate tax rate.

Currently low effective tax rate companies with high valuation multiples would possibly see the double effect of declining profits and declining valuation multiples.

Currently high effective tax rate companies with high valuation multiples may see support for their multiples as their profits increase as their taxes decline.

If a company with a current 35% tax rate (with a 65% after-tax income rate) goes to a 20% tax rate (with an 80% after-tax income rate), that would be a 23% increase in profits.  That profits increase could offset a similar decline in valuation multiple, that might be triggered by a general multiple contraction in the broad market.

All-in-all that suggests to us that overweighting stocks of companies that would most strongly benefit by a corporate tax rate reduction, and a underweighting stocks whos effective tax rates might increase as a result changes in the tax law is a reasonable idea.

Within these two lists, there should be good hunting ground for strong Trump tax plan beneficiaries, that may be suitable for you.

Post Script: How the QVM 4 Factor Trend Indicator:

A quick summary is in the graphics below.  A more expanded discussion is at this link.


Rational Risk Retirement Withdrawal Strategies – Part One of Three

Thursday, October 13th, 2016

[ this is a letter we sent to clients on September 9.  It discusses a retirement issue important enough that it should be shared with the investing public ]

In our September 8th post, we discussed the outlook for lower portfolio returns over the next 10-20 years due to reversion to the mean from the above mean returns of recent years – a factor that has particular importance to those near or in retirement.

We promised to discuss withdrawal strategies in follow-up communications. We begin that discussion here.

Most people will be surprised to learn how much money they will need in their portfolio at retirement to provide a retirement lifetime of financial support for their lifestyle in a rising cost environment. That will become clear as you read this letter.

This letter is Part One of three letters on retirement portfolio withdrawal strategies.

  • This letter examines the “4% Rule”, probably the most widely known rule-of-thumb for safe maximum retirement withdrawal, and an X% derivative of the rule.
  • Part Two will examine other withdrawal strategies, including variations of the 4% rule; and examine a portfolio of mixed taxable and tax deferred accounts and tax-exempt income.
  • Part Three will discuss retirement asset allocation strategies during the withdrawal stage of financial life.

Key Factors in Success or Failure of a Retirement Withdrawal Strategy:

  • Life expectancy (number of years of needed withdrawals)
  • Changes in cost of living
  • Withdrawal rate
  • Expected portfolio mean return
  • Expected portfolio volatility
  • Portfolio asset allocation
  • Taxable status of portfolio and withdrawals.

All of these will come under consideration over the three letters.


Typically an uncomfortable subject, but life expectancy is an integral part of retirement withdrawal strategy selection and design. So let’s quickly put some broad parameters on that and move on to the next factor.

There are differences in life expectancy based on age, gender, lifestyle, family history, and current health/disease profile as examples. However, for the purposes of this discussion, let’s start with the Social Security Administration national tables that merely consider attained age and gender. An extract from that table with round numbers for attained ages in 5-year increments from 50 – 75 as the starting ages for retirement is as follows:


(click images to enlarge)


From this it appears that strategies that last from roughly 10 to 35 years may be needed in retirement.

The problem is those life expectancies are means, and you may not be average. Not everybody dies in their 80’s. There is a distribution of shorter lives and longer lives around those means. Some people live into their 90’s. It may well be appropriate to plan on living to 95, just in case – so you do not live longer than your portfolio.

Just imagine setting up a plan that is expected to work until age 85 – and it does work until 85 with $1 left in the portfolio – then you live 10 more years (on family or state assistance).

When thinking about “safe maximum withdrawal”, death at age 95 is a better choice than a population level life expectancy table.

The IRS is more practical that way, because for their Required Minimum Distributions (RMDs), which begin at age 70, they start the distribution of your IRA assets with withdrawals at a 27-year rate (to age 97).

As a rule-of-thumb, assuming life to age 95 is probably a good idea. So, based on your age at retirement, these are good starting points for modeling a portfolio and withdrawal strategy:



Let’s be square about it. The longer you assume you may live, the less you can withdraw per year to avoid the “risk of ruin” (outliving your assets), but part of a “safe maximum” withdrawal rate is assuming a maximum life expectancy.


The 4% Rule is probably the most widely suggested withdrawal strategy. It was popularized after a 1994 article by William Bengen in the Journal of Financial Planning.

The Rule: The retiree in the first year of retirement would withdraw a fixed amount equal to 4% of the portfolio assets (e.g. $40,000 from a $1 million portfolio). Each subsequent year, the retiree would increase the fixed amount withdrawal by the rate of inflation of the preceding year; and never take less than the prior year withdrawal amount.

Bengen based the rule on this set of assumptions:

  • age 65 retirement
  • 30 year withdrawal period to age 95
  • withdrawals from a tax deferred retirement (non-taxable rebalancing; and ordinary tax on distributions)
  • no transaction or management fees
  • assets allocated 50/50 between US stocks (S&P 500) and bonds (US 10-year Treasury bonds)
  • the 10 year bonds were purchased at the beginning of each year, sold at the end, followed by the purchase of new bonds for the next year.

Example: with a $1 million portfolio, withdraw $40,000 (4%) in the first year, and then if inflation were 3%, withdraw $40,000 X 1.03 ($41,200) in the second year; and so on with inflation adjustments throughout retirement. In the 30th year, the withdrawal would be $94,263 (inflation raises needed income to 2.36 times original withdrawal amount) . So the portfolio has to perform to support the growth in withdrawals.

The portfolio must have growth components to maintain spending power. For various life expectancies with the long-term average 3% inflation (the approximate long-term average) the terminal withdrawals would be these multiples of the initial withdrawal amount:

  • 10-years: 1.30 X
  • 15-years: 1.51 X
  • 20-years: 1.75 X
  • 25-years: 2.03 X
  • 30-years: 2.36 X
  • 35-years: 2.73 X
  • 40-years: 3.67 X

With the 4% Rule there is an approximate 93% chance of success, meaning the portfolio lasting throughout the 30 years (7% chance of failure, portfolio being exhausted before 30 years).

Note well, that all of the calculations in this letter are before investment costs. It is critical that the sum of transaction costs, fund expenses and advisory fees are kept as low as possible. If effect, they are part of your cost of living and reduce the sustainable amounts you can withdraw from your portfolio in retirement.

