Importance of sequence of real returns for SWR, CAPE valuation, and Luck

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marcopolo
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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by marcopolo » Tue Aug 14, 2018 8:39 am

Random Walker wrote:
Tue Aug 14, 2018 8:18 am
HomerJ wrote:
Mon Aug 13, 2018 10:43 pm
Random Walker wrote:
Mon Aug 13, 2018 10:30 pm
I think it’s Bernstein or maybe Zwecher who refers to “Murphy’s Law Of Retirement”. An investor profits from a long bull market. As valuations rise, his portfolio swells. Seeing the larger than expected portfolio, the investor decides to retire. But he is retiring into a period of high valuations and low future expected returns.

Dave
But if he reads this forum, he changes his Asset Allocation to be more conservative as he retires and moves money into bonds, LOCKING IN SOME OF THOSE GAINS.

Someone who saw their stock money double from 1996 to 2000, if they followed the standard advice on this forum, probably did just fine. Their portfolio swelled, they decided to retire, and moved from say 60/40 to 40/60, and got to keep most of that money. Actually ALL of it, since they could live off the bonds while waiting for the stocks to recover.

Not once did they have to look at valuations for this strategy to work.

The key variable is the fact that they retired. Regardless of valuations, they should have changed their allocation to be more conservative the moment they realized retirement was close or at hand.
Basically we’re on the same page, but valuations do have some information in them. Why not add that bit of information to the decision process you describe. Knowing that valuations are high, mean expected returns low, and whole dispersion of returns shifted left, the retiring investor might fine tune the decision we are talking about a bit.

Dave
Dave,
a couple of questions:

1) What specifically should they do based on that information? If one is already using 4%, or perhaps a bit lower for a longer retirement horizon, what should be the adjustment based on a currently elevated CAPE?

2) How well has CAPE predicted returns AFTER Shiller first proposed it in 1988? If it has been "high" since 1992, perhaps the post data-mining correlation is not as high as the .40 that gets mentioned? i did a little searching, but could not find a reference that calculates the CAPE to returns correlation post-publication. All the correlation discussion i see compute it over all historical data, which is still dominated by the data that was used to develop the metric in the first place. We all know how that can skew actual predictive value of a metric.
Once in a while you get shown the light, in the strangest of places if you look at it right.

bradshaw1965
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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by bradshaw1965 » Tue Aug 14, 2018 8:57 am

CraigTester wrote:
Mon Aug 13, 2018 9:45 pm

I'm not sure the 1966 retiree would completely agree with you. He literally spent his last penny in his 30th year of retirement - after a whole series of very depressing conversations with his financial advisor along the way....

And to pour salt in his wounds, many of his buddies who retired at times when valuations were not so stretched, died with more than they started with....and never had a sleepless night...
As long as we are building narratives it's more likely that a male 1966 retiree bid adieu from this mortal coil well before those depressing conversations with his financial adviser. Time and money, nothing is certain and we probably shouldn't try to make things certain.

Random Walker
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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by Random Walker » Tue Aug 14, 2018 8:58 am

Marcopolo,
1) I would use a lower number perhaps 3-3.5%. I think the best way to do this is with Monte Carlo for your specific proposed AA.
2) don’t have a good answer for you on that one. My understanding of CAPE is probably about the same as yours. I am impressed by the shifting dispersion of potential returns more than the Mean. Less good good outcomes and worse bad outcomes really gets my attention. Just makes me think that at certain stages of life the equity risk is not as worthwhile.

Dave

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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by AlohaJoe » Tue Aug 14, 2018 9:05 am

marcopolo wrote:
Tue Aug 14, 2018 8:39 am
2) How well has CAPE predicted returns AFTER Shiller first proposed it in 1988?
Correlations aren't always the best thing to look at. CAPE's correlation has actually gone up but so has its forecast error. And forecast error is probably what people really care about.

Out-of-sample forecasts made since 1985:

Correlation of predicted returns with actual returns: 81% (up from 56% for the 1960-onward period, which is a good thing as predictions go)
Average forecast error (root-mean square error): 7.8% (up from 6.3%, which is a bad thing as predictions go)

So CAPE's already quite large errors of 6.3% has increased by 25% since the mid-1980s. To show it graphically, see the complete failure of CAPE to predict returns since the early 1990s (only a quarter of a century now....)

Image

(All numbers come from the recent Vanguard paper about CAPE and "fair-value".)

marcopolo
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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by marcopolo » Tue Aug 14, 2018 9:21 am

Random Walker wrote:
Tue Aug 14, 2018 8:58 am
Marcopolo,
1) I would use a lower number perhaps 3-3.5%. I think the best way to do this is with Monte Carlo for your specific proposed AA.
2) don’t have a good answer for you on that one. My understanding of CAPE is probably about the same as yours. I am impressed by the shifting dispersion of potential returns more than the Mean. Less good good outcomes and worse bad outcomes really gets my attention. Just makes me think that at certain stages of life the equity risk is not as worthwhile.

