US (S&P 500) Stock Market – December 2009 Update

To try and squeeze some more performance out of a retirement investing strategy that is heavily focused on asset allocation I am using a cyclically adjusted Price / Earnings (PE) ratio for the S&P 500 to attempt to value the US (specifically the S&P 500) Stock Market. The method used is that developed by Yale Professor Robert Shiller. My numbers will always appear slightly different to Professor Shiller as I also use the Earnings forecasts from Standard & Poors to complete the data set up to the month of interest. I will call it the Shiller PE10 and it is the ratio of Real (ie after inflation) S&P 500 Monthly Prices to 10 Year Real (ie after inflation) Average Earnings. I will use this data set as a proxy for my UK Equities as well as my International Equities (mostly Japan, US and EU equities). Ideally I would create a PE10 for each country however good data is impossible to find and I am working on the principle that these stock markets are now heavily correlated with globalisation.

To give an example of this I have just read a very good book called Wall Street Revalued by Andrew Smithers. He presents data that shows the following stock market correlations for the period 1999 to 2008:
US to France, 0.92
US to Germany, 0.93
US to Japan, 0.84
US to UK, 0.93

I will assume that stocks always return to their long run PE10 average and so reduce my exposure when stocks are overvalued and increase my exposure when they are undervalued. For my US and International Equities I will use the long run average of the Shiller PE10 to equate to when I hold 21% UK Equities and 15% International Equities respectively. For my retirement investing strategy on a linear scale I will target 30% less asset allocation when the Shiller PE10 average is Shiller PE10 average + 10 and will have 30% more asset allocation when the Shiller PE10 average is PE10 average - 10.

All figures are taken from historic data provided by Professor Shiller. Current stock market data is taken from Standard & Poors and inflation from the Bureau of Labor Statistics. The December market price is the 30 December S&P 500 stock market close.

Chart 1 plots the Shiller PE10. Key points this month are:
Shiller PE10 = 20.6 which is up from 19.8 last month. My UK Equities target asset allocation is now 18.3%. Additionally my International Equities target asset allocation is now 13.1%.
Shiller PE10 Average = 16.4
Shiller PE10 20 Percentile = 11.0
Shiller PE10 80 Percentile = 20.6. This means the S&P 500 is currently sitting right on the 80 Percentile.
Shiller PE10 Correlation with Real (ie after inflation) S&P 500 Price = 0.78

Chart 2 plots further reinforces why I am using this method. While the R^2 is low there appears to be a trend suggesting that the return in the following year is dependent on the Shiller PE10 value.

Chart 3 plots Real (after inflation) Earnings and Real Dividends for the S&P 500. Real Dividends are still falling however they are still above their long term trend. Real Earnings have a roller coaster ride continually, particularly since about 1990. If the Standard and Poors forecast earnings are to be believed however we are now back above the long term earnings trend.

US Inflation – November 2009 Update

The above chart shows the Consumer Price Index (CPI-U) up to November 2009 courtesy of the Bureau of Labor Statistics. I have taken the liberty of dividing the chart into two sections. The first red section runs from 1871 to 1932 and the second blue section runs from 1933 to present day. I chose this break point as during 1933 the US officially ended their link to the gold standard. I think this chart demonstrates a point that government will always choose to inflate debt away at the expense of savers if given the chance. They could not do this under the gold standard. To demonstrate this average inflation rates have been:
1871 to 1932, 0.5% with deflation being a regular occurrence.
1933 to Present, 3.7%

Australian Stock Market – December 2009 Update

To try and squeeze some more performance out of a retirement investing strategy that is heavily focused on asset allocation I am using a cyclically adjusted PE ratio for the ASX 200 to attempt to value the Australian Stock Market. The method used is based on that developed by Yale Professor Robert Shiller. I will call it the ASX 200 PE10 and it is the ratio of Real (ie after inflation) Monthly Prices and the 10 Year Real (ie after inflation) Average Earnings. For my Australian Equities I will use a nominal ASX 200 PE10 value of 16 to equate to when I hold 21% Australian Equities. On a linear scale I will target 30% less stocks when the ASX 200 PE10 average is ASX 200 PE10 average + 10 = 26 and will own 30% more stocks when the ASX 200 PE10 average is PE10 average -10 = 6.

All figures are taken from official data from the Reserve Bank of Australia except December which is estimated by taking the price from the 28 December Market close. Additionally the December Dividends and Earnings are assumed to be the same as the November numbers.

Chart 1 plots the ASX 200 PE10. Key points this month are:
ASX 200 PE10 = 18.7 which is up from 18.5 last month. My target Australian Equities target is now 19.3%.
ASX 200 PE10 Average = 22.9
ASX 200 PE10 20 Percentile = 17.3
ASX 200 PE10 80 Percentile = 27.7
ASX 200 PE10 Correlation with Real ASX 200 Price = 0.82

Chart 2 plots further reinforces why I am using this method. While the R^2 is low there appears to be a trend suggesting that the return in the following year is dependent on the ASX 200 PE10 value.

Chart 3 plots Real (after inflation) Earnings and Real Dividends. Dividends appear just about on trend however Earnings are still struggling and heading very much downwards. If this continues and Prices hold the ASX 200 PE10 will surely start to rise.