You may retire at a different age, have a different tax status of your assets, and a different portfolio allocation; which may justify or require a different percentage than 4%.

We will examine variations in length of withdrawal, stock/bond allocation and beginning percentage withdrawal in the next section (the X% Rule).


Let’s generalize from the 4% rule, and acknowledge that for different circumstances and investment assumptions, different percentages could be applied to the same logic structure as the 4% rule: an inflation indexed, fixed amount withdrawal, beginning with a certain percentage of the beginning portfolio.

Figure 3 is based on applying the X% rules (from 3% to 7%) to the actual annual returns of 11 different allocations between the S&P 500 (or large-cap precursors) and US 10-year Treasury bonds from 1928 through 2015 (88 years of actual annual returns).

This period included the Great Depression, WWII, periods of high and low inflation, the period of steeply rising interest rates into the early 1980’s and the declining interest rates since then, and the DotCom crash and the 2008-2009 stock market crash.

You can see that a 3% rule worked for a 40 year retirement for all allocations, except the 100% bonds allocation, and a 4% allocation worked for 30 years for all allocations except either 100% bonds or 100% stocks.

A stock/bond allocation of between 50/50 and 80/20 gave the best results.



Figure 4 from 1972 -2015 (44 years) was selected to ignore the Great Depression and WWII, and to specifically experience the huge run up in interest rates to the early 1980’s and the long period of declining interest rates to the end of 2015.

A 3% initial withdrawal rate worked for a 40 year retirement for all of the asset allocations. A 4% initial withdrawal rate worked for a 30 year retirement for all asset allocations except 100% bonds, and 10% stocks/90% bonds.




Let’s see how the X% rule might be expected to work using Monte Carlo simulation based on historical return and inflation data from 1972 to 2015 (44 years).

Monte Carlo will be described below, but for the moment understand that it is a method to explore thousands of plausible portfolio returns to test how withdrawal strategies might work.

We examine the general method of the 4% Rule, but with variations at 3%, 3.5%, 4%, 4.5%, 5%, 5.5% 6.0% . 6.5% and 7.0%; and tested all of those initial withdrawal rates ability to survive without complete portfolio exhaustion over multiple periods of 15, 20, 25, 30, 35, and 40 years – 9 different withdrawal rates tested over 6 different periods of years (54 scenarios).

What the results suggest is that if you want nearly 100% confidence (based on history) of not outliving assets over 30 years, 3% initial withdrawal is about as far as you should go. If you want to toss the dice a bit, and possibly have a 7% chance of outliving your portfolio (a 93% success rate) then 4% could be attempted. If you are totally ill-advised and chose to withdrawal 6.5%, you have less than a 50% chance of success.

The table further shows that the shorter the number of years the portfolio is expected to last, or the lower the initial withdrawal rate, the lower the “risk of ruin” (outliving the portfolio).

Some people have commented that these data are silly, because they believe they know of people who have been retired for years and taken out a lot more than 4% indexed for inflation and have done well, and their portfolios are larger than when they started. Maybe so and maybe not, but not with these or similar core assets. We would bet that if all the facts are known, few if any people beat these odds. We will discuss asset allocation in Part Three.




Monte Carlo Simulation is a computerized method of using random selection of returns to construct huge numbers of plausible portfolio outcomes (instances), and then to see the frequency distribution of results of those portfolio instanced to understand what is most likely, and how far from the mean some results may end up.

Specifically in the case of the table above in Figure 5, the computer created 10,000 instances of the 50/50 portfolio for each of the 54 scenarios in the table above (540,000 portfolio instances)

Because there were 44 annual returns for each of stocks and bonds from 1972-2015, the computer could randomly chose between 1,936 possible stock and bond return combinations for each of the years in each instance of each scenario. And, because there were also 44 possible inflation values to choose at random each year in each instance of a scenario, there are 85,184 possibilities results per instance.

In all the computer made over 30 million random selections of individual annual returns and inflation levels for portfolio assets to assemble the probabilities in the table in Figure 5.

The 10,000 portfolio simulations of each scenario were compiled in a statistical distribution to determine success probabilities. From practical experience with the software, repeating simulations over and over seldom resulted in a different success rate, and when it did a few times, the variance was only 1 percentage point.

Suffice is to say for now, that Monte Carlo simulation is a well-established method of attempting to examine risk and opportunity.

Here are the annual returns data used in the random selection of stock and bond returns for the portfolio simulation:



And here are the inflation data points in the random selection for the annual increase in the withdrawal:



If you care to look more into Monte Carlo simulation, a good place to start is Wikipedia.

Before moving on to see how the X% Rule might work in the lower expected return world of the next couple of decades, let’s look at more of the data that came out of the simulation of the 4% Rule over 30 years with a 50/50 portfolio.


First, for the 4% rule, although 7% (700 of 10,000 iterations) of the portfolio failed to work (portfolio did not last 30 years with a positive balance), 93% did last.

Specifically, 75% of instances began with $1 million, took out an inflation indexed $40,000 (initial 4%) and ended up with at least $2.3 million after 30 years; and 25% ended up with more than $8.8 million; and 50% ended up with more than about $5 million.

So why not take out a lot more than 4%. You could, but let me quote Clint Eastwood in the 1971 movie “Dirty Harry” pointing his Smith & Wesson 0.44 magnum revolver at a bad guy (that is the metaphor for betting that you will not be in the 7% who outlived their assets): “Do you feel lucky? Well Do ya?” That is the question.

By the way, if you are old enough to remember the movie, you are probably old enough to retire. If not, you probably have years to go before this is a big issue for you, but this data can give you good clues to how much you need to accumulate to have the retirement you desire.



When Does the 4% Rule Begin To Fail in a 50/50 Portfolio Based on Historical Data?

This chart of failure points shows the 4% rules in a 50/50 portfolio working well through about 20 years, but then more and more instances failing until it reaches 700 failures (7% failure, or 93% success).



What Is The Distribution of Return Outcomes In This Instance?

While the median outcome is around a $5 million ending portfolio, the range is $0 to $21 million; but there are very many more zero outcomes than very high ones (7% at zero)



What is the Distribution of Maximum Drawdowns in this Instance?