Dave
1) Going from 4% to 3% probably requires working somewhere around 5 extra years for most people? That seems like a heavy price to pay for something that might happen if we have conditions worse than anything we have encountered in the last 100+ years. As others have said i various discussions, if you happen to get to 3% naturally, or really enjoy your job, no problem. But, if you are in a job you are not excited about every day, working for another 5 years for this low probability outcome seems like a heavy cost.

I generally like Monte Carlo analysis, but I am not sure how helpful it is for this specific situation. In this case you are trying to incrementally improve the far tails of the distributions. 60/40 work 95% of the time, can we get to 97 using 50/50, etc? But, MCS is known to have heavier than observed tails. The spread of MCS ends up being quite a bit worse than the actual spread observed in real world returns. So, it is not clear how reliable MCS is for evaluating behavior at the tails of the distribution.

2) I know the data shows that higher CAPE shows lower mean returns 10 years out. Not, as convinced about the worse getting worse. Take a look at the second plot n the link below showing the relationship between CAPE and 10yr returns. To, me it looks like the "worst" bad cases occur with CAPE in the range of 20-32. Once CAPE gets above 32, the returns are actually more tightly clustered. Maybe, there are just not enough samples, but i am not sure how one could conclude form this that higher CAPE leads to worse bad outcomes. Based on the plot, the worst outcomes at CAPE > 32 don't seem any worse than with CAPE in the 15-20 range.

EDIT: Edited to add link mentioned above: https://www.cxoadvisory.com/4281/fundam ... k-returns/
Last edited by marcopolo on Tue Aug 14, 2018 3:27 pm, edited 1 time in total.
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marcopolo
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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by marcopolo » Tue Aug 14, 2018 9:25 am

AlohaJoe wrote:
Tue Aug 14, 2018 9:05 am
marcopolo wrote:
Tue Aug 14, 2018 8:39 am
2) How well has CAPE predicted returns AFTER Shiller first proposed it in 1988?
Correlations aren't always the best thing to look at. CAPE's correlation has actually gone up but so has its forecast error. And forecast error is probably what people really care about.

Out-of-sample forecasts made since 1985:

Correlation of predicted returns with actual returns: 81% (up from 56% for the 1960-onward period, which is a good thing as predictions go)
Average forecast error (root-mean square error): 7.8% (up from 6.3%, which is a bad thing as predictions go)

So CAPE's already quite large errors of 6.3% has increased by 25% since the mid-1980s. To show it graphically, see the complete failure of CAPE to predict returns since the early 1990s (only a quarter of a century now....)

Image

(All numbers come from the recent Vanguard paper about CAPE and "fair-value".)
Thanks for digging that up!
I can now go back to largely ignoring valuation metrics as a means to predict future returns
Once in a while you get shown the light, in the strangest of places if you look at it right.

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willthrill81
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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by willthrill81 » Tue Aug 14, 2018 9:26 am

AlohaJoe wrote:
Tue Aug 14, 2018 9:05 am
marcopolo wrote:
Tue Aug 14, 2018 8:39 am
2) How well has CAPE predicted returns AFTER Shiller first proposed it in 1988?
Correlations aren't always the best thing to look at. CAPE's correlation has actually gone up but so has its forecast error. And forecast error is probably what people really care about.

Out-of-sample forecasts made since 1985:

Correlation of predicted returns with actual returns: 81% (up from 56% for the 1960-onward period, which is a good thing as predictions go)
Average forecast error (root-mean square error): 7.8% (up from 6.3%, which is a bad thing as predictions go)

So CAPE's already quite large errors of 6.3% has increased by 25% since the mid-1980s. To show it graphically, see the complete failure of CAPE to predict returns since the early 1990s (only a quarter of a century now....)

Image

(All numbers come from the recent Vanguard paper about CAPE and "fair-value".)
I think that illustrates that CAPE hasn't completely lost whatever predictive value it may have once possessed, but it's likely less predictive than many believe.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

CraigTester
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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by CraigTester » Tue Aug 14, 2018 9:29 am

AlohaJoe wrote:
Tue Aug 14, 2018 9:05 am
marcopolo wrote:
Tue Aug 14, 2018 8:39 am
2) How well has CAPE predicted returns AFTER Shiller first proposed it in 1988?
Correlations aren't always the best thing to look at. CAPE's correlation has actually gone up but so has its forecast error. And forecast error is probably what people really care about.

