US (S&P 500) Stock Market – January 2010 Update

To try and squeeze some more performance out of a retirement investing strategy that is heavily focused on asset allocation I am using a cyclically adjusted Price / Average 10 Year Earnings (PE10) ratio for the S&P 500 to value the US (specifically the S&P 500) stock market. The method used is that developed by Yale Professor Robert Shiller. Background information here.

Chart 1 plots the Shiller PE10. Key points this month are:
- Shiller PE10 = 21.0 which is up from 20.6 last month. My UK Equities target asset allocation therefore drops from 18.3% to 18.1%. Additionally my International Equities target asset allocation drops from 13.1% to 12.9%.
- Shiller PE10 Average (1881 to Present) = 16.4
- Shiller PE10 20 Percentile (1881 to Present) = 11.0
- Shiller PE10 80 Percentile (1881 to Present) = 20.6. The Shiller PE10 has now passed through the 80 Percentile.
- Shiller PE10 Correlation with Real (ie after inflation) S&P 500 Price = 0.78

Chart 2 further reinforces why I am using this method. While the R^2 is low there appears to be a trend suggesting that the return in the following year is dependent on the Shiller PE10 value. Using the trend line with a PE10 of 21.0 results in a 1 year expected real (after inflation) earnings projection of 4.4%.

Chart 3 plots Real (after inflation) Earnings and Real Dividends for the S&P 500. Real Dividends are still falling however they are still above their long term trend. Real Earnings have a roller coaster ride continually, particularly since about 1990. If the Standard and Poors forecast earnings are to be believed however we continue to be above the long term earnings trend. These forecasts maybe aren’t so good though with the year getting off to a bad start – profits at Alcoa (the first to report for 2010) down and Chevron also announcing lower fourth quarter profits than forecast.

Assumptions include:
- Q1 ’09 & Q2 ’10 earnings are estimates from Standard & Poors.
- Inflation data from the Bureau of Labor Statistics. December ‘09 & January ‘10 inflation is extrapolated.
- January ‘10 dividend is estimated as December ‘09 dividend.
- Prices are month averages except January ‘10 which is the 11 January ’10 S&P 500 stock market close.
- Historic data provided from Professor Shiller website.

Methods to Calculate Historical Market Returns – Arithmetic Means versus Compound Annual Growth Rates

When I described previously how I was building my low charge investment portfolio and forecasting potential future retirement dates it turns out that in mathematics terms I have generally been using arithmetic means to calculate percentage returns from various data sets. That means I've taken the yearly percentage change for each entry of the dataset, summed these values and then divided by the number of items in the dataset.

It looks like this might be too bullish a method and instead I potentially should be using the compound annual growth rate (CAGR) which is the smoothed annualised gain. The formula is CAGR = (End Value/Start Value)^(1/number of years)-1.

Let me demonstrate with an example. At the end of year 0 your index is worth 100, by the end of year 1 your index has increased to 200 and then by the end of year 2 your index has decreased to 150. Using the arithmetic mean the mean annual return is (100% [year 1 gain] + -25% [year 2 loss])/2 = 37.5%. This can’t be correct as you don’t have 100 x 137.5% x 137.5% = 189 at the end of year 2. Now using the CAGR the return is (150/100)^(1/2)-1 = 22.5%. Checking this 100 x 122.5% x 122.5% = 150.

Let me now calculate a stock market example, the real (ie inflation adjusted) S&P 500 for the period January 1871 to January 2009. Using the arithmetic mean we get an average annual real price increase of 3.7% and an average annual real dividend of 4.5% for an average annual real return of 8.2%. Now using the CAGR (more complicated to calculate as I had to first calculate a real total return for the S&P 500) for an average real return of 6.7% which is significantly less than the 8.2% arithmetic mean calculation.

I'm now considering calculating real CAGR returns for my (S&P 500, ASX 200 and Gold) datasets and using these when projecting my retirement dates and amounts.

As always I would be very interested to hear others experience here.

You might also be interested in calculating portfolio year to date returns, annualised returns or multiple year returns.

How Much Am I Saving For My Retirement

My retirement investing strategy is focused on getting to a point where work can become optional as quickly as possible. Some would call this retirement. My thinking is that you never know what life is going to throw at you and by being financially independent at least it gives you choices.