Definition: A maximum drawdown is the maximum portfolio value change from a peak to a trough of a portfolio, before a new peak is attained.

It looks like a good 5% or so of the outcomes could have maximum drawdowns in the negative mid-30%, with the average maximum drawdown of about 26% and the median drawdown about 17%. However, note that around 5% also drawdown to zero (presumably, those near the end of the portfolio life for those 7% that do not last as long at 30 years).




Now let’s look at a 20-year time horizon. That is the longest period for which we can find future return expectations from a recognized institutional source. This will create some informational value for those with a 20-year horizon — those 75 years old, or perhaps those with illnesses that make a 30 year horizon unrealistic. Primarily, however, a 20-year horizon allows us to compare a future view of lower returns with actual historical periods when using the X% rule.

The tables in Figure 12 examine the success rate of inflation indexed fixed dollar amount withdrawals over 20 years representing the 5 generic allocations. Those 5 allocations circumscribe the mostly likely range of most retirement portfolios (30% stock/ 70% bonds, 40/60, 50/50, 60/40 and 70/30). They are generic because they involve only two US assets; S&P 500 and 10-year US Treasury bonds. Other asset selections may be more appropriate for specific retirees, but these generic portfolios are useful to study the withdrawal strategy. Part Three of this letter series will discuss asset allocation choices.

The rows of each table present Monte Carlo simulations based on different historical periods of time ranging from 94 years from 1928-2015 to 10 years from 2006-2015; and simulations based on the 20-year forward view of returns published by McKinsey Global Institute, “Why Investors May Need to Lower Their Sights” (April 2016). We presented information about the McKinsey 20-year forward view (along with other essentially corroborating institutional view) in our September 5th letter.

The conclusion we draw is that lower expected returns, also means lower safe withdrawal rates in retirement.

The columns of each table present the success rate (not outliving assets) for each withdrawal rate (from initial 3% to 7%) for simulations based on different historical asset performance periods, and one future 20-year period of expected asset returns (the McKinsey view). The bottom row of each table is based on the McKinsey forward view of lower return from 2016-2036.

What do we see?

  • 3% works well (100% to 99% — dark green shaded) for all historical allocations; and for the McKinsey lower return future for the 30/70/ 40/60 and 50/50 allocations, but slightly less than well (97% to 98% – light green shaded) for the 60/40 and 70/30 allocations for the McKinsey lower future returns
  • 3.5% works well for almost all of the historical allocations, but slightly less than well for all of the McKinsey lower return future allocations.
  • 4% mostly works mostly well for the 30/70, 40/60 and 50/50 historical allocations, but slightly less than well for the 60/40 and 70/30 historical allocations; and works slightly less than well for all of the allocations for the McKinsey lower future returns
  • 4.5% works mostly slightly less than well for all of the historical allocations, except for the 70/30 where is works only moderately in great part (lower 90’s, shaded yellow); and it works poorly (less than 90%, shaded in degrees of pink to red) for all of the allocations for the McKinsey lower return futures
  • 5% works mostly moderately for historical allocations, except for the 70/30 which tends toward poorly; and poorly for McKinsey lower return futures.
  • 5.5% and greater allocations, run into success rate problems pretty much across the spectrum of history and allocations

The 4% rule essentially holds up under Monte Carlo simulation with historical data, but the comfortable success probabilities drop back to 3.5% if the McKinsey lower return futures discussed in our September 8th materialize.




For 1972-2015, the actual annual returns were the possible random choices (see Figures 6 and 7).

For the other historical periods and the McKinsey forward view, only the return and standard deviation parameters were provided; and the computer randomly generate returns with a mean equal to the specified mean and with a standard deviation equal to the specified standard deviation as shown in Figure 13 below. The inflation rate was constant as listed in Figure 13.




Best to bet your survival on the workable withdrawal rates from a tested strategy (such as in this letter), and hope that the markets are generous leaving a large estate to your beneficiaries. Also, just as we are told these days to think of multiple jobs or careers, maybe we should think of multiple retirements.

Joyously, if the markets are so generous that our portfolios are growing substantially, perhaps “re-retiring” every 5 years or so, could rationally allow for an upward adjustment. And sadly, it the markets are punishing, we may have to consider “re-retiring” at a lower withdrawal rate than our initial retirement rate; or foregoing some of the inflation increases to our withdrawals.

So, how much money do you need to retire?

In really rough terms, if all of your money was in tax deferred accounts, and you expected to need a 20 to 30 year retirement, you would need portfolio assets in the neighborhood of 25 to 33 times the annual pre-tax income you require from the portfolio. That multiple will vary based on different facts, including the mix of taxable and tax deferred assets and tax exempt income; and the specific assets you hold, But as a yardstick, first cut, back of the envelope form of retirement readiness testing – ask yourself how much pre-tax equivalent income you need from the portfolio and multiply that by 25 to 33 to get a rough idea of needed investment assets. You either have to save and invest until you reach a good multiple, or scale back spending expectations.

For the young investor, keep the 25 to 33 multiple in front of you as you lay out your plans and execute your savings and investment.

In Part Two, we will look at other withdrawal strategies, and discuss the significance of taxable and tax deferred accounts (and RMDs), and tax exempt income in the withdrawal strategies; and in Part Three, we will look at retirement asset allocation strategies for retirement.


The models in this post are based on portfolios consisting exclusively of the S&P 500 and 10 year Treasury bonds — not a recommendation, just the basis of most safe retirement withdrawal models.

The bonds can be purchased directly from the Treasury or from a broker, but are sold through a broker.

The three leading ETFs for the S&P 500 along with their expense ratios are:  IVV, expense ratio 4 basis points; VOO, expense ratio 5 basis  points; and SPY, expense ratio 9.5 basis points.

There are, almost unbelievably, load mutual funds out there charging a 5% front sales commission load with annual expenses of 150 basis points (typically with a 25 basis point annual payment to the sales person).  First, you would have to be nuts to purchase one of those when you could purchase IVV, VOO or SPY with costs approaching zero.  If anyone ever proposes you buy a load S&P 500 fund or one with a large expense ratio, run do not walk from that, and assume that the balance of their ideas are equally not good for you (but great for them).  Second, you could not come even close to the withdrawal rates in this post if you owned such funds.