Out-of-sample forecasts made since 1985:

Correlation of predicted returns with actual returns: 81% (up from 56% for the 1960-onward period, which is a good thing as predictions go)
Average forecast error (root-mean square error): 7.8% (up from 6.3%, which is a bad thing as predictions go)

So CAPE's already quite large errors of 6.3% has increased by 25% since the mid-1980s. To show it graphically, see the complete failure of CAPE to predict returns since the early 1990s (only a quarter of a century now....)

Image

(All numbers come from the recent Vanguard paper about CAPE and "fair-value".)
Nice to see some actual number crunching, AlohaJoe!

I'd have to irritate you with a hundred detailed questions to fully understand what your chart represents, (for instance, not sure what the note on the bottom of the chart is saying regarding 1926-1959). But if I understand it at all, it appears that your forecast is "directionally correct".

The amplitude begins to skew, but the direction is on target. Definitely not random.

BTW, its appropriate that we are having this conversation around PE10, specifically. After all, that's what the OP's chart used for his valuation metric. However, we shouldn't lose site in all these battles over PE10, that its not the only metric that suggests the SP500 is very expensive right now.

CULater
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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by CULater » Tue Aug 14, 2018 9:51 am

Perhaps CAPE is no longer a useful measure of valuations and expected 10-year returns from stocks. This time is different. The backtesting data are not relevant. Maybe that's the case. But why does it make sense to believe that the 4% rule is still carved in stone? This time is the same. The backtesting data are all good. We choose to believe what we choose to believe, inconsistent as that might be.
May you have the hindsight to know where you've been, The foresight to know where you're going, And the insight to know when you've gone too far. ~ Irish Blessing

bradshaw1965
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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by bradshaw1965 » Tue Aug 14, 2018 9:53 am

CULater wrote:
Tue Aug 14, 2018 9:51 am
But why does it make sense to believe that the 4% rule is still carved in stone?
4% rule was *never* carved in stone. It was a single study that drove *down* the general rule of thumb for retiree withdrawals.

bikechuck
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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by bikechuck » Tue Aug 14, 2018 10:02 am

Random Walker wrote:
Mon Aug 13, 2018 1:41 pm
Sequence of returns is a huge issue immediately preceding retirement and in early retirement. This, influenced by recent valuations, is perhaps the biggest reason I’ve diversified as much as I can across sources of return. I’ve decreased overall equity exposure, increased bond exposure, tilted equities heavily to SV, taken international equity exposure to 50%, added alternatives. I believe this will decrease the SD and maximal drawdown of the portfolio compared to more conventional TSM portfolios with similar expected return.

Dave
My friend, you are speaking in tongues for this acronym challenged reader. I have no clue what SV and SD stand for. I am guessing that TSM might be total stock market but I am not sure.

This forum would be far more useful to newbies and people like me that struggle with this if posters would take the few extra seconds to spell things out.

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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by willthrill81 » Tue Aug 14, 2018 10:05 am

bradshaw1965 wrote:
Tue Aug 14, 2018 9:53 am
CULater wrote:
Tue Aug 14, 2018 9:51 am
But why does it make sense to believe that the 4% rule is still carved in stone?
4% rule was *never* carved in stone. It was a single study that drove *down* the general rule of thumb for retiree withdrawals.
That's not entirely accurate. Yes, Bengen's study was seminal, but it was a study that has been replicated countless times after with the advent of the Internet, good data, and cheap computing power. What I believe are the two biggest valid criticisms of the '4% rule' are that (1) it revolves around one country (U.S.) and (2) the future could look worse than the past.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

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willthrill81
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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by willthrill81 » Tue Aug 14, 2018 10:06 am

bikechuck wrote:
Tue Aug 14, 2018 10:02 am
Random Walker wrote:
Mon Aug 13, 2018 1:41 pm
Sequence of returns is a huge issue immediately preceding retirement and in early retirement. This, influenced by recent valuations, is perhaps the biggest reason I’ve diversified as much as I can across sources of return. I’ve decreased overall equity exposure, increased bond exposure, tilted equities heavily to SV, taken international equity exposure to 50%, added alternatives. I believe this will decrease the SD and maximal drawdown of the portfolio compared to more conventional TSM portfolios with similar expected return.

Dave
My friend, you are speaking in tongues for this acronym challenged reader. I have no clue what SV and SD stand for. I am guessing that TSM might be total stock market but I am not sure.