To enable this to occur I do two things. Firstly, I live extremely frugally except occasionally I will also enjoying myself on a specific I consciously choose. Secondly, I always pay myself first. What this means is that as soon as my salary enters my account my retirement investing allocation is immediately moved to the appropriate location and I force myself to live on the remainder. If this means beans on toast at the end of the month then so be it. It would be so easy to spend first and then save later. However my thought is that there would be unlikely to be anything left to save at the end of the month as companies today have made it so easy to spend. I can really see how people get into this trap.

Additionally as pay rises are given (unfortunately usually only inflation matching) I always try and allocate this extra to my retirement strategy rather than increasing my standard of living. This means where I live is not as ‘nice’ as where my peers live, my television is not as large and I eat at home more but that’s the choice I have made in exchange for financial independence in the future.

Even where I am today, while not having yet reached retirement, I am happy knowing that if I lost my job tomorrow I would be ok. It’s amazing how liberating this is.

So what does this mean in terms of retirement savings per month? You hear about people saving 10 to 15%. If you save only this amount it’s going to be a long time before you get the retirement option. In my instance the UK government will take 23% (income tax and national insurance) and I will spend 17% on day to day living. This means I am left with about 60% of my earnings going to my retirement investing strategy. I am serious about financial independence and I intend to keep this up until I reach my goals. With a fair wind this is about 7 years away.

7 years is a short period of time meaning most of my final retirement pot will come from direct savings rather than the compound interest effect. If you are prepared to wait a lot longer for financial independence then compound interest may have time to work its magic meaning potentially less direct contribution from you.

Government Bond Yields are Rising

I monitor the government bond yields of three countries (Australia, United Kingdom and the United States) and they are all rising. My chart today shows the month end (except the last point which is the 08 January 2010) 10 year bond yields since 2007.

Why are they rising? Comparing Australia and the UK I think for different reasons.

As an outsider I think Australian bond yields are rising because the country is being run relatively prudently by the Reserve Bank of Australia and is raising interest rates as they are serious about keeping inflation at 2-3% over the cycle. The cash rate set by the RBA is now 3.75%. Savings account interest rates are also rising and without too much difficulty it is easy to find an instant access bank account paying 4.25%. So it makes sense for Bond yields to be rising to the 5.76% today.

I think United Kingdom bond (gilt) yields are rising for very different reasons:

Reason 1. I have shown previously that inflation is rising and it appears to me as though the Bank of England is going to hold interest rates at 0.5%, ignore their inflation target of 2% and start to let debts be inflated away which I discussed here. This seems to be reinforced by the Pension Fund of the Bank of England who have 88.2% of assets devoted to Index-linked gilts and other government guaranteed index-linked securities and 10.9% to fixed-interest gilts and other government guaranteed fixed-interest securities. This is up from 70.7% and 22.3% respectively in 2008. Buyers of government debt will however expect a real (after inflation) return on their investment and so if inflation rises then gilt yields must also rise.

Reason 2. The 2009 pre-budget report stated that UK government borrowing would be 12% of gross domestic product (GDP) in 2010/2011 and still a crazy 9.1% in 2011/2012. The Office for National Statistics reported on the 22 December that Q3 2009 GDP was £315.5 billion. Extrapolating this indicates that borrowing in 2010/2011 will be £150 billion and in 2011/2012 will still be £110 billion. To find buyers for all this debt (particularly if the Bank of England stops quantitative easing) you are going to have to attract them with increased yields.

Reason 3. The UK government are yet (and for that matter the Conservatives also) to explain how they are going to reduce the levels of borrowing. So far they have done nothing more than rearrange the deck chairs on the Titanic. If this continues the credit worthiness of the UK is going to be downgraded meaning yields will have to rise.

Reason 4. Those who already own government bonds and can see what’s happening will start to sell their holdings putting yet more gilts onto the market. This issue is real with the world’s biggest bond investor , Pimco, has started to sell off its holdings of gilts. More gilts coming to the market will mean gilt prices falling which will then mean rising gilt yields.
So what does this mean for my retirement investing strategy?