Remember the sum of fund expenses and advisor fees are effectively part of the cost of living in retirement.  Those are a direct take-away from the amount you can withdraw reasonably safely.


Why Investors Need to Lower Long-Term Portfolio Return Expectations

Thursday, September 8th, 2016
  • Long-term (10+ years) balanced portfolio returns expected to be in 4% to 5% range.
  • Intermediate-term Treasury yields are foundational rates for setting required rate of return for bonds generally, stocks, real estate and many other assets
  • Stocks earnings yield is more useful in comparing stocks to bonds than stocks P/E; by evaluating spread between earnings yield and Treasury yield
  • Stacking Fed Funds rate, 10-year Treasury premium to Fed Funds, and stocks premium to 10-year Treasuries implies long-term GAAP P/E range of 12.5 to 20 versus current 25.2
  • Dividend yield-to-Treasury yield was important for valuation for decades; then lost investor interest for decades; and may once again be gaining prominence as part of stock market valuation.

The broad consensus is that portfolio returns over the next decade will be significantly lower than the last decade, and even the last several decades. Institutions and professional prognosticators have varying explanations as to cause, and varying estimates, but few disagree that return expectations must be tempered.

Generally, it appears that the consensus centers around an expectation for a balanced stock/bond portfolio to generate somewhere in the 4% to 5% total return over the next decade.

McKinsey & Company (a leading management consulting firm) published a May 2016 report titled “Diminishing Returns: Why Investors May Need To Lower Their Expectations”. They presented historical return data showing more recent returns higher than longer-term returns, and discussion of multiple factors that suggest a reversion to longer-term return levels is baked in the cake. If you care to read the 60 page report it can be downloaded here.

This table presents historical annualized total nominal return data for US large-cap stocks and intermediate-term US Treasuries from the McKinsey report for 100 years, 50 years and 30 years; and also for Vanguard mutual funds focused on those same assets for 15 years, 10 years, 5 years, 3 years and 1 year. It also provides our calculations of how various stock/bond allocations would have worked out over those time periods.

The loud and clear implication of the data is that very recent returns are well above multi-decade returns, which in turn are above 100 year and 50 year returns. The cries out MEAN REVERSION as a likely process to drive portfolio returns over the next decade or more. The short-term could be anything, high or low, but the long-term is likely subject to a gravitational pull of very long-term returns.

This letter looks at Treasury interest rates and earnings yield-to-Treasury yield spreads as an explanation of why mean reversion must occur.

(click images to enlarge)


The McKinsey study sees the next 20 years producing US stock returns of 6.0% to 6.5% and 10-year Treasury bonds producing returns of 2.0% to 2.5% in a slow growth environment (the more likely case); or 8% to 9% for stocks and 3.5% to 4% for bonds in a growth scenario (the less likely case).

In their base case, taking the mid-point of their ranges, a 50/50 portfolio would therefore be expected to produce about a 4.25% total return over the next 20 years.

That will not support the assumptions built into the pension funds backing millions of retiree pensions, or the low level of annual pension funding by corporations, unions and governments for their defined benefit plans. Nor will it produce the kind of end of work-life assets in 401-k plans that were part of the expected result of switching from defined benefit plans to defined contribution plans (other than relieving employers of a cost and liability).

Pension plan sponsors will have to pay in a lot more, or defaults may occur. Individuals will have to save and invest a lot more, or retirement income security goals will not be met.

For example, according to a leading pension plan consulting firm, Callan & Associates, the average long-term return assumption for the nearly $4 Trillion of state pension plans is 7.62%. That is a far way from the 4% to 5% expected for a plan vanilla 50/50 balanced portfolio. For the past 10 years those state plans averaged 5.8%, but for the past 25 years they averaged 8.3%.

Individuals will now need a lot more saved up for retirement too (the subject of our next client letter).

  • Bill Gross, who is quite concerned about things not working out well as interest rates normalize, sees balanced portfolios generating something in the vicinity of 4% to 5% over the next 10 years.
  • Vanguard founder John Bogle sees US stocks returning around 4% to 5% over the next decade, and aggregate corporate and government bonds returning around 2.5% (about 3.25% to 3.75% for a 50/50 balanced portfolio).
  • There are some very Bearish thinkers out there such as GMO lead by Jeremy Grantham. They see nominal returns over the next 7 years of about negative 1% on US large-cap stocks, and about negative 0.1% on US government bonds (negative 0.55% for a 50/50 US large-cap stocks/Treasury bond allocation).
  • BlackRock (world’s largest money manager), State Street (sponsor of SPDR funds), and JP Morgan see long-term US large-cap stock returns of 5.1%, 6.0% and 7.0% respectively; and US aggregate bond returns of 1.9%, 2.8% and 4.25% respectively. The average of their views is 6.0% for stocks and 3.0% for bonds; and about 4.5% for a 50/50 stock/bond portfolio. That effectively predicts mean reversion to the approximate 100-year and 50-year returns published in the McKinsey report.


10-year Treasury rates, the effective benchmark rate for so many purposes, is at the lowest level since 1871 (135 years).

The closest rates came to this low level was during World War II, but they just basically touched 2%. As of last Friday the bond yielded 1.60%; and on July 5, 2016 the yield hit its all-time low of 1.37%.

Given that about 1/3 of developed markets government bonds have negative yields (the investor pays the government for the privilege of borrowing the money from the investor for years at a time) it is not impossible that US Treasuries have meaningful yield downside left, but that is not likely; and would indicate much greater problems with the economy and corporate profits and stock prices. Right now German 10-year is negative 0.05%, the Swiss 10-year is negative 0.52%, and the Japanese 10-year is negative 0.02% — and they have been lower.

The chart below shows the monthly history of the US 10-year rate for 135 years. It shows the 135-year median yield as 3.88% and the 50 year median as 6.30%. We should think of those as gravitational forces, not necessarily to be reached any time soon, but as exerting a strong long-term mean reversion force for rates to rise rather than fall.

