The Most Dangerous Threat to Your Retirement

John Mauldin | Thoughts from the Frontline
February 7, 2003

Today I discuss one of the most dangerous threats to your retirement and then we listen to a few seasoned pros tell us why the market is not going up. It should make for an interesting session, so let's get started.

I got the following email from a reader yesterday which so upset me I decided to make it the lead for this week's letter. Quote:

The Most Dangerous Threat to Your Retirement

"My wife and I just heard another presentation by an investment firm recommending that retired people, needing income from their sheltered funds, place enough assets in fixed instruments for 5 years living expenses and the rest in stock funds. The hope is that within 5 years, there will be an upturn such that stock funds can be sold at a gain, from which to draw income. Ibbotson data was, of course, used to show how unlikely it was for there to be many consecutive years of down markets. The firm had a CPA and several financial advisors who had been working in the field for 20 - 30 years.

"It drove me nuts also, especially at this meeting where heads were nodding around the room as these advisors (looking for people to give them their money to manage) explained how scientific their approach was. The CPA member of the firm said (in comparison to 1966 -1982) that the market could be that bad or even worse, but that this was very unlikely, and went on to recommend the strategy described above."

Let's review this for a moment. I will leave aside the question of making a one size fits all recommendation for retirees, as I assume such stupidity is self-evident. That alone should be enough to make you run, not walk, to the exits.

In 1976, a young Roger Ibbotson co-authored a research paper predicting that during the following two decades the stock market would produce a return of about 10% a year, and that the Dow Jones Industrial Average would hit 10,000 in 1999. Ibbotson, now a professor at Yale, currently forecasts a compounded return on stocks during the next two decades of 9.4% - about 1 percentage point a year lower than his earlier projections.

"I'm neither an optimist nor a pessimist," Ibbotson said recently in an interview. "I'm a scientist, and I am not telling people to buy or sell stocks now. I'm saying that over the long run stocks will outperform bonds by about four percentage points a year." (from AdvisorSites, Inc.)

It turned out Ibbotson was right about 1999, and with the imprimatur of a Yale professor, investment managers everywhere use this "scientific" study to show investors why they should put money in the stock market and leave it. (I am not sure how economists get to be scientists, or how investment predictions can be scientific, but that is a debate for another time.)

If the S&P were to grow at 9.4% for the next two decades, it would be in the range of 4,500 and the Dow would be at 42,000 or so in 2023 (give or take a few thousand). Of course, that's starting at today's market values. If we start out with the market tops in 2000, we get around 8,200 and 63,000 respectively in 2020. Thus, investors shouldn't worry about the short term. Ibbotson assures us, as a scientist, that things will get better buy and buy.

Today we are going to look at why you should leave the room whenever an investment advisor brings out this study to sell you on an investment strategy. If your advisor actually believes this nonsense, then this will help you understand why you should fire him. (That should get me a few letters.)

There may be reasons to think the markets might go up, but the Ibbotson study is not one of them, in my opinion. Further, over the next 70 years, the market may in fact rise 9.4% a year. But to suggest to retirees it will do so over the next few years based upon "scientific analysis" is irresponsible and misleading.

Let's start our analysis in 1976, the year Ibbotson did the study. (I could make a much better case starting with another year, but 1976 works just fine.) From 1976 through 2002, the S&P 500 returned 12% a year (including dividends), even better than Ibbotson predicted, and after a rather significant drop over the last few years. However, 5% of that annual return is due simply to inflation. In real, inflation adjusted terms the S&P was up 7% a year.

The Price to Earnings (P/E) ratio was a rather low 12 in 1976. It ended up around 22 last year, using pro forma numbers (see more below). Thus almost half the return from the last 26 years has been because investors value a dollar of earnings almost twice as much in 2003 as they did in 1976.

At a similar P/E ratio to 1976, the S&P would be less than 500 today (around 466 or so as I glance at the screen, again using pro forma earnings numbers.) Thus, without increased investor optimism, the compound growth would be around 6.3%-7% over the last 26 years, or only a few points over inflation during that time. The point is not the exact number but that a significant part of the growth in the stock market is due to increased P/E valuations.

In fact, if you back out dividends, the growth is almost entirely due to inflation and increased P/E valuations. The stock market has been a good investment since 1976 primarily because of these two factors. The question that investors must ask today is, "To what extent will these two factors, plus dividends, contribute to the return from the stock market over the next 5-10-20 years?"