This forum would be far more useful to newbies and people like me that struggle with this if posters would take the few extra seconds to spell things out.
SV (or SCV) = small cap value

SD = standard deviation, a measure of volatility

TSM = total stock market
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

bradshaw1965
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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by bradshaw1965 » Tue Aug 14, 2018 10:27 am

willthrill81 wrote:
Tue Aug 14, 2018 10:05 am
bradshaw1965 wrote:
Tue Aug 14, 2018 9:53 am
CULater wrote:
Tue Aug 14, 2018 9:51 am
But why does it make sense to believe that the 4% rule is still carved in stone?
4% rule was *never* carved in stone. It was a single study that drove *down* the general rule of thumb for retiree withdrawals.
That's not entirely accurate. Yes, Bengen's study was seminal, but it was a study that has been replicated countless times after with the advent of the Internet, good data, and cheap computing power. What I believe are the two biggest valid criticisms of the '4% rule' are that (1) it revolves around one country (U.S.) and (2) the future could look worse than the past.
I'm probably being pedantic, my point is simply that it's not a rule. I think it's a good rule of thumb, 3.5% is probably better for the intended audience, 3.0% probably better for early retirees. But for the 1966 cohort as compared to now I'm much more worried about the following chart and keeping my wits about me as far as dementia and quality of life at the end of life then I am about splitting hairs about SWR. Image

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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by HomerJ » Tue Aug 14, 2018 10:37 am

CULater wrote:
Tue Aug 14, 2018 9:51 am
Perhaps CAPE is no longer a useful measure of valuations and expected 10-year returns from stocks. This time is different. The backtesting data are not relevant. Maybe that's the case. But why does it make sense to believe that the 4% rule is still carved in stone? This time is the same. The backtesting data are all good. We choose to believe what we choose to believe, inconsistent as that might be.
CAPE10 has failed to predict returns accurately since it was discovered. For 26 years, CAPE has been predicting low returns, and we've gotten decent-to-good returns instead.

4% hasn't failed yet.
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HomerJ
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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by HomerJ » Tue Aug 14, 2018 10:49 am

willthrill81 wrote:
Tue Aug 14, 2018 10:05 am
bradshaw1965 wrote:
Tue Aug 14, 2018 9:53 am
CULater wrote:
Tue Aug 14, 2018 9:51 am
But why does it make sense to believe that the 4% rule is still carved in stone?
4% rule was *never* carved in stone. It was a single study that drove *down* the general rule of thumb for retiree withdrawals.
That's not entirely accurate. Yes, Bengen's study was seminal, but it was a study that has been replicated countless times after with the advent of the Internet, good data, and cheap computing power. What I believe are the two biggest valid criticisms of the '4% rule' are that (1) it revolves around one country (U.S.) and (2) the future could look worse than the past.
(1) is a good criticism
(2) I'm not as worried about since the data includes the Great Depression, World Wars, and the perfect financial storm that started in 1966.

Basically when people say 4% may not be good enough going forward, they are predicting some serious bad times ahead. Certainly possible, of course, but if we get another Great Depression or another World War, I can probably cut back on my vacations and still feel very lucky.

I mean, people here using 4% have a decent chunk of discretionary spending built in. If 4% was bare-bones survival, I would be hesitant to champion it whole-heartedly as well.

But for most Bogleheads, 4% includes vacations, and eating out, and occasional new cars, and trips to the ballpark or theater, etc.

If the Great Depression II hits, most of us can survive warm, fed, and safe, on 3% if needed.

I just don't think high valuations alone are enough to predict that the next 30 years are going to be worse 30-year financial period ever in American history.
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willthrill81
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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by willthrill81 » Tue Aug 14, 2018 11:18 am

bradshaw1965 wrote:
Tue Aug 14, 2018 10:27 am
willthrill81 wrote:
Tue Aug 14, 2018 10:05 am
bradshaw1965 wrote:
Tue Aug 14, 2018 9:53 am
CULater wrote:
Tue Aug 14, 2018 9:51 am
But why does it make sense to believe that the 4% rule is still carved in stone?
4% rule was *never* carved in stone. It was a single study that drove *down* the general rule of thumb for retiree withdrawals.
That's not entirely accurate. Yes, Bengen's study was seminal, but it was a study that has been replicated countless times after with the advent of the Internet, good data, and cheap computing power. What I believe are the two biggest valid criticisms of the '4% rule' are that (1) it revolves around one country (U.S.) and (2) the future could look worse than the past.
I'm probably being pedantic, my point is simply that it's not a rule. I think it's a good rule of thumb, 3.5% is probably better for the intended audience, 3.0% probably better for early retirees. But for the 1966 cohort as compared to now I'm much more worried about the following chart and keeping my wits about me as far as dementia and quality of life at the end of life then I am about splitting hairs about SWR. Image
:thumbsup