Since the peak of interest rates in 1982, the large decrease in rates over those 30+ years has provided a capital gain tailwind to bonds (bond prices rise when market yields fall). That tail wind could possibly be a small gust if rates fall further briefly, but the prevailing winds will be for upward movement in rates, which will create downward pressure on bond prices, which will subtract from the yield component of total return.

So Treasuries (the basis of virtually all other investment required rate of return decisions – meaning stock price multiples, real estate capitalization rates, and mortgage rates as examples) are a key element in evaluating the prices of other assets.

Bonds generally are likely stay at current levels until Fed Funds rates begin to rise. There is a possibility of further Treasury yield declines, but they would likely be short-lived and of small magnitude. For the long-term, yields will rise toward historical levels and mute the returns from bonds.



The common parlance uses P/E multiples (price divided by earnings) to describe stock valuation – how much you pay today to buy a current $1 of company earnings. A more useful ratio is the “earnings yield” (E/P = earnings divided by price) – how many earnings dollars the company is producing per dollar of purchase price at the time of purchase.

Why is E/P better than P/E? Because, it is easier to compare a bond yield to a stock yield, than to compare a bond yield to a stock price-to-earnings ratio. If you are good with math and work with the numbers all of the time, maybe either comparison is easy, but earnings yield compared to bond yield is immediately clear. By subtracting the bond yield from the earnings yield, you get the “yield spread”.

When the yield spread is positive (stock yield higher than bond yield), stocks tend to be more attractive than bonds. When the yield spread is negative (stock yield lower than bond yield), bonds tend to be more attractive than stocks.

Of course on an individual stocks basis, there are massive differences in credit quality, growth prospects, management effectiveness, etc., which overwhelm the yield spread question; but on a total market basis the yield spread is a particularly important relative value consideration. Earnings growth prospects are still important, but over the long-term growth trends to an average and the yield spread may say a lot, if not more, about long-term stock price appreciation potential.

So what does the US large-cap stocks (S&P 500 and precursors) yield spread say about stocks appreciation potential?

This chart shows the rolling yield from 1871 through mid-2016.

Over the full history, the yield spread median was 2.87%, and over the last 50 years the median was negative 0.54%. As of mid-2016, the yield spread was 2.53% — essentially at the 135 year median and way above the 50 year median.. That suggests that stocks are probably reasonably prices relative to interest rates. Yes, stocks have high P/E ratios, but bonds have low yields, and now we can see quantitatively, instead of just qualitatively, that stocks and bonds are moving in a logical way relative to each other.

Certainly, one could argue, and I do, that with the poor showing for earnings growth, a secondary level of review suggests stock are still expensive.

That argument is countered, though, by those who believe the 2017 and 2018 earnings growth forecasts. Those forecasters expect earnings to be put back on track, As of 06/30/2016 the trailing reported GAAP earnings for the S&P 500 were $86.88 (down for 5 quarters in a row, the last time being 2009, and the time before 2001), but the data provided by Standard and Poor’s looks forward to $113.86 by 06/30/2017 (a 31% increase), and $122.10 by 12/31/2017 (a 41% increase 18 months from now).

Those projections are highly (actually massively) dependent on an oil price recovery. I’m still from the “Show Me” state of Missouri on those forecasts.



So, if stocks are “fairly” valued relative to 10-year Treasuries, why all the doom and gloom about long term stock returns?

The problem is that if stocks are in line with current interest rates, and if interest rates are bound to rise, and if stocks continue to be in line with interest rates, then stock returns would be subdued going forward (either by a significant drop followed by rebuilding, or a path of price growing more slowly than earnings until the yield spread returns to a reasonable level). Of course, you can see from the chart that yield spreads vary widely, but when thinking about the long-term it is important to thinks about medians and averages.

The GAAP earnings yield right now is 3.97% ( P/E = 25.2) and the yield spread is 2.37%. The long-term yield spread is somewhere between the 2.53% of the past 135 years, and the negative 0.54% of the past 50 years (mid-point = about 1.5%).

So if the 10-year Treasury were to recover to say 4% (based the Fed Reserve “dot plot” forecast plus the typical yield spread between the Fed Funds rate and the bond), then US large-cap stocks would need to have an earnings yield between about 6.5% (P/E = 15.4; generally thought of as a reasonable long-term fair multiple) and 3.5% (P/E = 28.6) to be in the 135 year to 50 year range.

A 15 P/E multiple is a lot more plausible than one of 28. A change from a P/E of 25 to one of 15 would be either a drop in price of 40%, or rise in earnings of around 67%, or combination.


Over the past 60 years, the 10-year Treasury yield has been 2.5% or more above the Fed Funds rate when the Fed is stimulating and/or times are good and rates are rising with a strong economy. The spread narrows to zero or less when the Fed puts on the brakes; and that presages a recession.


The Fed Funds rate like the 10-year Treasury is at historic lows, and the Fed is evaluating when to let it “normalize”. This chart shows the long history of the Fed Funds rate.


In their published “dot plot” the Fed shows the separate opinions of the Fed presidents who are members of their decision committee.



Somewhere between P/E multiples of roughly 12 and 20 (likely y 15 to 16) is in the store long-term for stocks (earnings yield of 5% to 8+%)..

The Fed sees 1.5% for the Fed Funds rate by the end of 2017. That plus 2.5% would imply a 4% 10-year Treasury, and all that may mean for bond prices and stock prices.

Add into your thinking the 3% Fed Funds rate they see long-term, and the 5.5% 10-year Treasury that implies for the long-term, and the 5% to 8% earnings yield (based on 50-year ad 135-year median spreads), and you see long-term P/E ratios from 20 to 12.5 for US large-cap stocks – both multiples significantly lower than today.

Of course, the growth rate of earnings factors is important too (P/E divided by Growth Estimate – PEG), but over a full business cycle growth should move to long-term trend. Whether the world economy is slowing for this or that reason (such as the demographics of aging populations as a slowing factor; or the rise of emerging markets middle class as an accelerating factor) is yet to be unfolded.

In our next letter we will discuss the implications for these possible futures on necessary savings for retirement, portfolio withdrawal rates in retirement, and several different approaches to withdrawal management.


It is still unclear how much the stocks dividend-to-Treasury yield will play in the long-term in the price setting process. As you can see from this chart, for almost 90 years, stocks had dividend yields equal to or higher than Treasury yields – generally spreads of 0% to 4%, with a lot around 2%.