Firstly, if I owned gilts I’d be considering selling. As I’ve described previously I don’t own fixed interest gilts so I’m ok here. I do own index linked gilts but with inflation kicking off I’m comfortable with this.

Secondly, I’ll be watching house prices carefully. The interest rates on mortgages will have to rise as those wanting to borrow for a house will effectively be competing with the UK government for funds. I can’t see how house prices can continue to rise with increased borrowing costs and this could turn out to be the catalyst that brings on a reduction in house prices.

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The Bank of England Decides – Punish the Prudent

For the eleventh month in a row the Bank of England decided to keep the Official Bank Rate at 0.5%. This is the lowest rates have been even if I look back to the year 1694. Even during the Great Depression the Bank Rate only went as low as 2%. My first chart today shows the rates going back to 1948 showing just how low the Bank have set rates compared with recent history. Additionally, the Bank also decided to continue with its £200 billion quantitative easing program with £7 billion left to spend.

To me it looks as though the Bank of England decided today to punish the prudent and to reward the reckless. Who are the reckless? Well they are those who maxed out on as much credit as they could, whether to buy houses or plasma televisions. Who are prudent? Well they are those who didn’t extend themselves and decided to save for their future. I put myself into this category as I’ve decided to save for my retirement by investing with money I have earned.

What makes me think the bank has made this decision? As I’ve already identified previously inflation is starting to take off. Annualised UK Consumer Price Index (CPI) is currently 1.9% and the UK Retail Price Index (RPI) is currently 0.3%. The second chart however shows the true inflation story. As of November while the 12 month figure is 0.3% (as published by the ONS) disturbingly the 6 month figure is 3.6% and the 3 month figure is 4.1%.

By keeping the Bank Rate at record lows, quantitative easing and other factors like the return of VAT to 17.5% can only push inflation higher. I think the Bank has decided to take the inflation route. Allow those with debts to have them magically inflated away while those with assets see them devalued.

Why did I decide to take responsibility for my own future?

Australian Property Market – January 2009 Update

I intend to keep a close eye on Australian house prices as I build my retirement portfolio. This is because Australia is a very likely retirement possibility (if not sooner) for me.

The first chart shows the quarterly Real (adjusted for the Consumer Price Index) Brisbane and Real (again adjusted for CPI) Australian Eight Cities (Sydney, Melbourne, Brisbane, Adelaide, Perth, Hobart, Darwin & Canberra) House Price Index with data taken from the Australian Bureau of Statistics catalogue 6416.0 since 1991. This Index was reset in 2003/2004 and so I have “corrected” pre March 2002 data by taking the ratio’s of the pre and post September 2003 to June 2004 data as a multiplier. This chart carries data only until September 2009 and clearly shows a nice dip at the start of 2009. Could this be the Bull Trap phase of my second chart with us now nearing the Return to “Normal” phase?

My third chart shows Real Annual Changes in price from 1995 to present. In Real terms over this period Brisbane has seen average increases of 5.2% and the Australian Eight Cities has seen average increases of 4.8%. Unfortunately for me though the trend lines (particularly for Brisbane) continue to head upwards.

In non-inflation adjusted terms over the period Brisbane prices have seen average increases of 8.1% and the Australian Eight Cities prices have seen average increases of 7.6%. Unfortunately if you don’t already own a property (or three) you continue to be priced out when compared with average earnings. Using the Australian Bureau of Statistics catalogue 6302.0 which looks at average weekly earnings shows that Total Weekly Earnings has only increased by a yearly 3.8% and Total Full Time Adult Earnings by 4.3%.

My fourth chart shows what happens when house prices continue to rise at a rate greater than salaries. Over this period affordability of Brisbane houses when compared to Adult Full Time Weekly Earnings has gone from a low of 0.063 to 0.125 meaning affordability has halved and the Median Eight Cities houses have gone from a low of 0.064 to 0.113 which is a huge reduction. This type of shift is just not sustainable but when will the market turn? Will Australia raising interest rates and reducing first home buyer grants be the catalyst. Only time will tell...

