Australian 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 PE ratio for the ASX 200 to attempt to value the Australian Stock Market. The method used is based on that developed by Yale Professor Robert Shiller. I will call it the ASX 200 PE10 and it is the ratio of Real (ie after inflation) Monthly Prices and the 10 Year Real (ie after inflation) Average Earnings. For my Australian Equities I will use a nominal ASX 200 PE10 value of 16 to equate to when I hold 21% Australian Equities. On a linear scale I will target 30% less stocks when the ASX 200 PE10 average is ASX 200 PE10 average + 10 = 26 and will own 30% more stocks when the ASX 200 PE10 average is PE10 average -10 = 6.

Chart 1 plots the ASX 200 PE10. Key points this month are:
ASX 200 PE10 = 18.8 which is up from 18.7 last month. My target Australian Equities target is now 19.2% which is down from 19.3% last month.
ASX 200 PE10 Average = 22.9
ASX 200 PE10 20 Percentile = 17.3
ASX 200 PE10 80 Percentile = 27.7
ASX 200 PE10 Correlation with Real ASX 200 Price = 0.82

Chart 2 plots further reinforces why I am using this method. While the R^2 is low at 0.1358 there appears to be a trend suggesting that the return in the following year is dependent on the ASX 200 PE10 value. Using the trend line with a PE10 of 18.8 results in a 1 year expected real (after inflation) earnings projection of 12.5%. The correlation of the data in chart 2 is -0.37.

Chart 3 plots Real (after inflation) Earnings and Real Dividends. Dividends and Earnings are below the trend line. In fact Earnings are now very close to that of Dividends. What this means is that currently Australian companies are using nearly all their Earnings just to fund the Dividends. Yet the trend line suggests typically clear distance between the two with the trend lines running almost parallel. Where is the money for investments going to come from?

As always DYOR.

Assumptions include:
- All figures are taken from official data from the Reserve Bank of Australia.
- January price is the 21 January ’10 market close.
- January Earnings and Dividends are assumed to be the same as the December numbers
- Inflation data from October ’09 to January ’10 is estimated.

A History of Severe Real S&P 500 Stock Bear Markets

Looking at the first chart which shows the real (inflation adjusted) S&P 500 (or its predecessor) stock market I have identified three historic severe stock bear markets. These I am defining as stock markets where from the stock market reaching a new high, they then proceeded to lose in excess of 60% of their real (inflation adjusted) value. These are best demonstrated by the second chart which shows each of these stock bear markets and the fall in percentage terms from the peak. So what were these bear markets.

The first severe stock bear (marked in purple on the chart) market started with a new real high being reached in September 1906. This period incorporated the 1907 Bankers Panic which was caused by banks retracting market liquidity and depositors losing confidence in the banks. This occurred during an economic recession and there were a number of runs on banks and trust companies. Additionally many state and local banks were bankrupted. All sounds a bit familiar doesn’t it? So from the high it took until January 1920 for the stock market to reach a real loss of 60.9% and then until December 1920 to reach its real low of -70.0%. That’s a period of 14 years and 3 months.

The second severe stock bear (marked in blue on the chart) market started with a new real high being reached in September 1929. This is obviously the well known period of the Great Depression. I won’t go into the history here as I’m sure it’s well known by all readers. What is interesting however is that the markets passed through -60% on a number of occasions. So from the high it took until January 1931 for the stock market to reach a real loss of 62.0% and then until June 1932 to reach its real low of -80.6%. That’s only a relatively short period of time however it really wasn’t over then as the market never really recovered and kept dipping back below -60% in real terms. This occurred in January 1933, July 1934, April 1938, June 1940, February 1941 and was back at -73.1% in May 1942. That’s a period of 12 years and 8 months. Even 20 years later the market was still below the real -60% mark.

The third severe stock bear (marked in olive on the chart) market started with a new real high being reached in December 1968. This period incorporated the stock market crash of 1973 to 1974 which came after the collapse of the Bretton Woods system and also incorporated the 1973 Oil Crisis. So from the high it took until March 1982 for the stock market to reach a real loss of -60.9% and then until July 1982 to reach its real low of -62.6%. That’s a period of 13 years and 7 months.

So that brings me to the last line on the chart marked in red which shows the real bear market that we are currently in. This period began in August 2000 with the Dot Com Crash however we were unable to reach a new real high before the Global Financial Crisis took hold. In this real bear stock market we were unable to break through -60% ‘only’ reaching -58.6% in March 2009. That is a period of only 8 years and 7 months. Even today we are still -38.1% which is a period of 9 years and 5 months which is a relatively short period of time compared with the bears shown above.

My question is once the governments of the world are forced to stop stimulating the economies through borrowing (for example a bond market strike) or quantitative easing (for example excessive inflation) could we yet see that real -60% bear? History suggests there is still plenty of time for it to occur.

Assumptions include:
- Inflation data from the Bureau of Labor Statistics. December ‘09 & January ‘10 inflation is extrapolated.
- 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.

