The Shiller cyclically adjusted (for inflation) price-to-earnings ratio—referred to as the CAPE 10 because it averages the last 10 years’ earnings and adjusts them for inflation—is a metric used by many to determine whether the market is undervalued, fairly valued or overvalued. Employing a 10-year average for earnings, instead of the most current 12-month earnings, was first suggested by legendary value investors Benjamin Graham and David Dodd.
In their classic 1934 book “Security Analysis,” Graham and Dodd noted that traditionally reported price-to-earnings ratios can vary considerably because earnings are strongly influenced by the business cycle. To control for the cyclical effects, Graham and Dodd recommended dividing price by a multiyear average of earnings and suggested periods of five, seven or 10 years.
Then, in a 1988 paper, economists John Campbell and future Nobel Prize-winner Robert Shiller, using a 10-year average, concluded that a long-term average does provide information in terms of future returns. This gave further credibility to the concept, and led to the popular use of the CAPE 10.
A Changing Horizon
However, as Graham and Dodd noted, there’s really nothing special about using the 10-year average. Other time horizons also provide information on future returns. With that in mind, today we’ll analyze how changing the horizon can impact our view of the market’s valuation.
We’ll begin by looking at the current level of the CAPE 10. As of April 13, it was 26.3. This compares to a long-term (136-year) average of 16.7. The differential between the CAPE 10 today and its historical average has led many observers to conclude the market is overvalued and headed for a sharp decline. Jeremy Grantham and John Hussman have been among market gurus who, for the last four years or so, have been warning about an impending debacle as valuations eventually revert to their historical mean.
However, the market looks less overvalued if we change the horizon. Why would we consider a different horizon? First, as mentioned earlier, there is nothing magical about using 10 years to calculate the earnings average. Graham and Dodd even suggested using a five- or seven-year period. More importantly, in 2008, the earnings of the S&P 500 temporarily collapsed as a result of the financial crisis.
Note that in the following analysis, I’ve used the operating earnings of the S&P 500 as shown on NYU professor Aswath Damodaran’s website. The Shiller CAPE 10, however, uses “as reported,” or GAAP (generally accepted accounting principles), earnings. This distinction is important because operating earnings are generally higher, especially during recessions. With the Great Recession causing S&P 500 earnings to not recover to their 2007 level until 2010, we will look at CAPE ratios using earnings beginning in 2010. Thanks to the folks at AQR, we can examine both the CAPE 6 and CAPE 5 ratios using operating earnings as our measure.
CAPE Based On Operating Earnings
As of April 13, the current CAPE 6 was 18.7. Its average since 1960 was 15.5. That puts the CAPE 6 about 21% above its average over the past 56 years. Observe that when using GAAP earnings, the CAPE 6 is also lower than the current CAPE 10 of 26.3. It’s now at 22.7, or roughly 19% above its mean since 1960 of 19. The CAPE 5 was 18.5, again, as of April 13. Its average since 1960 was 15.7, placing it approximately 18% above its average. Using GAAP earnings, the current CAPE 5 would be 22.1, also about 18% above its mean of 18.1 since 1960.
While this still leaves the market looking somewhat highly priced compared with its historical averages, it no longer looks dramatically overvalued. That said, before you draw any conclusions, we need to consider the issues related to Shiller’s use of a 136-year historical mean.
The discussion that follows should highlight why I chose to look at the mean since 1960 instead of since 1880. In addition, some of the issues raised are based on changes made in just the last 20 years. When adjustments for them are made, the current high valuation (19% above the CAPE 6 mean since 1960 and 18% above the CAPE 5 mean) could disappear. Keep this in mind as you read the arguments.
Problems With Using The 136-Year Mean
In finance, it’s generally best to look at the longest data series available, thereby minimizing the risk of data mining. However, there are several reasons why using a 136-year average for the CAPE 10 will lead to a false conclusion that the market is overvalued.
The Shiller CAPE 10’s historical mean is about 16.7, with the dataset for the full period going all the way back to 1880. The data includes economic eras in which the world looked very different to investors than it does today.
