Taking The Gloves Off On The Discussion of Rational Investment Analysis (Part 2)

• IRON100
• July 11th, 2010

On this, the 101st post for this StockTwits blog, I wanted to begin the whole discussion regarding whether a simple "buy and hold" strategy is always the best idea when investing in stock indexes (index funds or index related exchange traded funds (ETFs), or even in individual stocks. 

I think I will get to the discussion of individual stocks in part 4 or 5, but for now, let us deal with index-related investing, which is the one that most individual investors are taught by the "do-it-yourself" investment community. I am a great believer in doing it yourself, because I have for nearly 35 years. One can save a ton of money if one pursues such a course, and one can avoid all the heartache of being forced into discomfort by a so-called professional who does not always have the investor's interest at heart.  What I am going to do today is to reference some research I first saw in John Mauldin's Weekly E-Letter and which was featured in Bull's Eye Investing his 2004 book which contains I think useful data with regard to how to manage one's investment timeframes. I have my own problems with some of what Mr. Mauldin does because he carries his own sales agenda with it. However, as a free market capitalist, I fully support his right to do so. He does, however, provide some very stark information about what timeframe has to do with investment success. He cites data compiled by Crestmont Research covers 109 years of market performance data from a pure index perspective, taxpayer real return perspective, and tax-exempt real return perspective.  There has always been a raging debate over pure "buy and hold" tactics for wealth (something a friend of mine who died in 2005 at the age of 93 held onto with steadfast determination) and those who believe in pure market timing (a lot of which can indeed be suspect if one analyzes the techniques used to "time" markets). Based on this research, which includes virtually all of the high-taxation period of American history, from William McKinley to Barrack Obama, the answer has to be put into perspective. The concepts I am discussing are shown in their report called "The P/E Report" It is a quarterly analysis of earnings in the S&P 500 Index with larger historical context applied to them. The analysis is purely data based and is adjusted to take into account reported earnings so that reasonable comparisons across time can be completed. 

There are probably two best ways to describe the key factors associated with "long-term" holding of financial assets and those are:1) Valuation as determined by trailing earnings divided by actual price or TRAILING Price/Earnings ratios 

2) The distance of that trailing valuation to normalized or average valuations.That has two implications associated with it. The net return over time one receives in annualized returns in the equity market is more a function of a given index valuation distance from the mean and not the time involved. That is, as market valuations move closer to the low end of trailing valuation figures, the greater the stock market returns will be over time. If one is at the high end of those valuations (as we were in 2000, it should be no shock to anyone that returns could be low or even negative (as they were, from 2000-2009, and not off to such a great first half in 2010.)  

Because I was swamped this week, I was not able to get permission from Ed Easter ling, one of the principals of Creston Holdings, LLC to post some charts with statistics on trailing price/earnings ratios (P/E ratios) versus returns over a 20 year period. I will attempt to do so this week (and hopefully present a small excerpt of his book which covers some specifics). What is known about U.S. S&P 500 Index total returns (on a nominal taxpayer basis) from 1900 to 2009 is as follows: 

1) For the S&P500 Index, annual return on a nominal tax basis averaged about 6.0% (not 7, 8, 9, or 10% as if often quoted). This data was collected from Crestmont Research's chart on taxpayer nominal returns.

2) Over any 20 year period in that grouping, when one started investing as trailing P/Es were above 20, returns were anywhere from -2% per annum to 6% per annum. (This is based on the First Printing ( 2004) of John Mauldin's book, Bull's Eye Investing, Targeting Real Returns in a Smoke and Mirrors Market, page 64, Figure 5.2). 

3) If one started investing in years where price earnings ratios were less than 10 (typical of the beginning of bull market cycles) based on the accumulated data in this study, ranged from 2% to roughly 13% per annum over a 20 year period. This is a much different (and positive) result. (This is based on the First Printing (2004) of John Mauldin's book, Bull's Eye Investing, Targeting Real Returns in a Smoke and Mirrors Market, page 64. Figure 5.2). Here is the doctrinal ("real deal" as they say on the street) question. What is the long term? I doubt seriously that an individual in 1900 invested for 109 years to get to that 6% average. Why? 1) The average Joe in America did not really even know what the stock market was in 1900 and 2) that person's average lifespan was 47.3 years. The individual who lived in that time, between growing up, getting a job (remember, many never WENT to college, let alone graduated), might have had 20 years at most of real savings ability. To that man (or woman), one full generation, or about 20 years, was ALL the individual likely had to save money. And remember, we went through two depressions (the miniature one in 1920 and the big one between 1929 and 1941.) 

Today, the average lifespan of a person in the USA as of is 78.1 years. Between growing up college, repayment of student loans and personal debt, an individual may have 40 years (or basically 2 full generations) to save effectively for retirement. That is a great help, and ought to be incentive for Americans to take back control of their savings and financial future, but that might not be enough. 

Next week, I will begin the detailed discussion of what that long-term should be for most investors and why. It may be by luck of the draw into which kind of economic cycle one is born whether stock market returns will be favorable or unfavorable to that investor.  I also think I will get permissions from the author of this data to get into a bit more of the real nitty-gritty about longer-term returns in stocks and stock indexes. The main reason I am writing this series is that I want younger investors to think rationally about what real and absolute returns can be in each kind of investment cycle and to learn how to anticipate their arrival as best as possible. I will go into detail about why I was unable to bail out in 1987 when I really wanted to do so and how I did so in 2000. After that time, I changed my investment mix and strategy to protect and grow assets sanely while avoiding the secular bear market potholes that we are still hitting at this moment. Remember, average returns are just that, averages. There is no guarantee that one can always get those returns, despite all the crap one hears from brokerage firms, financial planners, and the like. YOU and only YOU can ultimately be responsible for building and protecting your wealth.  That is why understanding timeframes is essential to that ability to have a retirement savings nest egg. If one does not have that, one has nothing.  

The average annual temperature is 60 degrees F in Greenville, SC (my birthplace), but the highest temperature was set in 2007 at 105 degrees F and the lowest temperature was set in 1966 at -6 degrees F. If one expects 60 degree temperature all the time and does not have a warm jacket, one will freeze one's (pick a body part of one’s choice) off if one does not have one and norms are hit. The same thing applies to investing. It all depends on where one starts and where one finishes. More great learning is coming.

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