Saturday, June 12, 2010

So, Pension fund yields going to be 8%?

I got on this subject the last time around the tub in 2003. I read a lot, saw the projections then and did a total compound analysis on the data on the market Robert Shiller posts on his site monthly. . This could get really long, so I might move it to my blog.

Firat of all, I believe the Fed at that time estimated underfunding at $400 billion, but underfunding was marked at 90% of full funding and the use of actuarial returns of 8% to 9%. I believe 10 year treasuries were in the 4% range at the time, so any assumption of returns 4% to 5% over risk free would in itself be on shaky ground. I might add that it is difficult for the true, sustainable monetary base to grow in excess of risk free rates, which adds fuel to the fire.

To demonstrate the truth revealed in Shillers data, one must suspend from the nonsense about growth fundementals and get down to real facts. The first proposition, contrary to argument, is that the stock market is nothing more than a discount of a future stream of income known as dividends. Earnings is about nonsense, timing of losses, control fraud and other matters, but the dividend check goes in the bank. One could propose the companies have a salvage value, but once a company goes broke, shareholders are generally wiped out. That idea is for bond holders.

To make matters simple, I am going to use a 40 year holding period, March 1970 to March 2010. This will eliminate some noise, even though valuations are inflated today. To equate the matter, one has to either adjust the price in 1970 upward to reflect the current dividend rate or adjust the most recent downward. Many of you will wonder why, because it has been preached that dividends don't matter, only capital gains matter. This is nonsense, because the company's profits have to be liquidated in some fashion and without dividends over time, the company has no financial value.

Through careful though, I have deduced that the dividend is the basis of growth over time, thus has little present relation to inflation or anything else, including growth prospects. The market can't see 40 years, only what the current mania or downturn reflects. Inflation and the risk premium is reflected in the growth rate, so we could have a relatively low dividend and higher inflation or a high dividend and low inflation. History of these prices have provided us with both situations. IN any case, I am going to make the price of the 1970 market equal the value of what the dividend yield is now on the dividend of 1970. Then I am going to find the 40 year inflation rate based on the CPI and adjust the 1970 price up to today CPI. The division of the current price by the 1970 price should provide the compounded factor of growth over inflation. This should provide 3 rates, the inflation rate, the real growth rate and the dividend rate. The dividend rate will be what the current yield is. An easier way to do this and probably more accurate as well, as adding the compound inflation factor and the compound real growth factor will overstate the return slightly.

The price of the SPX in March 1970 was 88.65, the CPI was 38.20 and the dividend was 3.17. That gives us a dividend yield of 3.58%. The March 2010 SPX price was 1152.05, the CPI 217.63 and the dividend 21.91. This gives us a dividend yield of 1.902%. To adjust the 1970 price to current valuation would require the division of 3.17 by .01902, which gives a yield adjusted price of 166.68. I could do the reverse and divide the current dividend by the yield 40 years ago, which would provide a current price of 612.01. You might note this price is below the bottom price of 666 and I might add that a price that provides a 3.58% yield has been historically a high price to boot.

The CPI factor is 217.63/38.20. This equals 5.697, meaning it takes $5.70 to make a 1970 dollar. If I take the yield adjusted price of the SPX from 1970, 166.68 and adjust by the CPI, the current back inflation/dividend adjusted price from 1970 would be 949.59. This would be the current price if everything merely followed inflation. By being in the stock market from 1970 using the current dividend yield you would have made a compound 1158.05/949.59 or 1.2132 times your original investment. Subtracting 1, we have a total real growth in dividends of 21.95% over 40 years. I won't get exact in the compound factor, but simple math of 21.32% divided by 40 years gives us roughly 1/2%.

One might wonder, why the practice. What this series of calculations reveal is the real long term return on stocks is dividends plus inflation plus around 1/2%. Without going into the math directly I will add that I developed a longer term model, I believe from the January 1926 base that so many academic studies use. It it, I deduced that dividend plus real growth should equal around 6%. This would give the 9% return so talked about when adding a 3% inflation rate. As one might be able to see, real growth has fallen short of that model and if we adjusted the stock market to reflect 6% growth plus dividends, we would arrive at a price of 21.91/.055 or 398.36. Though this sounds shocking, an adjustment of stock prices to this model is 100% sure to happen at sometime in the next 10 years and the only factor is going to be what the CPI factor is at the time.

So, what have stocks, under this model made over the past 40 years? 1.902% plus (1152.05/166.68)^1/40. I will make an estimate on the 40 year factor of 6.91174. Dividing this number by 1.0495 forty times gives 1.00066 making the after inflation return 4.95%. This gives an adjusted 40 year return on the SPX of 6.852%. I might add the inflation rate or the 40 year factor for 5.697. This is somewhere between 4.44% and 4.45%, meaning we are looking at a long term yield adjusted return in stocks of inflation plus 1.902% plus 1/2%. For anyone who has ever studied finance, you know the risk free return is 3% and we are looking at stock returns in the 2.4% range. The theoretical return on treasuries has beaten stocks.

What this tells me is we aren't looking at 8% returns out of the market, but something on the order of inflation plus 2.4%. This would be fact if we are going to get a long term inflation rate of 5.6%, but can anyone fathom financing the pile of debt in the US or for that matter, the dollar denominated debt around the world at 10%? We are more likely to adjust downward to somewhere between the 391 I mentioned and the low 600's on the SPX. That is if the credit system holds up.

1 comment:

D said...

and then there's "execution" risk. aka social/systemic externalities to consider.

score is a function of a game being played and a game requires opponents to be played, right? what if there's only one participant that shows up for the game?