Consider just two examples. For a significant part of the period, there was neither a Federal Reserve to dampen economic volatility nor an SEC to protect investor interests. The presence of both organizations has helped to make the world a safer place for investors, justifying a lower equity risk premium and thus higher valuations. In addition, we haven’t experienced another Great Depression, and there haven’t been any worldwide wars since 1945.
Another reason for the CAPE 10 rising over time is that the U.S. has become a much wealthier country since 1880. This matters because, as wealth increases, capital becomes less scarce. All else equal, less scarce assets should become less expensive.
Changing FASB Rules
Another reason the Shiller CAPE 10’s full-period mean may be an inappropriate benchmark is because accounting rules have changed, impacting how earnings (and thus price-to-earnings, or P/E, ratios) are determined. In 2001, the Financial Accounting Standards Board (FASB) changed the rules regarding how goodwill is written off.
As a post on the blog Philosophical Economics explained: “In the old days, GAAP required goodwill amounts to be amortized—deducted from earnings as an incremental non-cash expense—over a forty year period. But in 2001, the standard changed. FAS 142 was introduced, which eliminated the amortization of goodwill entirely. Instead of amortizing the goodwill on their balance sheets over a multi-decade period, companies are now required to annually test it for impairment. In plain English, this means that they have to examine, on an annual basis, any corporate assets that they’ve acquired, and make sure that those assets are still reasonably worth the prices paid. If they conclude that the assets are not worth the prices paid, then they have to write down their goodwill. The requirement for annual impairment testing doesn’t just apply to goodwill, it applies to all intangible assets, and, per FAS 144 (issued a couple months later), alllong-lived assets.”
While FAS 142 may have introduced a more accurate accounting method, it also created an inconsistency in earnings measurements. Present values end up looking much more expensive relative to past values than they actually are. And the difference is quite dramatic. Adjusting for the accounting change would put the CAPE 10 about 4 points lower.
Another reason not to rely on the long-term historical mean of the Shiller CAPE 10 as a yardstick is that far fewer companies pay dividends now than in the past. For example, in their 2001 study, “Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay?”, Eugene Fama and Kenneth French found that the firms paying cash dividends fell from 67% in 1978 to 21% in 1999. This has resulted in the dividend payout ratio on the S&P 500 dropping from an average of 52% from 1954-1995 to just 34% from 1995-2015.
In theory, higher retention of earnings should result in faster growth of earnings as firms reinvest that retained capital. That has been the case for this particular period; from 1954-1995, the growth rate in real earnings per share (EPS) averaged 1.72%, and from 1995-2015, it averaged 4.9%.
As the post on Philosophical Economics explained, to make comparisons between present and past values of the Shiller CAPE 10, any differences in payout ratios must be normalized. The adjustment between the 52% payout ratio (the average from 1954-1995) and the 34% payout ratio (the average from 1995-2015) corresponds to approximately a one-point difference on the Shiller CAPE 10.
The Liquidity-Risk Premium
And there’s yet another reason why the long-term mean of the CAPE 10 might be misleading. Investors demand a premium for taking liquidity risk (less-liquid investments tend to outperform more liquid investments).
All else equal, investors prefer greater liquidity. Thus, they demand a risk premium to hold less-liquid assets. Over time, the cost of liquidity, in the form of bid/offer spreads, has decreased. There are several reasons for this, including the decimalization of stock prices and the provision of additional liquidity by high-frequency traders. In addition, commissions have collapsed in price.
But we aren’t done quite yet. Another important factor is that the presence of financial instruments that allow investors to buy and sell illiquid assets indirectly (such as index funds and ETFs) work to lower the sensitivity of returns to liquidity. These instruments enable investors to hold illiquid stocks indirectly with very low transaction costs, reducing the sensitivity of returns to liquidity. With these innovations in markets, all else equal, we should see a fall in the equity risk premium demanded by investors, and thus higher valuations.
