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The Sweet Buy and Buy

This is the sweet buy and buy sales pitch. The Ibbotson study (and numerous similar studies) is one of the most misused pieces of market propaganda ever. If I thought for one minute you really could get 7% compound annualized returns over the next 20 years by simply buying and holding, I would agree that it would be a smart thing to do.

Today, with the help of a different and remarkable study by Ed Easterling of Crestmont Holdings, I am going to help you figure out what type of returns you should expect in your investment future, whether you are 20 or 80 years old. We are going to see when you should be buying, when you should be holding and when you should simply fold and walk away.

I cannot tell you how many soon-to-be-retired couples I have talked to, after their retirement savings have been hit 30-40-50% and their comfortable retirement dreams shattered, who tell me their brokers or advisors told them if they just hold on the market would come back. Soon, they are promised. These were the investment professionals they trusted and they assumed they had done their homework.

Now they know these guys flunked Stock Market Returns 101, or possibly skipped class in order to attend lectures by Jack Grubman on "How To Buy Telecommunications Stocks." Today I give you the class notes they should have shown you.

Ed Easterling is a colleague of mine in the world of hedge fund analysis. He is an expert on Texas based hedge funds. (Let's hear it for specialization.) His client list consists of institutions and high net worth individuals. He has been trying to develop a graphic way to show his clients what they should expect from simple stock market returns over the next decade.

He showed me some of his work. Basically, he has developed an Excel spreadsheet showing the stock market returns for the last 102 years. By looking at his tables, you can see what annualized return you would have earned if you had bought stocks in any year and held them for any length of time. Then he began to analyze what affect inflation, taxes and commissions would have on returns. And finally, he correlated those returns with Price to Earnings (P/E) ratios.

I looked at those charts for a long time, asked him to modify them for your use, and have posted them on my publisher's website. In today's e-letter, I am going to share with you some insights you can get from looking at these tables. We are going to see that:

There are clearly times to be in the market, and times when you should be on the sidelines. When you start investing is one of the most critical components for a successful investor. There are clear market cycles, and fighting the trend is a loser's game. Expecting to make 6-7% over the next 20 years is unrealistic in the current cycle.

I suggest you read this letter, and then go to the tables, should you find them of interest. (I should also point out that you might have to be patient, because if all 1,000,000+ recipients of this letter try to hit the website at the same time, the web site will be somewhat slow. You will need Adobe Acrobat Reader to view the tables. More about where to go for these tables later in the letter.)

First, let me describe the tables. Stick with me, because you are going to get some very important insights from this study.

#1. The table is a 100 x 100 matrix, starting with 1901. You can start with any year, move right along the row and find out what investment return you would have made in any subsequent year. For instance, if you had bought in 1930 you would have made a average of 2% a year over the next 20 years. If you bought stocks in 1980 and held, you would have compounded at 16% a year for the next 20 years assuming no inflation or taxes. For this study, we use the S&P 500 plus dividends.

#2. Each cell which holds a return number is color-coded. If a return was less than zero, it is colored red. If it was more than 10%, it is dark green, with various colors in between. As you look at the report, you see periods where there are lots of red, and periods where there are lots of dark green.

#3. Easterling does something I have never seen in any tables. He correlates the annualized return for a given period with P/E ratios. In the tables, if a number is black, that means that P/E ratios have been rising since the beginning of that period. If they are white, that means P/E ratios have been falling.

#4. They are four tables. Tables labeled "nominal" do not adjust for inflation or deflation. Tables labeled "real" take inflation/deflation into account. This way you can see what actual buying power you are getting from your stock market returns.

Tables labeled "individual" assume you are paying 30% taxes. Tables labeled "retirement" assume your funds have been in a pension or an IRA, and therefore not subjected to taxes. Easterling assumes 30% taxes as an average over this period. We are aware that the income tax did not exist in 1901. This was a tricky number to assumer, as taxes on stocks are comprised of both long term and short term gains, and are taxed at different rates for different times. Some of you pay state taxes.

Why not just assume all long-term gains? If you buy your stocks through mutual funds, as most individuals do, then you are probably seeing a lot of turnover in your portfolio. Remember Peter Lynch of Magellan fame? I am told his average holding period was about 7 months during the 70's. Some of you will pay higher taxes, and some of you will pay lower, depending upon your investment styles. 30% is probably fair. You can adjust your expectations accordingly.

#5. There is a thin black diagonal line going from the top right to the lower left. This line shows you what the returns are 20 years after an initial investment.

#6. Along the right hand side you can see the average P/E ratio for any given year, and along the bottom you can see the inflation rate.

Now, what can we learn from these tables?

First, there are very clear periods when returns are better than others. These relate to secular bull and bear markets. No big insight there. But what I notice is the correlation with P/E ratios. In general, when P/E ratios begin to rise, you want to be in the stock market. When they are falling, total returns over the next decade will be below par.

With the exception of WWII, when these periods of falling P/E ratios start, they just keep going until P/E ratios top out. Generally, this topping period comes prior to a recession.

Can you use the P/E ratios to signal a precise turn from a secular bull to a secular bear? No, but you can use them to confirm other signals. And once that turn has begun, the trend continues. You generally want to exit the stock market, except for trading accounts and special situations.

Second, this chart shows the high probability that a secular bear is currently in progress. High and falling P/E ratios, along with negative returns, are always associated with the beginning of such markets. When you let your eyes follow along the tables, you can see those "red" periods when annual gains were negative. Look at the corresponding P/E ratio. If it is high, it historically has correlated with the beginning of a secular bear, which always takes years to work itself out. Fighting this trend is frustrating at best.

When Can We Make Money In Stocks Again?