That made sense for two important reasons. First, investors felt they needed to receive cash-on-cash continuing returns for the risk they took investing in stocks with no guarantee of return of capital; and second, they did not want to have to sell their investment to make a return – because what fool would have wanted to buy a piece of paper that did not result in a cash-on-cash return during ownership (Oops! Maybe that argument applies today too?!).

Then in the late 1950’s modern portfolio theory came about, basically stating that it was tax inefficient to pay corporate tax and then dividends received tax; and that corporate managements had better opportunities and better judgement to invest corporate profits on behalf of the owners. That retention of all cash flow in turn would amplify the growth in value of the company and produce larger capital gains upon sale of the stock. So somehow investors collectively drank the cool-aid and allowed management to withhold dividends and reinvest the cash, turning stock investing significantly more toward measuring earnings than measuring dividends to value stocks.

Before that time the definition of value was the Dividend Discount Model (how much is the present value of the expected dividend stream worth discounted into perpetuity).

However, once investors got duped (sorry, I meant convinced) that receiving dividends wasn’t all that important, the valuation approach became discounting into perpetuity the earnings or cash flow of the company that the investor would never receive.

That approach to valuation reduced management accountability to shareholders, by removing the strong discipline that paying dividends while building the company imposes. Management was then more free to build the company often times in ways more beneficial to their own compensation or egos of the executives, than to the ultimate benefit of shareholders. Managements put forth all manner of earnings overstated by “unusual” and “one-time expenses”. Eventually, the analysts who in many cases had employers whose bread was buttered by representing the companies being analyzed, began to put forth valuations based on “operating earnings” that focused on the earnings excluding the “unusual” and “one-time” expenses, that seemed to occur in different forms every year anyway — you know, except for this or that billion dollar write down, everything is good.

Paying dividends requires more executive discipline and stronger capital management than not paying dividends.

Then inflation took off big-time and those dividends that were being paid could not keep up, forcing the dividend-to-Treasuries yield spread into negative territory where it remained for about 50 years. However, as inflation subsided allowing Treasury rates to moderate, the yield spread improved, due to a combination of declining interest rates and rising dividends.

Now we are back to dividend yield and Treasury yields close to each other with dividend yield ahead – 10-year Treasuries yield about 1.6% (ordinary tax rate) and the S&P 500 yields about 2% (lower dividends tax rate). That is mostly because the Fed has suppressed Treasury yields so much, but also because more and more companies are paying dividends than they did before; and more are increasing dividends; and more are seeing investor demand for dividends to support stock prices – at least for many mature businesses.

Clearly, early stage companies can’t pay dividends, and companies with fantastic growth and investment opportunities may actually better serve investors by reinvesting all cash flow, BUT for a mature company with modest growth prospects to withhold dividends to find ways to buy this and that company to achieve non-organic growth (and enrich executives along the way) just doesn’t compute for me.

For investors in pre-retirement and retirement situations, the vagaries of stock market price multiples should be moderated not only by diversifying with bonds and other assets, but also by making sure that the overall basket of stocks owned pay a reasonable dividend, with reasonable dividend growth history and prospects. Trying to live in retirement based on selling assets with volatile prices is not a formula for success.

That said, there has been so much dividend chasing by investors who would have otherwise put the money into bonds, the pickings are not all that great for dividend yield seekers right now.

Assuming that the newly revived investor demand for a share of corporate cash flow in the form of dividends will persist in great part due to the aging population and underfunded retirement portfolios, it may be a reasonable speculation that the dividend-to-Treasuries yield spread will become more important going forward in driving stock price multiples as Treasury yield rise.

If total returns are expected to be lower going forward, and possibly less certain, then investors should be all the more focused on making sure that they get paid along the way when they own stocks.

Single Country ETFs in UpTrends With Better Valuation Than Total US Stocks

Tuesday, August 16th, 2016
  • 16 of 43 single country ETFs are in ongoing uptrends or recent reversals from downtrends
  • 12 of 16 have composite valuation levels lower than total US stocks
  • 8 of 12 produced positive earnings growth in the past 3 years and is forecasted for 1-year forward positive growth
  • 3 of 8 have higher trailing yields than total US stocks

Those three single country funds are for South Korea (EWY), Taiwan (EWT), and New Zealand (ENZL).

Here are the data the 43 ETFs:

(click images to enlarge)


The data is sorted according to the composite valuation, which is the average of the relative valuation for Price/Dividends, Price/Earnings, Price/Book, Price/CashFlow, and Price/Sales.

Relative Valuation in this study is the valuation multiple for the ETF divided by the valuation multiple for total US stocks (as represented by VTI).

All of the other metrics are also relative calculated in the same manner.

The trend rating is based on four monthly factors:

  • direction of the tip of the 10-month moving average (solid gold line in chart)
  • position of the price above or below the moving average (black vertical bars in chart)
  • price change vs a geometric pace -Wilder Stop & Reverse (red dotted lines in chart)
  • buying or selling pressure (dashed green line in chart)

The upper panel of the chart plots the trend rating over time with rating of 100, 50 or 0.

Here is chart data for the three filtered ETFs, made with Metastock and code we developed in-house:




EWT 2016--8-15


ENZL 2016-08-15

These are additional charts made with; shown the monthly price performance, 10-month moving average, ratio of the ETF performance to SPY (the leading S&P 500 proxy), and the Stock Charts Technical Rating (“SCTR”).

The upper panel in red is the technical rating. The middle panel in blue is the performance relative to the S&P 500.  The main panel shows the monthly performance and the 10-month moving average.

The South Korea and Taiwan trends are developing, and the New Zealand trend may be peaking or ready for a pause, based on the StockCharts technical ratings.

ewy 460 2106-08-15

ewt 460 2106-08-15


enzl 460 2106-08-15

BarChart technical ratings differ.  They see Taiwan as being the weakest Buy with the weakest trend direction.  They see Korea and New Zealand as strong Buys.


ewy bc






Standard and Poor’s Capital IQ has a market weight rating on all three, with these underlying rating details:


ewy sp


ewt sp



S&P ranks the top 25% of the ETF universe as Overweight, the middle 50% as Marketweight, and the bottom 25% as Underweight.