How to Lose 20% in Five Years - Guaranteed

Before I attempt to answer that, let's look at the advice the investment managers were suggesting to retirees at the seminar my reader attended. Assume that you can make 5% (today) on your investment portfolio. You can take that 5% and live on it in retirement (plus social security and any pensions) and not touch your original principal. It doesn't make any difference in this example what the amount is. I simply assume you live on a budget of what you actually get.

If that 5% is what you need for the next five years, then according to the analysis given at the seminar, you will need to put about 22% or so of your savings in bonds, which will be consumed over the next five years (remember the 22% will grow because of interest). The other 78% or so will be put in stocks. Since the Ibbotson studies show stocks grow around an average of 9.4% per year, your total portfolio will have grown to122% of where it is today. For this advice, we want you to pay us 2% a year.

Mean Lean Reversion Machine

50% of all doctors graduated in the bottom half of their classes. 2 + 2 is 4. Trees do not grow to the sky. And markets always come back to the trend.

Let's leave Ibbotson's office and go down the hall at Yale and look in on Professor Robert Shiller. I have written before about his must-read book, Irrational Exuberance . In my opinion, no one should invest in the stock market today without having read his book. Shiller clearly demonstrates that when broad market indexes go above P/E ratios of 23 or so, that investors essentially get no return over the next ten years. The markets return to trend.

I especially recommend Shiller's first chapter, which even if you don't want to buy the book you should go to your Barnes and Nobles, get the book, sit in the comfy chairs with a latte and read at least these brief 11 pages.

Shiller uses a scatter chart that economists and statisticians love to use to show the relationship between price to earnings ratios (P/E) and the return that investors got over the next ten years. Basically, the higher the P/E the less the stock market return the next ten years.

Some quotes from this chapter and then comments.

"Suffice it to say that the diagram suggests substantially negative returns, on average, for the next ten years."

"Long term investors would be well advised, individually, to stay mostly out of the market when it [the P/E ratio] is high, as it is today, and get into the market when it is low."

"...times of low dividends relative to stock price in the stock market as a whole tend to be followed by price decreases (or smaller than usual increases) over long horizons, and so returns tend to take a double hit at times, from both low dividend yields and price decreases. Thus the simple wisdom - that when one is not getting much in dividends relative to the price one pays for stocks it is not a good time to buy stocks - turns out to have been right historically."

I do not believe that Shiller is saying that low dividend and high P/E ratios cause low returns. He just simply points out the historical connection. The cause is much more basic and has to do with a mix of human emotions: hope, envy, greed, fear, desire and dreams and aspirations.

Shiller writes for many chapters about bubbles and what causes them. But it all boils down to human emotion and how investors feel about the future.

Why are times of high P/E ratios and low dividend yields followed by a decade of poor or negative returns? Because trees don't grow to the sky. There are limits. And eventually enough investors begin to realize this and take their money off the table.

As studies by Jeremy Grantham point out, bubbles always - in every case- with no exceptions - come back to trend. Period. This stock market is a long way from the trend line.

In 2000, I noted a study by some analyst which basically asserted investors should expect returns from the major tech stocks like Microsoft, Cisco and Intel to continue. I pointed out that these stocks simply could not deliver returns in the next ten years like they had in the last ten unless these few companies by themselves became larger in market cap size than the entire US economy.

These are great companies with wonderful futures. But they were (and are) still great companies with very high stock prices relative to earnings. At some point, enough investors realize the emperor is naked and the stock drops back to reality or at least stops growing. As investors realize this price action is possible for stocks of great companies they begin to worry about the prices of other similar companies. The connecting dot to a general lowering of stock prices is the "expectations for future earnings growth," not the price to earnings ratio. It is emotions, and not a hard rational analysis.

Increasingly, in secular bear markets, investors get fed up with slow growth and look for other opportunities. Each investor who leaves takes a marginal bite out of the stock market. At each point the gains of the bull market die a little more, and the market continues down. This correction is normally done over many years. Shiller's work and many others like it show that the market does not correct to the average but just as it went up too high, it tends to go back down too low.

In every case in the last century, without exception, when P/E ratios rose to over 23 they were less than half that approximately two decades later.