Further Reasons Why I Use the Shiller PE10

Regular readers will know that to try and squeeze some more performance out of a retirement investing strategy that is heavily focused on asset allocation I use a cyclically adjusted Price / Average 10 Year Earnings (PE10) ratio for the S&P 500 to value the US stock market. The method used is that developed by Yale Professor Robert Shiller. My latest update is that for January ’10.

The first chart today shows the chart that I show each month which reinforces why I use this method. The R^2 value is low at 0.0566 and the correlation is also low at -0.15. That said however these values, along with a look at the trend line, suggests that some advantage may be able to be taken of the relationship. I must point out here how the x and y axes are calculated for this chart.

The x axis should not be an issue for any regular reader. It is simply the monthly PE10 ratio which is the real (ie inflation adjusted back to 1871) price of the S&P 500 divided by the real monthly average of the previous 10 years earnings. The y axis is the real price in 13 months time minus the real price in 1 months time plus the real dividend all divided by the real price in 1 months time. Hope that makes sense... It is also important to note that I then calculate these values every month to form the scatter chart that I show.

I have been thinking about the fact that I am only analysing the historical return on investment from the S&P 500 that can be expected for a period of 1 year. I am certainly not a 1 year investor and so I wondered what these charts would look like for 5 or even 10 year periods.
To do this easily I am going to switch from monthly data points to one data point for each year which I have chosen to be January for no other reason than it is the first month of the year. This is because before I can run the real return calculations I first have to calculate a total return for the S&P 500 going back to 1871 and this is easiest done with yearly data.

Now to the interesting bit. Firstly, as a comparison to the monthly chart above my second chart shows the 1 year real total return versus the PE10. Charts three and four then show the 5 and 10 year real total return versus the PE10. Examining the R^2 and correlations shows:
1 year, R^2 0.0462, correlation -0.21
5 year, R^2 0.1554, correlation -0.39
10 year, R^2 0.2725, correlation -0.52

This for me is really interesting. It suggests that the longer the period of time you hold the stocks or equities the more the Shiller PE10 becomes a useful measure for predicting future expected real returns. This reinforces why I am using the PE10 ratio as part of my retirement investing strategy.

As always some assumptions:
- 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.

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.

US (S&P 500) Stock Market – December 2009 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 / Earnings (PE) ratio for the S&P 500 to attempt to value the US (specifically the S&P 500) Stock Market. The method used is that developed by Yale Professor Robert Shiller. My numbers will always appear slightly different to Professor Shiller as I also use the Earnings forecasts from Standard & Poors to complete the data set up to the month of interest. I will call it the Shiller PE10 and it is the ratio of Real (ie after inflation) S&P 500 Monthly Prices to 10 Year Real (ie after inflation) Average Earnings. I will use this data set as a proxy for my UK Equities as well as my International Equities (mostly Japan, US and EU equities). Ideally I would create a PE10 for each country however good data is impossible to find and I am working on the principle that these stock markets are now heavily correlated with globalisation.

To give an example of this I have just read a very good book called Wall Street Revalued by Andrew Smithers. He presents data that shows the following stock market correlations for the period 1999 to 2008:
US to France, 0.92
US to Germany, 0.93
US to Japan, 0.84
US to UK, 0.93

I will assume that stocks always return to their long run PE10 average and so reduce my exposure when stocks are overvalued and increase my exposure when they are undervalued. For my US and International Equities I will use the long run average of the Shiller PE10 to equate to when I hold 21% UK Equities and 15% International Equities respectively. For my retirement investing strategy on a linear scale I will target 30% less asset allocation when the Shiller PE10 average is Shiller PE10 average + 10 and will have 30% more asset allocation when the Shiller PE10 average is PE10 average - 10.

All figures are taken from historic data provided by Professor Shiller. Current stock market data is taken from Standard & Poors and inflation from the Bureau of Labor Statistics. The December market price is the 30 December S&P 500 stock market close.

Chart 1 plots the Shiller PE10. Key points this month are:
Shiller PE10 = 20.6 which is up from 19.8 last month. My UK Equities target asset allocation is now 18.3%. Additionally my International Equities target asset allocation is now 13.1%.
Shiller PE10 Average = 16.4
Shiller PE10 20 Percentile = 11.0
Shiller PE10 80 Percentile = 20.6. This means the S&P 500 is currently sitting right on the 80 Percentile.
Shiller PE10 Correlation with Real (ie after inflation) S&P 500 Price = 0.78

Chart 2 plots 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.

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 are now back above the long term earnings trend.

Australian Stock Market – December 2009 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 PE ratio for the ASX 200 to attempt to value the Australian Stock Market. The method used is based on that developed by Yale Professor Robert Shiller. I will call it the ASX 200 PE10 and it is the ratio of Real (ie after inflation) Monthly Prices and the 10 Year Real (ie after inflation) Average Earnings. For my Australian Equities I will use a nominal ASX 200 PE10 value of 16 to equate to when I hold 21% Australian Equities. On a linear scale I will target 30% less stocks when the ASX 200 PE10 average is ASX 200 PE10 average + 10 = 26 and will own 30% more stocks when the ASX 200 PE10 average is PE10 average -10 = 6.