Summary
If we make an adjustment from a CAPE 10 to a CAPE 6 or CAPE 5, and we use a still very long period of 56 years and operating earnings, we find the current valuation of the market is less than 20% above its mean. That’s a dramatically lower figure than the 57% difference between the current CAPE 10 and its long-term average.
What’s more, even the 20% difference doesn’t consider adjustments for any of the issues we raised, including the changes in accounting rules, the reduction in the tendency to pay dividends and the dramatic fall in transactions costs.
The bottom line is that once those adjustments are considered, there’s a case to be made that the market no longer looks overvalued. However, that doesn’t mean expected returns aren’t lower than the historical average. If we use the CAPE 6 of 18.7, that results in an earnings yield of 5.3%.
However, since earnings grow over time, we still have to account for an average lag of three years. I suggest using a real earnings growth forecast of 2%. Thus, we need to multiply 5.3% by 1.06 (1 + [3 x 2%]), producing an adjusted earnings yield of 5.7%. And that would be the forecast for future real returns for the S&P 500.
If we use the CAPE 5 of 18.5, we get an earnings yield of 5.4% and multiply that by 1.05 (1 + [2.5 x 2%]), which produces a slightly higher real expected return of 5.7%. In either case, that remains well below the historical 7% real return, but not as bad as the forecast of 4.2% you get from using the CAPE 10 figure of 26.3.
This commentary originally appeared April 20 on ETF.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2016, The BAM ALLIANCE
You’ve heard of the American dream, right? The American dream was this machine we built to get rid of uncertainty and create security. It’s the white picket fence, the job and the minivan. You watch Dan Rather and a sitcom. You go to bed, go to sleep and repeat.
It may not be that exciting, but hey, at least it’s stable. For years — for as long as we can remember — that’s been the end goal: stability and security. And millions of us work really hard to get there each year.
There’s nothing wrong with that if it’s what you’re into. But there’s a whole group of people — and this group is growing, by the way — who have said, “Forget that. I want to focus on experiences instead.”
You probably know the refrains by now: Experiences trump stuff. Experiences tend to bring us happiness. More stuff tends to breed discontent. There’s a wealth of research to back up these ideas up.
So people go out and spend a bunch of money to participate in adventure races like the Tough Mudder, just to have an experience. Instead of buying a new television, people buy skis and lift tickets. People pay to go to the rock climbing gym instead of paying to go to the movies. More and more, the economy is moving in this direction.
But the idea that you can leave a stable job, a 401(k), sell your house, retrofit your van and spend a couple of years living out of it by yourself, or with your spouse, or even with your kids, is something completely different. Not only is it different, it’s mind-blowing.
This mind-blowing concept is not the choice of experience over stuff. It’s not even experience over stability. It’s experience over security. And that is a very fascinating development in our culture.
Consider the professional baseball player Daniel Norris, who was making $2 million but living in a Volkswagen van. Who told him he could do that? At its extreme, choosing experiences over stuff isn’t just about making these kinds of value-based decisions about recreation on your weekends. It’s also choosing experience over security and making the same decisions on a life-size scale.
Once I began framing it this way, I kept learning about more and more people doing this. There is Jeremy Collins deciding to pursue a life of art and climbing after getting laid off from a comfortable office job, or the writer Brendan Leonard, leaving a copywriting job at IBM (arguably the definition of security) to follow his dreams of being a freelance writer and starting a blog.
The more I learn about people completely bucking convention and living these incredibly interesting alternative existences, the more I find myself wondering, “If they can do it, can I?”
Do I dare open that bulletproof, fireproof combination safe where I’ve locked up my dreams and say, “Oh, I’ll do that later, when life is more stable, when I’m more secure”? What if I try to make this really creative vision, one that I’ve always dreamed of, come true and I fail? Do I even dare to ask, “What if?”
As for you, O.K., so you don’t want to live in a van. Maybe you don’t have a dream locked up inside your own little Pandora’s box. That’s fine.
But if you do — and my gut tells me that for most people reading this, what I’m writing rings true — I am telling you to at least consider that one, simple question, “What if?”