If I recall, according to the Social Security Administration, a 65 year old male has a 20% chance of dying before the age of 74.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

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willthrill81
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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by willthrill81 » Tue Aug 14, 2018 11:23 am

HomerJ wrote:
Tue Aug 14, 2018 10:49 am
willthrill81 wrote:
Tue Aug 14, 2018 10:05 am
bradshaw1965 wrote:
Tue Aug 14, 2018 9:53 am
CULater wrote:
Tue Aug 14, 2018 9:51 am
But why does it make sense to believe that the 4% rule is still carved in stone?
4% rule was *never* carved in stone. It was a single study that drove *down* the general rule of thumb for retiree withdrawals.
That's not entirely accurate. Yes, Bengen's study was seminal, but it was a study that has been replicated countless times after with the advent of the Internet, good data, and cheap computing power. What I believe are the two biggest valid criticisms of the '4% rule' are that (1) it revolves around one country (U.S.) and (2) the future could look worse than the past.
(1) is a good criticism
(2) I'm not as worried about since the data includes the Great Depression, World Wars, and the perfect financial storm that started in 1966.

Basically when people say 4% may not be good enough going forward, they are predicting some serious bad times ahead. Certainly possible, of course, but if we get another Great Depression or another World War, I can probably cut back on my vacations and still feel very lucky.

I mean, people here using 4% have a decent chunk of discretionary spending built in. If 4% was bare-bones survival, I would be hesitant to champion it whole-heartedly as well.

But for most Bogleheads, 4% includes vacations, and eating out, and occasional new cars, and trips to the ballpark or theater, etc.

If the Great Depression II hits, most of us can survive warm, fed, and safe, on 3% if needed.

I just don't think high valuations alone are enough to predict that the next 30 years are going to be worse 30-year financial period ever in American history.
I entirely agree.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by Random Walker » Tue Aug 14, 2018 2:20 pm

Bikechuck,
I was trying to be efficient with my words. You’ll get up to speed very quickly I’m sure :-)

Dave

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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by Random Walker » Tue Aug 14, 2018 2:39 pm

Marcopolo,
When I say the distributions shift left and the bad outcomes are worse, I’m not looking at any of the above charts. I’m just using my version of common sense. We all tend to anchor on our greatest net worth or our current net worth. If markets fall to an average PE of say 15-20 (I know we can argue for a new higher Mean PE to revert to), the fall is more painful the higher we start from. And why wouldn’t Markets spend some time below the Mean PE? It is a mean after all. I just assume equities can fall 50% in any given year, and perhaps significantly more in a multi year bear.

Dave

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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by marcopolo » Tue Aug 14, 2018 3:22 pm

Random Walker wrote:
Tue Aug 14, 2018 2:39 pm
Marcopolo,
When I say the distributions shift left and the bad outcomes are worse, I’m not looking at any of the above charts. I’m just using my version of common sense. We all tend to anchor on our greatest net worth or our current net worth. If markets fall to an average PE of say 15-20 (I know we can argue for a new higher Mean PE to revert to), the fall is more painful the higher we start from. And why wouldn’t Markets spend some time below the Mean PE? It is a mean after all. I just assume equities can fall 50% in any given year, and perhaps significantly more in a multi year bear.

Dave
That seems an odd thing for you to say. The whole "CAPE is predictive" argument is based on looking at historical data. So many of the arguments for Factors and Alts you have been espousing are based on historical data analysis (uncorrelatedness, similar expected returns, etc.), but now, when the data does not match your assertion, you rely on your "version of common sense"? I am baffled.



Sorry, I noticed i forgot the link on my previous post.
Marcopolo wrote: 2) I know the data shows that higher CAPE shows lower mean returns 10 years out. Not, as convinced about the worse getting worse. Take a look at the second plot n the link below showing the relationship between CAPE and 10yr returns. To, me it looks like the "worst" bad cases occur with CAPE in the range of 20-32. Once CAPE gets above 32, the returns are actually more tightly clustered. Maybe, there are just not enough samples, but i am not sure how one could conclude form this that higher CAPE leads to worse bad outcomes. Based on the plot, the worst outcomes at CAPE > 32 don't seem any worse than with CAPE in the 15-20 range.
https://www.cxoadvisory.com/4281/fundam ... k-returns/
Last edited by marcopolo on Tue Aug 14, 2018 3:26 pm, edited 1 time in total.
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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by willthrill81 » Tue Aug 14, 2018 3:24 pm

marcopolo wrote:
Tue Aug 14, 2018 3:22 pm
Random Walker wrote:
Tue Aug 14, 2018 2:39 pm
Marcopolo,
When I say the distributions shift left and the bad outcomes are worse, I’m not looking at any of the above charts. I’m just using my version of common sense. We all tend to anchor on our greatest net worth or our current net worth. If markets fall to an average PE of say 15-20 (I know we can argue for a new higher Mean PE to revert to), the fall is more painful the higher we start from. And why wouldn’t Markets spend some time below the Mean PE? It is a mean after all. I just assume equities can fall 50% in any given year, and perhaps significantly more in a multi year bear.