The Burj Dubai and Real Estate Cycles

The Burj Dubai has been all over the press in the past couple of days as it had its grand opening. What an engineering spectacle! The tallest building in the world at over 800 metres tall with more than 160 stories and a luxury hotel designed by Giorgio Armani. So what do I think? I think of a great book entitled “The Secret Life of Real Estate : How it moves and why” by Phillip Anderson which states that “the world’s tallest buildings have a consistent habit of being completed right at the top of the real estate cycle ... producing for us – at least so far – the most reliable indicator of an approaching peak”.

Anderson also suggests a 24 Hour Real Estate Clock where hours 1 to 16 take approximately 14 years during which time property values rise reaching a peak and then hours 17 to 24 takes approximately 4 years during which time property values fall. I'll work through an example using a dataset that I’m closely following – raw (not adjusted for inflation) Nationwide UK Historical House Price shown in the chart above.

Anderson suggests that from the previous cycles low, the first 7 years will see property increase in price before a mid cycle recession. Using the Nationwide figures I'll call the low November 1992 and I'll call the recession start April 2000 which is 7 years and 6 months. During this period property increased in value by an average 6.5% per annum. So that fits.

I'll suggest using the Nationwide figures that there was a 6 month mid cycle recession during which time property increases slowed considerably and rose by 1.62% over that 6 months. Still positive as inflation for that 6 months was 0.9%. So that fits.

There is then a second 7 year cycle (completing the first 16 hours of the 24 hour clock) which starts from the onset of the mid cycle recession. During this second cycle property increases at a greater rate than during the first cycle. I'll call this peak October 2007 which is 7 years and 6 months. During this period property increased in value by an average 11.9% as predicted by the Anderson model. So that fits.

Now the fun begins with the 'Keynes crash phase' which runs for 4 years. Using this model we should come back and look at property in October 2011. What are highlights of this cycle - foreclosures and bankruptcies increase (yes!), stocks enter a bear market from past highs (yes!), credit creation institutions reverse policies (yes!), economic activity stalls (started but then QE began, I think we may still be here), wipe out of debts/stagnation (still needs to occur), wreckage is cleared away (still needs to occur) and finally stocks start climbing (they have but was it caused by QE and we are in for another big drop?) then the 18 year cycle can begin again.

As I’ve detailed previously I am yet to buy myself a flat or house. The above indicates that maybe I won’t get the opportunity until late 2011 or so...

2009 Yearly Retirement Investing Portfolio Review

Edited 06 June 2010: I have found more exact data allowing me to determine benchmark returns to the day.  I have therefore updated the data in this post to reflect this.  As the blog has developed I have also changed the method used to calculate the returns as I have learnt more accurate methods.  I started with:
- [assets at end of period – assets at start of period – new money entering portfolio] divided by [assets at start of period],
- then used the mid-point Dietz which was a more accurate method,
- and now use Excel's XIRR function for anual returns.  If it is not a full year I then adjust XIRR by the PRR (Personal Rate of Return) = [(1+XIRR Annualised Return)^(# of days/365)]–1.
In those post I also used incorrect weightings for the benchmark portfolio.  It should have been 72% stocks/28% bonds as per here.
Apologies for the confusion but I'm learning here too.
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2008 was a bad year for my investment portfolio and by year end the 02 January 2009 I was -19.7% -15.7% using [assets at end of period – assets at start of period – new money entering portfolio] divided by [assets at start of period] as my return calculation method. 2009 also started badly and at one point in March my portfolio was -12.4% and we weren’t even a quarter of the way through the year. As everyone knows the markets then started recovering and I rode the wave to end the year at period 02 January 2009 to 31 December 2009 at +21.5% +24.9% including fees.

Gold Within My Retirement Investing Strategy – January 2009 Update

Within my Retirement Investing Strategy I currently hold 2.6% of my portfolio in gold with a targeted holding of 5%. Gold is the only portion of my portfolio that does not provide some sort of yield (dividends, interest etc). So why do I hold it?

The first chart shows the Real price of gold since 1968 with it becoming quickly obvious that it can be a wild ride. The first reason I hold gold is demonstrated by drawing a trend line through the dataset which provides the formula Real Price = 1.37 x Year -2120. This suggests a trend Real price in 1968 of $573 and a trend real price in 2010 of $630. So provided you don’t buy during one of the scary boom periods this suggests that gold has the potential as a good long term place for me to protect myself from inflation.

