Tuesday, January 5, 2016

The FUD FACTOR ... Despite Market Meltdown Yesterday, Stocks Should Return ~8% Annually in the Future Low Inflationary Environment

The FUD factor (fear, uncertainty and doubt) is omni-present these days. President Obama's non-leadership and wrongheaded emphasis on climate change and gun control doesn't exactly engender confidence in our nation's CEO. Meanwhile, terrorism, immigration, indebtedness (personal, national and global), ISIS, Hillary and Bill, Donald, Ted, Bernie, Russia, Syria, Saudi Arabia, Iraq, Iran, Brazil, Venezuela, and others are creating additional unrest here and around the world, both politically and militarily.

And in addition to our own domestic economy, it's not exactly a peaceful and confidence building time in the rest of the world's economies either as the effects of China's slowing spread, oil and commodity prices falter, and global underemployment apparently is here to stay.

And lest we forget, the newest FUD contributor for 2016 and beyond, thanks to the Fed, is that short term interest rates are beginning to rise in America, albeit slowly and haltingly. So what's an individual investor supposed to do?

The stock markets around the world tumbled yesterday, and the 1.6% decline in the U.S. was mild when compared to the huge ~7% fall in China, ~3% in Japan and 2.5% in Europe.

The year's first day of trading was definitely ugly and many of the so-called market experts, after only one day of trading, are already proclaiming that 2016 won't be a good year for investors. See Markets Begin Year With a Thud. I say that long term oriented individual investors should ignore them and simply put the FUD factor aside.

The experts may be right, of course, but here's what I say. 2015 is history and 2016 is here, right on schedule. It's time for us to tune out the predicting pundits and instead save and invest for the long haul. And learning by doing is the easiest and most profitable way over time. Don't let FUD take control.

This Simple Way Is the Best Way to Predict the Market offers this sage advice this about predicting the future value of stocks:

"‘Tis the season to make guesses.

You might think that to predict stock or bond returns like a Wall Street strategist at year end, you need to mutter obscure incantations over a computer spewing out long equations bristling with Greek letters. But what if simplicity beats complexity?

Twenty-five years ago, John C. Bogle, founder of Vanguard Group, the giant investment firm, began publishing studies of stock and bond performance, seeking to determine the “sources of return” that have driven their results. . . .

Combing through returns all the way back to 1915, he found that you can explain the past returns on stocks — and predict their future returns with decent accuracy — by taking only three factors into account.

At first, that sounds so childishly simple it has to be wrong. But researchers in many fields have found that extremely basic formulas are often superior at making predictions about complicated systems.

The first of Mr. Bogle’s three elements is the starting yield, or annual dividends divided by stock price, currently about 2.2%. Second is earnings growth, which historically has averaged about 4.7%. Together those sources constitute what he calls the “investment return,” because they are based on the cash that companies generate.

Third is the “speculative return,” or any change in the mob psychology of how much investors want to pay for stocks. The S&P 500 is priced nowadays at about $23 per $1 of earnings per share, or a price/earnings ratio of nearly 23.

If that ratio rose to 25 over the coming decade, that would be roughly a 10% increase — boosting stock returns by about one percentage point annually. On the other hand, if the P/E fell to 20, that decline of more than 10% from today’s level would lower the next decade’s returns by about one percentage point per year.

That 2.2% dividend yield, plus the 4.7% earnings-growth rate, equals a smidgen under 7%. If market valuations rise one percentage point annually, that would take average returns up to about 8%; if they fall the same amount, total returns would drop to about 6%.

As for bonds, Mr. Bogle has found that essentially all you need to know is their yield to maturity, or interest income divided by market price. Analyzing 10-year periods back to 1906, he found that at least 90% of the subsequent return on bonds could be explained by their initial yields; capital gains and losses barely registered. So, with the Barclays U.S. Aggregate index of government and corporate bonds yielding 2.6%, that’s the baseline expectation.

None of these figures count inflation, which the Federal Reserve has targeted at 2% annually. Subtract that to account for loss of purchasing power, and stocks look likely to return an average of about 5% annually over time; bonds, less than 1%.

Note that these are expectations for the coming decade, not the next year — which is notoriously hard to predict.

By so clearly decomposing expected return into the factors that drive it, Mr. Bogle provides a model anyone can adapt. “If you don’t like my numbers [other than dividend yield],” he says, “you can put in your own.”

Do you think technology will enable future earnings to grow faster than in the past, or that investors might be willing to pay much more for those earnings than they used to? Do you instead believe the future will be worse? Then ratchet the earnings-growth rate and P/E contribution up or down accordingly. . . .

As 2016 approaches, ignore Wall Street’s elaborate guesswork. Sharpen your own pencil, think long-term and keep it simple."

Summing Up

Long term individual investors should contribute regularly to their 401(k) or IRA accounts.

Then if the market falls, they are buying cheaper, and if it continues to rise, they are seeing their account grow consistently.

It's a heads I win, tails I win scenario for those willing to get involved and stay involved with buying and owning stocks for the long haul.

That's my take.

Thanks. Bob.

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