When can you profitably begin to be a long term investor, even in a secular bear market? Look at the tables. You have reasonable to excellent chances of getting above average returns if you buy when P/E ratios are below 10-12. You might have to suffer in the short term, but long term you will probably be OK. A good strategy would be to start averaging in when the market values drop below a P/E of 10-12. Even in the worst of the Depression, you would have done well over the next 20 years using this criteria and strategy.

Death and Taxes

If you look at just the nominal returns without thinking about taxes, some would make the case that trying to time the market is pointless. Over enough time, the returns tend to be the same. And I agree, if you have 50 years, time can heal a lot of mistakes. Investing through full cycles would give you a 10% compound return after many decades, and 6-7% in inflation adjusted terms.

However, if you take into account inflation and taxes, real returns tend to be in the 2-3% annual average range. And if you begin to invest at the beginning of a secular bear, real returns over the next 20 years are likely to be negative! You lose buying power.

Now this is the major point I want to make that you cannot get from these tables.

First, these tables include dividends. That greatly increases their return potential over using simple S&P 500 Index returns

Second, inflation did a great deal to mask the seriousness of the 1970 bear markets. It took 16 years for the index to make new highs from 1966, but it was another 10 years, or 1992, before investors saw a rise in their actual buying power in terms of the S&P 500 index.

On the table, you see that compound returns over the 26 years from 1966 to 1992 was 9% without inflation and 3% taking into account inflation. The actual index was flat. That means the bulk of earnings on this table over that period came from dividends. The compounding effect of dividends upon returns was huge.

The 9% returns an investor apparently got from 1966 through 1992 depended largely upon inflation. The 3% real returns are entirely due to dividends. During much of that period, dividends were in the 4-5% range.

Today, dividends on the S&P are around 1.5%, instead of the 4-5% of the 70's. Further, we are not in a period of high inflation.

Go to the retirement account real returns table, and look at the 1966 through 1992 period. The after inflation return numbers for the majority of that decade are negative for a long time, until you begin to get to periods of low P/E ratios.

Today, inflation is well under 2%, and will probably be in that range for many years. To get a picture of what nominal returns could look like for the next decade, add 2% to the inflation adjusted real returns for the 70's. Further, since dividends today are about 3% less than they were in that period, you might want to subtract a few points. The two numbers would just about wash each other out.

A secular bear market in which inflation and dividends are low would look like the 1970's on the table titled "retirement real." I am suggesting that returns for the next decade will probably look like the returns of the 70's on this chart.

Now, look forward in time from any year in the 70's when P/E ratios were above 10. Figure out when you want to be able to use your investments for retirement. See if there is enough growth and time to get you to where you want to be.

If you expect to retire in 10 years, it is very unsafe to assume a 5-6% return on stocks from where we are today. The table suggests it might even be unsafe to assume 2%!

How can I even think that stocks might not compound at 2% a year over the next ten years? It is because there has never been a time when investors have made a 2% return over ten years when P/E ratios are over 21, which is easily where they are today. I would not want to bet my retirement plans on something which has never happened in history.

If you are using a standard retirement planning software program, and it asks you to assume how much you are going to get from stocks, you had better not be using 10% or even 5% if you are planning on retiring in 10 or 20 years. Yes, that means the when General Motors assumes they will get 10% on their pension portfolios, they are smoking funny smelling cigarettes. If 50% or so of their portfolio is in bonds, and we know how low those returns are, that means they assume that stocks will be returning 15% or more over the next 10 years.

Now, don't jump off that ledge yet. This doesn't mean you can't make 8% on your portfolio. It just means you have to look at alternatives to traditional buy and hold mutual funds. Value will rule. Think dividends. Absolute returns from bonds and specialized funds will be critical to the growth of your portfolio.

One last and major point: these numbers are all averages. That means 50% of investors will do worse than the numbers suggested on these tables. Just food for thought.

You can look at the tables by

clicking here. The original tables were done in an 11 x 17 format. You might have to increase the "zoom" percentage in order to see any details. If you want to print them out and only have an 8.5" x11" color printer, we have split the table in two. You can print both tables and put them together to get the full affect. If you don't have Adobe Acrobat Reader, we provide a link for you to download it for free.

New Web Sites

I have just put up a new web site called From there you can link to the chapters I post each week from my next book, Absolute Returns ; if you are an accredited investor you can subscribe to my free e-letter on hedge funds and private offerings; you can see my bio and pictures of my family, and; find out about my recommended investment managers.

We are working hard to add new information each week to help you in your efforts to maximize the returns from your investment portfolio. Let me know what you think of the web site, and what you would like to see us add which can help make you a better investor.

Welcome to New Readers!

My publishers tell me we are adding a lot of new readers this week. We are currently going to over 1,000,000 names each week, and growing rapidly. New readers can go to and see what other readers have to say about this weekly letter. I want to thank all of you who have helped make the letter one of the fastest growing investment letters on the internet by recommending this letter to your friends. I know a lot has to do with the price (free is always easier to sell), but I hope some of it has to do with the quality of the wiring and the advice.

I will be speaking in New York on October 10-11 at the annual 2002 Fund of Hedge Funds Forum; in Los Angeles on November 4-5 at the Endowments and Foundations Symposium; in New Orleans on November 7-9 at the always outstanding New Orleans Investment Conference ( and in San Francisco on November 11 at the Public Pension Funds conference. I still have some openings in my schedule to speak with clients and potential clients at these events.

But this weekend I am with my family, and I can tell you that tops my list, although I do not get quite the same reception from my speaking when I lecture the kids. But they love me anyway, and that's what counts. Make sure you spend some time this week with family and friends, because I can guarantee you the dividends will be better than 1.5%.

Your hoping to get another chapter written next week analyst,

John Mauldin
John Mauldin

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