Dave
That seems an odd thing for you to say. The whole "CAPE is predictive" argument is based on looking at historical data. So many of the arguments for Factors and Alts you have been espousing are based on historical data analysis (uncorrelatedness, similar expected returns, etc.), but now, when the data does not match your assertion, you rely on your "version of common sense"? I am baffled.
"It's difficult to make predictions, especially about the future."
- Dutch proverb

I am not convinced that anyone can reliably predict the future well enough to actually benefit the individual investor.
Last edited by willthrill81 on Tue Aug 14, 2018 3:25 pm, edited 1 time in total.
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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by HomerJ » Tue Aug 14, 2018 3:25 pm

Random Walker wrote:
Tue Aug 14, 2018 2:39 pm
And why wouldn’t Markets spend some time below the Mean PE? It is a mean after all.
This is why the CAPE model appears to be broken. It's been above its mean 98% of the time for the past 26 years.

And it's not like it didn't have chances to revert. We had two stock crashes in that time period, one of which was nearly a full-out financial panic.

Even during that, it barely crossed below the historical mean.

I think it's certainly reasonable to wonder if the model is broken, if some variable is unaccounted for, if something has changed.


I mean, if someone comes up with a 100-year flood model based on the past 100 years, and then we have three 100-year floods in the past decade, isn't it reasonable to wonder if something has changed and the model no longer correctly models the situation?

We could have just gotten really lucky with stocks, or in the flood example, really unlucky with floods.

The models could indeed still be correct. But can your really say we're being unreasonable if we don't quite trust the models as much anymore? If we wonder, if maybe, just maybe, something has changed?
I just assume equities can fall 50% in any given year, and perhaps significantly more in a multi year bear.
I agree with this, and make all my AA decisions around it. I believe this is possible in ANY year, REGARDLESS of valuations. I do not look at valuations to make a plan. The risk is never zero. I don't care if the risk is higher with high valuations. It doesn't matter to me if the risk is 3% or 15%...

I'm preparing for it either way, just in case.
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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by willthrill81 » Tue Aug 14, 2018 3:39 pm

HomerJ wrote:
Tue Aug 14, 2018 3:25 pm
Random Walker wrote:
Tue Aug 14, 2018 2:39 pm
And why wouldn’t Markets spend some time below the Mean PE? It is a mean after all.
This is why the CAPE model appears to be broken. It's been above its mean 98% of the time for the past 26 years.

And it's not like it didn't have chances to revert. We had two stock crashes in that time period, one of which was nearly a full-out financial panic.

Even during that, it barely crossed below the historical mean.

I think it's certainly reasonable to wonder if the model is broken, if some variable is unaccounted for, if something has changed.
Any honest person versed in research should be willing to admit that CAPE's supposed relationship with future equity returns may be spurious. The real litmus test of any predictive model is how well it predicts after it is proposed. In that sense, CAPE has definitely not performed well.

I've repeatedly asked people why 1/CAPE is a good estimate of forward returns given that CAPE has been above its historic average almost continuously since 1992, yet real returns from then until now have been slightly above their historic average. The only response I've gotten is that it's due to valuations themselves increasing, which is touted as being beyond anyone's predictive power. That strikes me as a truism and tautological, at best. It smacks of being a post hoc explanation for an event and indicative that one does not truly understand the phenomenon they are trying to predict.
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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by Riley15 » Tue Aug 14, 2018 4:07 pm

HomerJ wrote:
Tue Aug 14, 2018 3:25 pm

This is why the CAPE model appears to be broken. It's been above its mean 98% of the time for the past 26 years.

And it's not like it didn't have chances to revert. We had two stock crashes in that time period, one of which was nearly a full-out financial panic.

Even during that, it barely crossed below the historical mean.

I think it's certainly reasonable to wonder if the model is broken, if some variable is unaccounted for, if something has changed.
It's very interesting I am following this thread and another thread on international allocation here:

viewtopic.php?f=10&t=256423&start=50

Although two completely different topics, the parallels are intriguing. Here it' s mentioned the CAPE model appears broken because it's been above it's mean for the past 26 years so it's no longer relevant, a valid point. In the other thread it's pointed out that International stocks has lagged US for the past 22 years so one should not invest in International, also a valid point.