UK Inflation – November 2009 Update

The Office for National Statistics (ONS) reports the November 2009 UK Consumer Price Index (CPI) as 1.9% and the UK Retail Price Index (RPI) as 0.3%.

On the surface this sounds ok as the Bank of England has the following remit:
“The Bank’s monetary policy objective is to deliver price stability – low inflation – and, subject to that, to support the Government’s economic objectives including those for growth and employment. Price stability is defined by the Government’s inflation target of 2%.” The inflation measure they use is the CPI and so why would they raise interest rates?

I however don’t like what I see when I look at the raw data and think inflation could quickly get out of hand given the very low interest rates and quantitative easing that is currently occurring.
The first chart is tracking the CHAW Index which is the RPI including All Items. I focus on the RPI as my National Savings and Investments Index Linked Savings Certificates use the RPI to index from. This saw a big dip when the Bank of England dropped interest rates to historic lows however the chart shows that all the dip did was compensate for the big kick upwards that was seen from 2007. The current level of the Index is just about on the trendline suggesting we are back to the average annual increase since 1987 which is around3.5%.

The second chart is again based on the CHAW Index. This chart shows annual figures based on the previous 3, 6 and 12 month’s worth of data. As of November the 12 month figure is 0.3% (as published by the ONS) however disturbingly the 6 month figure is 3.6% and the 3 month figure is 4.1%. It will be interesting to see the official January 2010 numbers which is 12 months from the low in the Index at January 2009 and whether the Bank of England does anything about it. My simple projections suggest this could be up to 3.7%. I’ll keep buying Index Linked Savings Certificates whenever possible if this is going to continue.

Tax Efficient Investments and Tax Wrappers

You would think that governments throughout the world would be trying to encourage people to save for their own retirement and hence remove future burdens from the state. Unfortunately in the United Kingdom I don’t see the current government providing much support or encouragement here. Instead I see a lot of complexity which means unless you know exactly what you are doing you will over your investment life either:
- pay higher taxes than are necessary thereby ending up with a smaller investment pot in the future, or
- pay the same (effectively tax deferral) or lower taxes within tax wrappers but lose a lot or all of this benefit by paying higher fees / charges than needed or even in extreme cases charges on charges with in some instances the added negative of having certain restrictions on what you can and can’t do as defined by the government. Just to give one extreme example, I could even see that if you are only deferring tax within a wrapper but paying higher charges then you are actually worse off than not having a tax wrapper at all and just paying the full tax.

I guess it’s no different to anything else in life. Buyer beware and always carefully do your own research.

Minimising the tax I pay (along with the fees /charges I pay) is one of the cornerstones to my retirement strategy. I can easily show this by thinking of what percentage of my annual returns will come through dividends / interest and the affect that paying high rates of tax will have on my final retirement fund through losing on the compound interest effect. Let me give an example. Average Joe and Mr UK Average have £10,000 in share based investments that provide a dividend yield of 4.5% (average dividend yield of the S&P 500 since 1871 using the Shiller dataset). Both are higher rate 40% tax payers. Now Mr UK Average who doesn’t think about minimising taxation holds these shares outside of any tax efficient wrappers and so pays 32.5% (however in most instances this is really only 25% after tax credits on dividends are calculated). Average Joe holds half of his share based investments in tax wrappers meaning his effective tax rate is only 12.5%. I’m going to ignore capital gains to make the demonstration simple. So where are they after 20 years:

Average Joe has 11% more assets (and the more years in the calculation the better it gets for average Joe) than Mr UK Average meaning he has the potential for 11% more income in retirement or could hold a less risky investment portfolio for the same lifestyle. Taxes on investments matter.

I use one tax efficient investment type which are National Savings and Investments Index Linked Savings Certificates. Additionally I use 2 tax wrappers which are a Pension which is a Defined Contribution Scheme and a Stocks and Shares Individual Savings Account (Stocks and Shares ISA).

Just a little about each of these as I will cover them in more detail later:
- NS&I Index Linked Savings Certificates today offer a return of the Retail Prices Index (RPI) + 1% however the real benefit, particularly for high rate tax payers is that they are tax free.
- Pensions are extremely complex things and you would think that any government would be trying to simplify them so they could be understood and make them beneficial for all tax payers to save for their future. Unfortunately this doesn’t seem to be happening. I use them as for me personally they provide huge benefits. I can however think of a number of situations where they would provide little to no benefit and in some instances could even make a person worse off. What I am always nervous about however is that with a Pension you lock your money up for a lot of years and with past history as a guide governments will most likely change the rules. I therefore don’t put all my investments here.
- Stocks & Shares ISA’s seem to be no brainer for anyone wanting to invest in the stock markets. They form a pivotal part of my investment strategy. If you look around you can find Stocks and Shares ISA’s that don’t charge you to use the tax wrapper. You still pay to buy the investments inside and these investments might also see charges however this is no different to outside the wrapper. For higher rate tax payers they provide tax benefits from both dividends and capital gains. While for low rate tax payers today, they offer only really capital gains benefits. One thought however is that you never know when you might become a higher tax rate payer or given the disastrous state of the public finances of the UK you never know when as a low rate tax payer you will be taxed on your dividends.