For the stock market to easily double over the next ten years and more than quadruple over the next 20, as Ibbotson suggests, earnings would have to double over the next ten years and then more than double over the next ten. Further, for the first time in history, investors would have to be willing to keep P/E ratios at today's high levels. Anything can happen. But making suggestions to retirees based upon a scenario with no historical precedent does not suggest the advisors have done their homework. They simply are giving investors the same old cheerleader sales pitch.

If P/E ratios drop in roughly the same manner as they did in the last century, earnings would have to grow at twice the remarkable rate suggested above for the markets to get to Ibbotson's predicted growth targets.

How Much Can Earnings Really Grow?

Historically, earnings grow at around inflation plus GDP (or less), depending upon which study you want to use. What do you expect inflation to be over the next five years? What do you think GDP growth will be? If you answer 3% to both, then broad index corporate earnings should double over the next 12 years. But if P/E ratios are on their way down to half their current values --and they are-- then that suggests that the stock market will be roughly where it is today in 10-12 years. And that assumes pretty robust growth.

It also assumes that investors will continue to buy into inflated earnings reports, which I have written won't happen for a lot of reasons. In 1999, for instance, aggregate taxable earnings slipped by 2%, according to the Commerce Department, while S&P 500 GAAP earnings swelled by 28%. When the new accounting standards are put in place, and earnings reports have to be Honest-to-Pete real, earnings are going to have to grow significantly just to get back to 1999 levels.

What will happen in the meantime as we wait for earning growth? Will the market trade in a channel for the rest of the decade? Or will it drop further and climb back up?

Either way, in my opinion, the retirees taking the advice of the investment managers we mentioned at the first of this letter will not be happy. In order for the advice to work as planned, earnings and inflation have to grow at much higher than historical norms, and investors have to push P/E ratios to even higher levels. This is not impossible, but there is no historical precedent for it.

I invite you to go to www.2000wave.com/graphs.asp and click on the 11 x 17 graph called "retirement nominal." You will need Adobe Acrobat. Increase the magnification. This is a chart of the annual compound returns for the S&P 500, including dividends, less a small management fee with no adjustment for inflation. You can see returns taking inflation into account at "retirement real." The charts labeled "retirement" assume no taxes. Charts labeled "individual" assume taxes.

You can start at any year for the past 100 years, and see what your annual compound rate of return would have been for the rest of the century. It also correlates P/E ratios. Numbers in white are years of falling P/E ratios. (This amazing chart was developed by Ed Easterling of Crestmont Holdings. Serious investors should copy this chart to a disk and take it to Kinko's and print it out large enough to read and study. Refer to it often.)

What I want you to notice is what happens to annual returns once a definite period of falling P/E ratios begins. You will see a pattern. Once numbers start to go white (falling P/E's), they stay that way for years. Bottom line: annual returns get real ugly. You can kiss 9.4% goodbye for a long, long time.

These periods are called secular bear markets. (Secular in this context has to do with cycles or periods of time and has no religious meaning.) Bear markets could give a fig about Ibbotson studies. It does not matter if the economy is growing (it usually does) and/or if earnings are growing (they usually do). These periods have their own raison d'etre (or reason for being). When one starts, you might as well tell the tides to reverse as to tell the stock market that the economy is getting better and therefore the market should, too. It makes no difference to the tides or the markets.

And just in case I wasn't clear, the most dangerous threat to your retirement is not bear markets but cheerleading investment managers.

Why The Market Isn't Rising

First, from Richard Russell's Dow Theory Letter daily comments (www.dowtheoryletters.com with permission):

"Let's follow the money, which mean following the stock market. This is what I'm seeing. My Big Money Breadth Index broke to a new bear market low yesterday -- well below its October low. This indicates important big money saying "bye" to this market.

"My Most Active Stock Index broke to a new bear market low yesterday, for the first time plunging below its October low. Again, institutional money moving out of the market.

"Lowry's Buying Power Index fell to a five year low yesterday, well below its October low. This indicates a declining interest in accumulating stocks. Lowry's Selling Pressure Index rose above its "sell signal" level (up over 25 points from its recent low). This indicates a desire to unload existing positions.

"Daily new lows on the NYSE are starting to climb above daily new highs. This means more issues are breaking support.