These are long time frames and reversions to mean should have already occurred but obviously they have not. Maybe they will happen in the future in 10, 20, 30 even 40 years nobody knows. But none of us has that kind of time-frame to work with before we need dial down our equity allocations.

Should I ignore the CAPE model? Should I sell all my International stocks?

There is so much we don't know now, but in the future some really smart people will come up with models based on hindsight to explain the past claiming to know what to expect for the future.

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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by Random Walker » Tue Aug 14, 2018 4:11 pm

Marcopolo,
I think there is more to CAPE than historical data. It’s logical that the more expensive it is to purchase a dollar of earnings, the more likely the price is to move down rather than up.

HomerJ,
Completely agree that a model can be wrong. And I really agree that my understanding of a model can be wrong! I do not at all believe in market timing. I do believe in looking at one’s own circumstance and adjusting the glide path towards a retirement portfolio in a personalized / customized fashion depending on what the market has given, current valuations, expected returns. I don’t at all know what mean the current CAPE could/should/will revert to. But as a 55 yo employee, I’m only taking as much risk as I think I need to. And Monte Carlo Simulation using the best estimates of expected returns and correlations we have has helped formulate my decisions. If I took a more blind / head in the sand approach to my AA, I’m sure I would have a substantially more aggressive portfolio and likely end up with more money in the long run. But the potential of achieving specific goal would also be a bit less.


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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by marcopolo » Tue Aug 14, 2018 5:09 pm

Random Walker wrote:
Tue Aug 14, 2018 4:11 pm
Marcopolo,
I think there is more to CAPE than historical data. It’s logical that the more expensive it is to purchase a dollar of earnings, the more likely the price is to move down rather than up.

Dave
Is there some notion of prices as a function of earning being affecting future returns? I suspect that is true. But, i am not sure that necessarily leads to the conclusion that future returns will be negative, you have to look at in context with other factors, such as yield on bonds competing for the same investing dollar.

Even if you accept that to be the case, why would you not expect the current PE to be the better indicator of that.
Why 10 years of earnings, instead of 7 or 12? Why not smooth prices for a period of time as well? My suspicion is that a lot of those variables were analyzed at the time, and CAPE as we know it today is what provided the best (most publishable) results at that time. It did not just fall out of the air. It is only after the fact that people are imbuing it with all sorts of fundamental properties. More likely it was a result of a lot well informed data mining, and as such, much of its perceived predictive power has faded over time as out of sample data becomes available.
Once in a while you get shown the light, in the strangest of places if you look at it right.

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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by HomerJ » Tue Aug 14, 2018 5:39 pm

Riley15 wrote:
Tue Aug 14, 2018 4:07 pm
HomerJ wrote:
Tue Aug 14, 2018 3:25 pm

This is why the CAPE model appears to be broken. It's been above its mean 98% of the time for the past 26 years.

And it's not like it didn't have chances to revert. We had two stock crashes in that time period, one of which was nearly a full-out financial panic.

Even during that, it barely crossed below the historical mean.

I think it's certainly reasonable to wonder if the model is broken, if some variable is unaccounted for, if something has changed.
It's very interesting I am following this thread and another thread on international allocation here:

viewtopic.php?f=10&t=256423&start=50

Although two completely different topics, the parallels are intriguing. Here it' s mentioned the CAPE model appears broken because it's been above it's mean for the past 26 years so it's no longer relevant, a valid point. In the other thread it's pointed out that International stocks has lagged US for the past 22 years so one should not invest in International, also a valid point.

These are long time frames and reversions to mean should have already occurred but obviously they have not. Maybe they will happen in the future in 10, 20, 30 even 40 years nobody knows. But none of us has that kind of time-frame to work with before we need dial down our equity allocations.

Should I ignore the CAPE model? Should I sell all my International stocks?

There is so much we don't know now, but in the future some really smart people will come up with models based on hindsight to explain the past claiming to know what to expect for the future.
Just one note... I'm not saying the CAPE model is wrong. I'm saying it's reasonable to wonder if it's wrong. No one should be so SURE it's right at this point, in any case.
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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by HomerJ » Tue Aug 14, 2018 5:40 pm

Random Walker wrote:
Tue Aug 14, 2018 4:11 pm
Marcopolo,
I think there is more to CAPE than historical data. It’s logical that the more expensive it is to purchase a dollar of earnings, the more likely the price is to move down rather than up.
I agree with that.
Completely agree that a model can be wrong. And I really agree that my understanding of a model can be wrong! I do not at all believe in market timing. I do believe in looking at one’s own circumstance and adjusting the glide path towards a retirement portfolio in a personalized / customized fashion depending on what the market has given, current valuations, expected returns. I don’t at all know what mean the current CAPE could/should/will revert to. But as a 55 yo employee, I’m only taking as much risk as I think I need to. And Monte Carlo Simulation using the best estimates of expected returns and correlations we have has helped formulate my decisions. If I took a more blind / head in the sand approach to my AA, I’m sure I would have a substantially more aggressive portfolio and likely end up with more money in the long run. But the potential of achieving specific goal would also be a bit less.
And I agree with that!