In considering the possibilities, consider also that according to this new set of values, the uncertainty and the insecurity that you feel trying something adventurous and new is all part of the very reason for doing it. That’s part of the tangible benefit. That’s the hard part of the adventure race, the mud in your face and the suffer-fest.
As the Patagonia founder Yvon Chouinard famously said, “It’s not an adventure until something goes wrong.” Maybe you’ll lose some money in selling the house. Maybe you’ll make less income if you quit your job. But that’s part of the adventure.
If you would make the same experience-over-stuff choice weekend after weekend, maybe it’s time to start thinking about making the experience-over-security choice for your life. At the very least, you might want to ask yourself, “What if?”
This commentary originally appeared May 2 on NYTimes.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2016, The BAM ALLIANCE
As the director of research for The BAM ALLIANCE, I frequently receive questions related to the advisability of purchasing payout annuities (as opposed to variable annuities, which I generally categorize as products meant to be sold, not bought).
Combine the relatively poor performance of equities since 2000 (the S&P 500 returned just a little more than 4% and the MSCI EAFE index returned less than 3%) and the fact that current bond yields are at exceptionally low levels with concerns about Social Security’s solvency and the demise of defined benefit plans (then add in longer life expectancy), and it’s no wonder investors are seeking alternative strategies to ensure they’ll have sufficient assets to support their desired lifestyle in retirement. Given the importance of this issue, and how often I’m asked about it, I thought I would share my thoughts.
To begin, we buy insurance to protect our homes, cars and lives, transferring some or all of risks we prefer not to bear ourselves. Thus, buying insurance is really about diversifying risks we find unacceptable, because the costs of not being insured and having the risks “show up” are too great. The same logic applies to the purchase of payout annuities, payments from which can be in either nominal or inflation-adjusted (at least to some degree) dollars.
At its most basic level, deciding to purchase a payout annuity is a decision to insure against longevity risk (the economic consequences of outliving a portfolio of financial assets meant to provide lifetime income). As the pain of outliving one’s financial assets is extremely high, purchasing a payout annuity makes sense for individuals running significant risk of this event occurring. Hopefully, the following analysis will supply you with the necessary information, and proper framework, to analyze the problem.
Longevity Risk
The average remaining life expectancy for people surviving to age 65 is now about 13/15 years for the male/female 1940 cohort, and about 15/20 years for the male/female 1990 cohort. These, however, are just averages.
When thinking about longevity risk, you should also consider that, today, a healthy male (female) at age 65 has a 50% chance of living beyond the age of 85 (88) and a 25% chance of living beyond the age of 92 (94).
For a healthy couple, both 65, there is a 50% chance one will live beyond the age of 92 and a 25% chance one will live beyond the age of 97. This means that, assuming an investor is in his or her mid-60s, an investment portfolio may have a planning horizon greater than 35 years.
The risks of longevity have become greater, especially within the blue-collar group. It’s been well-documented that, in this group, we have an emerging retirement crisis due to the decline of defined benefit pension plans, a discomfort with investing in higher-expected-return assets (an issue related to financial illiteracy), and stagnation in real wage growth (leading to difficulty in accumulating preretirement wealth).
Exacerbating the problem is the low-yield environment we’ve been living in since 2008, making it more difficult for traditional fixed-income-oriented strategies to provide adequate and sustainable income that meets the desire to maintain established lifestyles.
In addition, at least in the United States, equity valuations are higher now than historically has been the case, leading financial economists to forecast equity returns of roughly 6-7% versus the historical figure of about 10%.
Developing A Retirement Plan
Equity investors must also consider that market volatility calls into question the use of risky assets to generate stable periodic cash flows throughout a long-term horizon. The reason is that, although long-term expected returns from stocks may be attractive, a sequence of negative returns can deplete a retirement income portfolio to the point where it lacks sufficient dollars to recover. In other words, the sequence of returns matters.
Consider the following example: From 1973 through 1999, the S&P 500 returned 13.9% per year and inflation rose 5.2% a year. Thus, the real return for an investor in the S&P 500 Index was 8.7%. Knowing this, in hindsight, one might think you could retire in 1972 and still safely withdraw an inflation-adjusted 7% every year (almost 2% per year below the annualized realized return) from your original principal and not worry about running out of assets.