All figures are taken from official data from the Reserve Bank of Australia except December which is estimated by taking the price from the 28 December Market close. Additionally the December Dividends and Earnings are assumed to be the same as the November numbers.

Chart 1 plots the ASX 200 PE10. Key points this month are:
ASX 200 PE10 = 18.7 which is up from 18.5 last month. My target Australian Equities target is now 19.3%.
ASX 200 PE10 Average = 22.9
ASX 200 PE10 20 Percentile = 17.3
ASX 200 PE10 80 Percentile = 27.7
ASX 200 PE10 Correlation with Real ASX 200 Price = 0.82

Chart 2 plots 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 ASX 200 PE10 value.

Chart 3 plots Real (after inflation) Earnings and Real Dividends. Dividends appear just about on trend however Earnings are still struggling and heading very much downwards. If this continues and Prices hold the ASX 200 PE10 will surely start to rise.

Building My Low Charge Investment Portfolio – Part 3 of 3

Portfolio construction starting point as previously described in Part 2:

22% Bonds (Cash, Index Linked Gilts, Index Linked Savings Certificates)
21% Australian Equities (ASX 300)
21% United Kingdom Equities (FTSE All Share)
15% International Equities (40% US, 40% EU, 20% Japan)
5% Emerging Markets Equities (MSCI Emerging Market TRN Index)
10% Property (Listed Euro Property and UK Commercial)
5% Commodities (Gold)

The final element associated with the construction of my portfolio is an attempt to assess whether the stock market is overvalued or undervalued. I am doing this as the stock market can be a highly volatile / high risk place and if I can take a calculated risk here I might be able to squeeze some more performance out of my portfolio. I will try and be underweight equities when the market appears overvalued and overweight equities when the market appears undervalued. This could be likened to timing the market which history suggests is difficult/impossible meaning I may also end up under performing compared with the traditional buy, hold and rebalance periodically strategy. Only time will tell.

The method I am going to use is that developed by Yale Professor Robert Shiller. He uses a very simple method where he looks at the monthly real (after inflation) market price of the S&P 500 and divides it by the average of the previous 10 years real earnings to get a long term historic real price earnings ratio (Shiller PE10). The real price and Shiller PE10 look to have a relatively high correlation of 0.78. A chart showing both the Shiller PE10 ratio versus the real S&P 500 can be seen below. The December 09 entry is the market close on the 04 December. My current Shiller PE10 estimate will always appear slightly different to Shiller as I use the Standard & Poors website to also enter forecast earnings estimates up to the month of interest. Since 1881 the average Shiller PE10 value has been 16.35.


Another way I have looked at this is to plot a scatter diagram of the Shiller PE10 versus the return made in 12 months time shown below. This I have calculated as the ((Price in 12 months – Price)/Price)+(Dividend in 12 months)/Price). While the R^2 value is quite low a trend line suggests there may be something to be had.


While I will use the average Shiller PE10 value I won’t go silly. I will try to squeeze some performance by on a linear scale will owning 30% less stocks when the Shiller PE10 average is Shiller PE10 Average + 10 = 26.35 and will own 30% more stocks when the Shiller PE10 average is PE10 average -10 = 6.35. I will use this methodology as a proxy for all my International Equities and United Kingdom Equities as Hale suggests a high correlation between UK Equities and International Equities and I have struggled to find good historic data for UK, European and Japanese equities. Today’s Shiller PE10 is 20.2 meaning that instead of holding 21% UK Equities today my target is 18.6%. Similarly instead of 15% International Equities today my target is 13.3%.

For my Australian Equities I have been able to find some Inflation and ASX 200 data from the Reserve Bank of Australia. Unfortunately all the data needed only starts from 1982 which is not a long time ago. Even so I have calculated and show what I will call the ASX 200 PE10 chart versus the Real ASX 200 below. I have estimated average ASX 200 PE10 to November 2009 to be 18.5. The correlation between the Real ASX 200 and the ASX 200 PE10 appears high at 0.82. For my Australian Equities I will use a nominal ASX 200 PE10 value of 16 to equate to when I hold 21% Australian Equities. Otherwise I will use the same assumptions as for the UK and International Equities. Therefore with an ASX 200 PE10 of 18.5 today my target is 19.3%.

When I am underweight I intend to hold the extra in bonds/cash. For my emerging markets equities because it is a small amount I will not vary the weighting but always target 5%.
So that’s how I’ve arrived at my target asset allocations. Today this means a Desired low Charge Portfolio of:

28.8% Bonds (Cash, Index Linked Gilts, Index Linked Savings Certificates)
19.3% Australian Equities (ASX 300)
18.6% United Kingdom Equities (FTSE All Share)
13.3% International Equities (40% US, 40% EU, 20% Japan)
5% Emerging Markets Equities (MSCI Emerging Market TRN Index)
10% Property (Listed Euro Property and UK Commercial)
5% Commodities (Gold)