The three country funds have significantly different sector compositions:

ewy ewt enzl sector composition


South Korea and Taiwan are heavy in tech, with little or nor real estate or energy.  New Zealand is more balanced with highest concentrations in communications, healthcare and utilities, with no financial services and light on consumer sectors.  They are all in the Asia/Pacific region.

MSCI country index returns have longer data series than some funds that track them.  Here is the gross return in Dollars for Korea, Taiwan and New Zealand:

EWY EWT ENZL index returns

Positioning Bonds Along The Yield Curve For a Fed Funds Rate Increase

Sunday, September 13th, 2015

Too much time and talk is being devoted to when the Fed will make its first Fed Funds rate increase in many years, while too little time and talk is being devoted to how to position for it.

Let’s talk about Treasury bonds as they relate to a future Fed Rate increase, whether it happens next week, in a few months, or later.

Before we do that, let’s look at corporate bonds, which we don’t think are particularly attractive in the short-term.

Corporate profits overall are recently flat to slightly down; with concerns about:

  • what impact a Fed Funds rate increase may have;
  • possible further strengthening of the Dollar to the detriment of corporate earnings
  • fears (we think not well founded so far) of a global recession induced by China or something else.

Those and similar thoughts have resulted in the yield spread between corporate bonds and similar maturity Treasuries to widen.  That puts downward price pressure on corporate bonds relative to Treasury prices.

Figure 1 shows the “credit spreads” for corporate bonds  of various quality levels — the spreads are rising — reducing the appeal of corporate bonds except for the highest quality.

(click images to enlarge)


Bill Gross in his September letter likes cash or 1-2 year corporate bonds best at this time:

“High quality global bond markets offer little reward relative to durational risk. …Cash or better yet “near cash” such as 1-2 year corporate bonds are my best idea of appropriate risks/reward investments. The reward is not much, but as Will Rogers once said during the Great Depression – “I’m not so much concerned about the return on my money as the return of my money.”

For those looking to follow Bill Gross’s opinion for cash or 1-2 year credit bonds, cash is an easy solution; and two investment grade corporate bond ETFs with 2-year average maturities from major sponsors might fit the Gross’s corporate bond idea: CSJ (iShares) and SCPB (SPDRs).

Figure 2  is a price performance chart of CSJ (trailing yield 1.04% ) versus the 2-year Treasury yield (current yield 0.71%):



Rates are more abstract that bond prices.  Figure 3 shows the year-to-date distribution adjusted prices for readily investable corporate bond funds:

  • Vanguard Short-Term corporates (VCSH),
  • Vanguard Intermediate-Term corporates (VCIT),
  • Vanguard Long-Term corporates (VCLT),
  • Ishares High Yield corporates (HYG).

We don’t see anything enticing there, particularly after-tax and inflation.  The short-term bonds did best so far this year.



Looking at corporate bond fund performance versus Treasury bond fund performance, Figure 4 shows short-term corporate bonds a bit ahead of short-term Treasuries, but intermediate-term and long-term corporates behind Treasuries.

It divides the performance of the three Vanguard corporate bond funds in Figure 3 by the performance of these Vanguard government bond funds:

  • Vanguard Short-Term governments (VGSH),
  • Vanguard Intermediate-Term governments (VGIT)
  • Vanguard Long-Term governments (VGLT).



Now on to Treasuries and the Fed.

Figure 5 is adapted from JP Morgan Asset Management, “Guide to the Markets” (August 31, 2015) shows the history of the Fed Funds rate since the stock market bottom in 2003 through now, plus the forecasts by the Federal Reserve Open Market Committee and by market participants.

It shows significantly rising rates over several stock Bull market years beginning in 2003.  It also shows forecasted Fed Fund rates increasing in small increments over a few years to levels which were not problematic for stocks in the past cycle.


FF forecast

But what about the impact on other Treasury rates (and Treasury bond funds)?

Figure 6 (adapted from a yield curve chart from the Federal Reserve) shows the Treasury rates over the range of maturities (the “yield curve”) for September 9, 2015 in comparison to the curve from 2 years prior on September 9, 2013.

The key observations are that 4-year Treasuries (they don’t issue 4-year Treasuries, but a 5-year bond 1 year after issue is a 4-year bond) have been the fulcrum of rate change — with longer rates declining and shorter rates rising.

Readily investable Treasury ETFs are displayed on the curve.  Their placement is approximate because we have the duration for the funds (shorter than maturity) and the maturity of the Treasuries.  It’s probably close enough for illustrative purposes, particularly at the shorter matures.

  • BlackRock: The ETFs on the chart are from BlackRock iShares:  TFLO (ultra-short-term, floating rate Treasuries), SHV (<1-yr Treasuries), SHY (1-3 year Treasuries ), IEI (3-7 year Treasuries ), IEF (7-10 year Treasuries ), TLH (10-20 Treasuries ), TLT (20+ year Treasuries ).
  • State Street: A similar but less granular set of ETFs from State Street SPDRs (not shown) are BIL (1-3 mo Treasuries), SST (short-term Treasuries), ITE (intermediate-term Treasuries), and TLO (long-term Treasuries).
  • Vanguard: The Vanguard ETF set used in Figure 4 also provide low granularity Treasury options: VGSH (short-term), VGIT (intermediate-term) and VGLT (long-term).


Chrono Yield Curve Change 2 years
Figure 7 is set up the same way as Figure 6, but compares the yield curve from now to 1 year ago instead of 2 years ago.  The fulcrum point has shifted down from 4 years to 3 years, but otherwise the situation is about the same — shorter rates higher and longer rates lower.


Chrono Yield Curve Change
The TFLO fund (a floating rate Treasuries fund) has a duration close to zero, meaning it should have minimal price impact from the Fed Fund rate — rather than a price decline, one would expect a yield increase — very small yield to be sure, but an increase nonetheless.  The current yield is17 basis point, but would likely rise to around 40 basis points, when/if the Fed Funds rate rises by 25 basis points.

We don’t have the data, or experience, or wisdom of Bill Gross (hardly anybody does), but from the limited view of these data above, it would seem that (at least for Treasuries) the 3-5 year range might be a bit safer than shorter periods — at least for the next 1-6 months.