However, because the S&P 500 declined by approximately 40% in the 1973-1974 bear market, the portfolio would have been depleted by the end of 1982—in just 10 years! In the decumulation phase, certainly the order of returns matters a great deal.
The bottom line is that success in retirement planning requires the careful consideration of your ability, willingness and need to take risk; appropriate and forward-looking assumptions about expected returns; an understanding of the consequences of changes in wealth; spending requirements; assessment of alternative strategies; and once the plan is implemented, ongoing monitoring not only of the financial condition of your portfolio but the spending assumptions made in building the plan as well.
When developing a retirement plan, your first objective should be to ensure the sustainability of adequate income over a lifetime. Risk modeling tools, such as a Monte Carlo simulator, play an important role in helping to determine the likelihood of ending with positive wealth, and if there is a shortfall, what its magnitude and duration may be. And risk models demonstrate that payout annuities can play an important role in retirement planning, helping to reduce the risk of running out of assets.
The Annuity Puzzle
Numerous academic studies advocate partial to full annuitization of financial assets. Despite the evidence, the majority of investors remain reluctant to annuitize both for behavioral and financial reasons.
Why or Why Not Annuitize?
An annuity is not an investment vehicle. Instead, it’s an insurance product designed to protect an individual from a catastrophic risk, specifically the risk of running out of money in retirement. It allows an individual to convert a lump-sum payment into a stream of income that continues for life.
The future payments from the annuity protect an individual from both financial market risk and, more importantly, longevity risk. Because the risk of outliving one’s assets is reduced, and annuities have built-in mortality credits, the academic literature has found structured annuity payouts allow a retiree either to increase the amount of dollars they can expect to withdraw from a portfolio without increasing the odds of failure (depleting assets) or to maintain the same withdrawal rate while increasing the odds of success.
Mortality Credits
The concept of a mortality credit is illustrated by the following example. On Jan. 1, we have 50 85-year-old males who each agree to contribute $100 to a pool of investments earning 5%. They further agree to split the total pool equally among those who are still alive at the end of the year.
Also, suppose that we (but not they) know for certain that five of the 50 will pass away by Dec. 31. This means the full pool, now $5,250 ($5,000 principal plus $250 interest), will be split among just 45 people. Each will receive $116.67, or a return on investment of 16.67%. If, instead, each person had invested independently of the pool, the total amount of money earned would have been $105, or a return on investment of 5%. The difference in returns is the mortality credit.
Despite the mortality credits, most individuals still hesitate when it comes to annuities. One reason is behavioral. A lot of investors exhibit what is called “loss aversion.” They feel that converting to an annuity “gambles away” their assets should they die earlier than expected. Thus, their heirs would inherit a smaller estate. Another reason is that some investors dislike giving up control of their assets, believing they might do better if the money remained and grew in their own investment accounts.
In addition, investors can be deterred by financial restrictions. Since most annuities are illiquid and irreversible, assets cannot be accessed should unexpected needs, such as health-related costs, arise. As a result, they may impose an unacceptable constraint on future consumption.
When to Annuitize?
Mortality credits are what make annuities worthwhile to consider. Offsetting the mortality credits are the costs embedded in the insurance contracts—costs that include not only management and administrative expenses, but distribution expenses (such as marketing costs and commissions) and the expected profit margin built into the products as well.
When we are young, the mortality credits are very small and are swamped by the costs. Thus, it doesn’t make sense to purchase an annuity when you are young. However, as we age, the mortality credits grow, eventually reaching a point where the product is worth considering. Which raises a new question: When is the right time to annuitize?
In general, the research indicates it is preferable to delay annuitization until your mid-70s or even your early 80s. A 2001 study, “Optimal Annuitization Policies: Analysis of the Options” by Moshe Milevsky, concluded that a 65-year-old female has an 85% chance of being able to beat the rate of return from a life annuity until age 80. For males, the figure was 80%. (Keep in mind that insurance companies issuing these policies are aware they are being adversely selected. The most likely buyers of longevity insurance are those who have a good reason to believe they will live a longer-than-average life.)
