Realistic return expectations in a secular bear

This morning's market letter from John Mauldin is worth a read: Is this a Recovery?
The article does a good job of explaining the reality behind this week's “positive” jobs report and how today's deficits are likely to create a cumulative drag on GDP for the next 5-10 years.
It also addresses a question that I have been hearing a lot from readers lately: “how can I make my investment portfolio pay me 5-6%+ a year in present conditions.” With interest rates presently at 75-year lows, and equities historically within the “most expensive” range, the most responsible answer is that you cannot make your retirement portfolio safely produce withdrawals today of more than 4% without a 1 in 2 chance that you will run out of capital within 20 years. Not acceptable odds in my view.
Ed Easterling of Crestmont Research has written an excellent paper explaining that the greatest challenge to investors in secular bear climates is that valuations start out in the most expensive range, and take years to work their way down to least expensive again. Today with PE's north of 20 we are back in the least likely to be rewarding, highest risk range for equity investing. Ignoring this fact and trying to implement a passive allocation to equities in an effort to increase yield has an unacceptably high chance of failure:

“…the level of valuation (P/E) has a direct impact on success and
ending capital. The implication for today’s investor is that the likelihood of financial
success in retirement is considerably less than most pundits are advocating. Twenty
years from now, if the response is “who knew?” it won’t be much comfort for retirees in
the employment line at Wal-Mart. This is especially true since a rational understanding
of history and the drivers of longer-term stock market returns can help today’s retiree to
avoid that “surprise.” I assure you that these are not fear-driven statements, but rather
insights that are based upon history and the financial principle that valuation is a major
determinant of future returns…
BUT I WANT 5% (RATHER THAN JUST 4%)…
A number of advocates and studies provide for 5% withdrawal rates: “I only want
$50,000 from my million dollars” and have it last for 30 years. The calculated success
rate for that rate of withdrawal is 73%. Pretty good odds…except when we consider the
impact of valuation…starting when the average PE of stocks is 18.5 and higher [like today] those trying to withdraw 5% a year from their investment accounts have more than a 53% chance of running out of money within 21 years.

See: Destitute At 80: Retiring In Secular Cycles:.
The good news is we don't have to just buy and hope with equities at today's valuations. We can exercise more control and care in timing our exposure for a higher probability of rewarding outcomes. But it’s not easy. It takes a lot more discipline, patience and enlightenment from investment managers and clients in order to manage well through these conditions. The keys are placing very strict controls on risk exposure, and planning to earn and withdraw less over the next few years. Trying to dictate our income demands to our portfolios through secular bear climates is a recipe for financial disaster.

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5 Responses to Realistic return expectations in a secular bear

  1. Anonymous says:

    Dear Ms. Park
    Excellent work, I really enjoyed reading those papers, specially because they are more-less in line with the study of the business cycle.
    Now, there is one out there explaining the underlying currents and a look into the future and what you should study seriously for a long run, unless you have seen it already.
    It is on the ECRI web site under: Upcoming Events- Presentation slides: Jobs recovery real but more frequent recessions ahead.
    29-Mar-10

  2. Anonymous says:

    I used to enjoy reading Mr. Mauldin but lately I find his optimism to be almost pollyannish.
    Take for example his comment “There are some amazing new medical therapies coming your way and you are likely to live longer. I would plan on it.”
    I work on the front line in healthcare. The present systems, no matter where you live, are simply not sustainable. They are having a hard time keeping up with present demands and staying affordable, never mind factoring in aging baby boomers and new treatments and therapies.
    What is coming our way are significantly lower living standards in the Western world, except for a privileged few. I'm not happy about it but I'm not going to try and delude myself either.

  3. Anonymous says:

    For folks who want to know more about health care issues I heartily recommend the following blog
    http://doctorfullerton.com/

  4. Anonymous says:

    Los Angeles may run out of money as soon as next month
    http://www.bloomberg.com/apps/news?pid=newsarchive&sid=arou25UDV1F0

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