If 3-5 year maturities are the fulcrum when the Fed Funds rate rises, then unless the entire yield curve shifts up in a parallel sort of shift, those maturities might experience the least yield change.  At the same time, the shorter maturity Treasuries are more prone to yield adjustment upward (price down).

As for the longer-term maturities, if inflation is not of great concern, and if China induced recession is a continuing fear, and if the Dollar strengthens, then maybe a flow of investments would stabilize if not reduce those longer-term rates.  That however is a speculative possibility, less predictable than that there may be a relatively stable yield maturity fulcrum for which there is some actual data.

Figure 8 from JP Morgan Asset Management forecasts the price impact of a 1% yield change at each maturity level (not 1% increase across the entire curve at one time, but if and when each maturity experiences a 1% yield change).  That is based on some well test math called the “Macaulay duration” formula.

That Macaulay formula is for a quantum change in yields.  If it happens over an extended period, the duration of any particular bond will have shortened by the passage of time, thus reducing somewhat the price impact of each step in the yield increase.

Based on the FOMC and market participants forecasts of the Fed Funds rate rising by about 25 basis points sometime soon, as supposing that the 2-year Treasury maintains its current yield spread to the Fed Funds rate, then Figure 8 suggests something like a 0.5% price reduction in that 2-year Treasury at the first Fed Funds rate increase.  If the yield cure flattens a bit and the yield spread is not maintained, then less than a 0.5% price decline would be expected.

Will the fulcrum hold?  Nobody knows for sure, but it has been relatively stable for 2 years with a lot of rates other than the Fed Funds rate gyrating.


Duration Effect
Figure 9 shows the daily distribution adjusted price changes for each of the iShares Treasury ETFs we saw in the two yield curve charts (Figures 6 and 7).

SHY (the 1-3 year / 1.86 year average duration / 1.85 year average maturity Treasury ETF) has the most stable performance of the lot.

IEI (3-7 year / 4.55  year average duration / 4.78 year average maturity) was more volatile, but with better total return.


Overall, we have “Fed fatigue”.  How about you?  Let’s get over it and make a nominal increase so we can move on to other sources or worry.

Let’s face it, bonds don’t do much for investors at this time.  Cash has price stability, but also has inflation risk (and currency exchange risk).  After tax and after inflation on the yield net of tax, there really isn’t much more benefit than cash in short-term bonds, and bonds have price variability, particularly now.

Longer-term bonds have better after-tax, after inflation yield but much higher price sensitivity to Treasury rates.

Overall, for the next few months, we prefer cash to bonds for tactical reasons.

Some of our customers chose to hold bonds right now, but most do not, However, most hold significant tactical cash.  Those who do hold bonds are in corporate bonds, light on the shorter-term and light on the longer-term, staying somewhere in the lower middle of the curve.


Treasury Dept Warns of “Quicksilver” Risk in a High Valuation Stock Market

Wednesday, March 25th, 2015

The Office of Financial Research at the US Treasury, published a brief on March 17, warning of historically high valuations in the US stock market, and the potential for a sudden and painful drop in prices.  It’s worth a read.

The eventual move by the Fed to raise interest rates, while likely modest, and while at rates well below rates that have not been a problem for stocks in the past, is likely to cause a degree of shock that will create a correction.

The basic argument by the OFR is that when certain ratios reach 2 standard deviation distances above their very long-term averages, they create great risk of a corrective movement back toward the long-term average.  That “mean reversion” tendency is a real thing, but when and whether the reversion takes place is hard to pinpoint.

They make note of the fact that the stock market has seemingly stretched valuations, at the same time that the economy as they describe it is not doing all that well.

The three indicators they present are:

  • Shiller CAPE Ratio
  • Tobin Q Ratio
  • Buffet Market Value to GDP Ratio

The CAPE Ratio (10-year CPI adjusted P/E) is approaching 2 standard deviations, and is at the approximate level of 2007.  The only two times it exceeded 2 standard deviations by this measure was in 1929 and 1999 — both bad years to own stocks.  However, the indicator did not signal the 2008 crash early enough to save a lot of money.


The Q Ratio (replacement cost of plant and equipment of public and private non-financial companies versus their financial statement net worth), is approaching 2 standard deviations.  However, the indicator did not signal the 2008 crash.



The Buffet Indicator (total stock market-cap divided by GNP) is approaching 2 standard deviations.  The indicator may have turned early enough for a close watcher to get out of the way of 2008.


The article goes on to identify other concerning facts, such as:

  • forward P/E ratios in common use having little predictive value
  • valuation arguments based on low interest rates not considering the macro-economic implications of low interest rates
  • historically high profit margins before and after tax
  • total profits 10-year rolling average above the regression trend of the average, and total profits above the 10-year rolling average
  • poor stock returns in years following high valuations
  • high margin debt at historically high percentage of total stock market value.

On a more optimistic note, David Rosenberg of Gluskin Sheff, made a strong statement a few months ago, that virtually all bear markets are preceded by an inverted yield curve (short rates above intermediate rates), and the Fed raising the discount rate.

We think his ideas are more compelling, because they directly deal with the investor alternatives of debt or equity, and the effect of interest rates on the ability of companies and households to borrow and for companies to cover interest expenses.

Looking only at the 2000 and 2008 crashes, we see s0mething a tad different than Rosenberg, but still using his favorite indicators (the yield curve as implied by the 2yr-10yr Treasury yield spread; and the Federal Funds Rate).

This weekly chart shows the Fed Funds Rate in the top panel (blue), the 2yr-10yr yield spread in the middle panel (red) and the S&P 500 in the bottom panel, along with its 40 week moving average, and the reported GAAP earnings per share.

Here is what we see.  When the S&P 500 falls below its 40 week average AND the yield curve has been flat (1.00 on scale) and then begins to steepen, AND the Fed Funds Rate begins to fall; that coincided with the tops.  We are not anywhere near those conditions now.

However, history does not repeat — it only rhymes; and there has not been a period in the US in the past like this one.  Perhaps investors are so used to zero interest rate policy that they will panic once debt starts to pay a little more.  We’ll see.  What do you thin?

(click to enlarge)