Another consideration is that in today’s environment of very low interest rates, the purchase of an annuity is locking in these low rates. (One strategy, then, is to diversify that risk by building a ladder of annuities over time, buying an equal amount over a period of, say, five or 10 years.)
Of course, delaying the purchase runs the risk rates will fall further. However, each year of delay also earns you more mortality credits. If you delay long enough, the mortality credits can even exceed the equity risk premium.
The bottom line is that, given today’s interest rates, and unless you are highly risk averse, you should probably not buy an immediate fixed annuity until your mid-70s or even approaching age 80. Similarly, if you are considering buying a deferred fixed annuity, you should think about delaying payments until age 80. There is one caveat, however, that goes with this advice.
Delaying the purchase of an annuity runs the risk that life expectancy increases, in turn increasing the cost of the annuity. A 2006 study, “Rational Decumulation” by David F. Babbel and Craig B. Merrill (both of the Wharton School of the University of Pennsylvania), calculated that a 1% annual improvement in mortality is associated with roughly a 5% increase in the price of an annuity, or a 5% reduction in monthly payouts. There’s also the risk that interest rates will fall from even today’s low levels, leading to lower monthly payouts upon annuitizing.
Which Annuity to Choose?
As mentioned, when deciding on a payout annuity, there are two types to consider, either an immediate or a deferred annuity. My recommendation is that, unless you already are approaching age 80, you should strongly favor the purchase of a deferred, or longevity, annuity. The reason is straightforward: We buy insurance to cover risks too dangerous for us to accept. We don’t buy insurance to protect against risks we can manage on our own.
For example, when buying automobile or homeowners insurance, it is usually the best strategy to buy the policy with the highest acceptable deductible that is appropriate in terms of risk. That limits the cost of the insurance.
Consider an investor who is 65 and has accumulated a portfolio that provides very high odds of not running out of money for the next 15 years. Thus, the main concern for our investor should be regarding the “risk” of living longer than 15 years. There is no need for an immediate payout annuity.
By purchasing the deferred annuity, you are buying the insurance only for the period for which it is needed, the mortality credits are much greater, and you greatly reduce the liquidity constraints imposed by the purchase of an immediate annuity. The later the start date, the lower the upfront payment will be. For example, one study found that for the same spending benefit, an individual purchasing an immediate annuity would have to annuitize more than 60% of his/her retirement assets versus just 11% of assets with a longevity annuity.
The same study ran additional scenarios comparing the spending benefits between men and women to highlight the difference in mortality rates by gender, and to further illustrate the higher spending benefit of longevity annuities over the purchase of immediate annuities. The results are shown here.
Conclusion
Partial annuitization through the use of longevity insurance not only reduces the risk that an individual will outlive their assets, but maintains the majority of assets in liquid, investable and, if possible, tax-managed accounts for flexibility and potential growth. This strategy is ideal for risk-averse investors with significant concerns about the possibility of outliving their assets.
Immediate annuities can be purchased using tax-deferred dollars because the annuities satisfy required minimum distribution (RMD) rules. In July of 2014, the Treasury department issued new regulations surrounding the purchase of deferred-income annuities in tax-deferred accounts.
The new regulations allow for the purchase of deferred-income annuities in qualified retirement accounts that begin payments after age 70.5 without violating RMD rules. However, there are certain requirements the qualified annuity must meet in order for the IRS to allow for annuitization after age 70.5:
Finally, the guaranteed income generated by the longevity annuity can allow a retiree to be more tolerant of risk, thereby making it more likely that they’ll stick to a specific investment strategy during the inevitable bear markets. In addition, a retiree might feel more at ease to spend a greater portion of savings earlier in retirement, knowing that the longevity annuity payments will kick in at a later date.
This commentary originally appeared April 11 on ETF.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2016, The BAM ALLIANCE