The second and very important reason I hold gold is that the correlation between the Real S&P 500 (also displayed on the first chart) and Real gold is negative at -0.34. The second chart provides the ratio of the S&P 500 to gold demonstrating just how far apart the two can vary. So my thought here is that there will be some opportunities where stocks will be overvalued but gold will be cheap (and I can buy) and vice versa. Over the long term maybe I can then squeeze some more performance out of my portfolio.

For the moment I don’t know what to do with gold. I’m certainly not selling what I already own as it’s a long way from its historic Real highs however I’m not sure whether to buy any more as it’s also a long way above its historic trend line...

Stock Market History – The Great Depression Compared with Today

So a second great depression has been avoided... Most countries are out of recession... The stock markets are headed upwards again...

All wonderful stuff except I just don’t feel comfortable with the above chart showing progress from the Real (prices adjusted for inflation to present day) peak in 1929 taken from the Shiller dataset and comparing that with the Real (again inflation adjusted) peak in 2000 for the S&P 500. The correlation between these two periods is currently sitting at 0.65.

Is the stock market out of the woods yet?

UK Property Market – December 2009 Update

I am yet to buy myself a flat or house even though the ownership of one is important to my retirement investing strategy in the longer term. The reason for this is in my opinion UK property is overvalued by a huge margin. Although given the press reports I sometimes feel as though I am the only one in the UK who thinks property can go up as well as down. Chart 1 shows compared to average earnings that property is very expensive when a ratio is created of the Real Nationwide Historical House Prices to the Average Earnings Index (LNMM) and it is for this reason I have yet to buy. In 1996 this ratio was as low as 607 and today the ration stands at 1,188. If we were to return to that number the average house using the Nationwide Index would be £82,929. Will we ever get that low again?

Yesterdays BBC headline states ‘House prices rise by 5.9% in 2009, says Nationwide’. I guess it depends on how you look at the data. According to my interpretation of the Nationwide data set house prices fell by £661 over the past month.

Chart 1 also shows Nationwide Historical House Prices in Real (ie inflation adjusted) terms. I’d like to compare it to Chart 2 above. Is this small decrease a one off or is it the ‘Return to “normal”’ phase of Chart 2 kicking in? Only time will tell but I’m still out for now.
Chart 3 shows the annual change in Nationwide property prices and compares this with the change in the average earnings index extrapolated a couple of months to match the Nationwide time period as LNMM is still only released to October 2009. It shows that on an annualised basis average earnings have turned negative at -1.7% while house prices continue upwards at that BBC quoted 5.9%.

That said, I think Chart 3 also shows clearly the problem we have. Since 1991 the UK Retail Prices Index (RPI) has averaged 2.8% annually. The Average Earning Index has averaged 4.1% for a real increase over inflation of 1.3%. What justifies this 1.3% - have we become more efficient? Now here’s the problem. The Nationwide dataset has increased by 5.8% annually for a real increase of 3% over inflation. How can this be? Has it become so expensive to build a new house? I believe the answer is no. It is pure asset price inflation. Of note also is that as time has progressed the trend line for house prices is heading in an upwards direction.

What’s causing this? I believe that when an economy is run with too loose a monetary policy you will see increases in one of two places – either inflation for goods / services will kick in or you will get asset price inflation. Our supposed experts who control the economy only look for the first one and control interest rates based on this. What we saw this economic cycle was inflation controlled with no care for the huge asset price inflation that was occurring. This has meant extraordinary bubbles in property, share markets and even commodities (what was oil $147 barrel?). These markets then started correcting themselves and we started to see asset price deflation. How have our experts responded? With even looser monetary policy which is resulting in new bubbles inflating in share markets (I showed yesterday that the S&P 500 is already at its 80th percentile based on historic data) and property. Why do they not try and control inflation with interest rates but value asset prices (for example, the Shiller PE10 has a good correlation with prices and could be used for share markets, ratio of prices to earnings could be used for property) and control this by, say, changing banks minimum capital ratios as suggested by Smithers? Maybe this would stop the large boom and busts we have seen in recent years.

With inflation now kicking off will the Bank of England increase interest rates and stop this property boom or will they allow inflation to occur at the expense of savers? Right now I’m backing the second and so I will protect myself with inflation linked products wherever possible.