"We are seeing an increasing number of "distribution" days on the exchanges. These are days when the market declines on increasing volume compared with the preceding day. "Distribution" days are days when institutions reveal their desire to unload stock positions.

"We saw our first "distribution" day of the new year on January 6. On January 15 and again on the 16th the market declined on rising volume. Then yesterday we saw another day of distribution as the market declined on expanding volume.

"All the above indicate steady deterioration in the technical understructure of the stock market. All the above indicate declining demand for stocks and an increasing desire to move out of existing positions.

"I want to say a few words about the Utilities. These companies are sensitive to the demand for energy, interest rates, and government regulations. Utilities often lead the rest of the market. Yesterday 14 of the 15 D-J Utility stocks were down. At its recent low of 162 recorded at the October lows, the D-J Utility Average was at its lowest level since 1988, at which time the Dow was selling below 3000. Something to think about."

Then Art Cashin of CNBC fame writes in his private letter:

"Caught Between Iraq And A Soft Patch - With everybody but the Cartoon Network doing all Iraq, all the time, investors are buying into not buying till the shooting starts. Traders, however, aren't so sure that Iraq is the market's only obstacle. But it is the focus of media attention.

"The Market Climate - No Global Warming - The market seems to churn on between 1.2 billion and 1.6 billion shares each day. Traders feel that, with between 35% and 45% coming from "program trading" and - maybe - 10% coming from lottery tickets ("it's under $2, ya gotta buy it") - the market is somewhat stagnant. That, they believe, is because sellers have been hibernating.

"Wait, you say. Hasn't the market gone down 100 or 200 points in several days? Yes, it has. But that's not a crush of panicky selling. Rather, as we have noted, those days are buyer's boycotts. "Let's start with a little Wall Street folklore. 'There is not always a reason to buy but there is always a reason to sell'. Buyers can postpone due to mood, info, price or a hundred different things. Sellers are different even if the economy's booming and peace is on the land - estates must be settled; tuitions and medical bills paid, etc.

"So.....traders believe that most 'trading' sellers are on the sidelines. Not - 'sold out' - but rather reluctant to sell at 'such low prices' as media types reassure that "we've bottomed". That leaves the direction of the market - for the time being - in the hands of the buyers and the above noted 'sellers for cause.'

"The logjam could break either way, of course. The economy could perk up and buyers might pay up. Or.....heaven forefend....we could make new lows bringing the disillusioned out of hibernation. Any wonder the battle [by the bulls] to hold Nasdaq 1300?"

And quickly to one more (let's just say we are all getting well seasoned) market veteran: Ian McAvity. In his recent Deliberations newsletter, he posted a chart of the Nikkei from 1990 alongside the Dow, gold from 1980 and some other bubbles. If the Dow acts like the other bubbles, it is getting ready to rally somewhat and then trade in a long sideways trading channel before dropping further a few years from now.

Could that happen here and now? Possibly. We are not through this secular bear by a long shot. No bear market has ever ended with such high valuations. But a lot of them have gone sideways for long periods.

Next week I intend to review the economy. There are so many conflicting reports, if you are confused as to the direction we are headed, it is not surprising. Jobs are up, sales are down, consumer debt is down, GDP is flat, etc. I will try and make some sense of it for you.

Thanks for all the kind wishes about the skin cancer surgery last week. It went much better than the doctors initially thought and was not as deep, although I still have a 3 inch long slash in the shoulder.

I will be in Delray Beach, Florida next month. I have just been asked to speak at the Oxford Club Investment University conference. The conference is March 5-9. They have knocked $200 off the registration price. I will be there for the weekend, speaking on alternative investments and funds. The conference program is quite good and has some very good speakers. It is geared for active individual investors. You can find out more by going to http://www.agora-inc.com/reports/300SCONF/F300D312.

I am reminded this week of how time flies. My 17 year old twin daughters have both been nominated for the Homecoming Court at their school, so next week Dad gets to escort them. It is almost Graduation Day for them. You can see pictures of four beautiful daughters and one beautiful wife (plus the three boys) at http://www.johnmauldin.com/ and click on "Who Is John Mauldin?" I know it is not "professional" to talk about family in an investment letter, but the letter is free so I can get away with a little exuberance. Besides, Dad is justifiably proud.

Enjoy the week.

Your wondering if I qualify as a seasoned veteran analyst,

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