:sharebeer
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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by HomerJ » Tue Aug 14, 2018 6:03 pm

marcopolo wrote:
Tue Aug 14, 2018 5:09 pm
My suspicion is that a lot of those variables were analyzed at the time, and CAPE as we know it today is what provided the best (most publishable) results at that time. It did not just fall out of the air. It is only after the fact that people are imbuing it with all sorts of fundamental properties. More likely it was a result of a lot well informed data mining, and as such, much of its perceived predictive power has faded over time as out of sample data becomes available.
It's a long read, but well worth it. If you want to skip to the bottom go ahead. The article is from 2014, so even more true today, as we've had 4 more years where actual returns were higher than "expected" returns.

http://www.philosophicaleconomics.com/2 ... ixpercent/

Some excerpts:
After presenting the chart, I’m going to demonstrate that its tight correlation is an illusion. I’m going to carefully flesh out its subtle trick, a trick that is ultimately hidden in every chart that purports to use valuation to accurately predict returns in historical data. Such a feat cannot be accomplished–the historical data will not allow it.
Since 1945, the method has underpredicted returns roughly 58% of the time. Since 1991, it’s underpredicted them roughly 95% of the time–half of the time by more than 5% annually. Compounded over a 7 year time horizon, that’s a big miss.

The fact that the method has failed to make accurate predictions in recent decades shouldn’t come as a surprise to anyone. Since early 1991, roughly the end of the first Gulf War, the Shiller CAPE has only spent 10 months below its assumed mean–out of a total of 278 months. There is no way that a forecasting method that bets on the mean-reversion of a valuation metric can produce accurate forecasts when the metric only spends 3.6% of the time at or below its assumed mean.
What makes me maddest is how people continue to state that CAPE predictions have been pretty good the past 20-25 years. They haven't. Hiding behind "one standard deviation", where a SD is plus/minus 6%-8% is a total cop-out. You don't get to say your predictions still count as good if you are 5% off (for multiple years). It's not some amazing useful model if it predicts long-term stock returns will be in the 0%-14% range.
Now–and this is the key takeaway–every single forecasting method in existence that purports to use valuation to accurately predict point-to-point equity market returns in U.S. historical data exploits this same trick. The data set that we’re working with, covering the U.S. equity market from 1871 to 2014, contains significant variability in the average valuations and average rates of return that it exhibits. That variability can be dampened by limiting the analysis to very large time horizons and by using Shillerization, but it can’t be eliminated. It’s been especially pronounced in the last two decades, with valuations having migrated to what might otherwise be described as a “permanently high plateau.” Given this migration, any model that attempts to predict returns in the data set on the basis of a normal rate of return is bound to produce significant errors, even when the returns are Shillerized. The only way for the predictions of the model to fit with the actual results in the presence of the errors is for the errors to cancel. When you see a tight fit, that’s always what’s happening.

When a person sits behind a computer and sifts through different configurations of a model (different prediction time horizons, different mean valuations, different growth rate assumptions, different date ranges for testing, etc.) to find the configuration in which the predictions best “fit” with the actual subsequent results, that person is unwittingly “selecting out” the configuration that, by chance, happens to best achieve the necessary cancellation of the model’s errors. The result ends up being inherently biased. For this reason, we should be deeply skeptical of models that claim to reliably predict returns in historical data on the basis of successful in-sample testing. We should judge them not by the superficial accuracy of their fits (an accuracy that is almost always engineered), but by the accuracy of their underlying assumptions.
Last edited by HomerJ on Tue Aug 14, 2018 6:34 pm, edited 2 times in total.
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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by vitaflo » Tue Aug 14, 2018 6:13 pm

HomerJ wrote:
Tue Aug 14, 2018 3:25 pm
This is why the CAPE model appears to be broken. It's been above its mean 98% of the time for the past 26 years.

And it's not like it didn't have chances to revert. We had two stock crashes in that time period, one of which was nearly a full-out financial panic.

Even during that, it barely crossed below the historical mean.

I think it's certainly reasonable to wonder if the model is broken, if some variable is unaccounted for, if something has changed.
It's also possible we have a very painful 26 year mean reversion. I'm not saying I think that will happen, but it's another possibility. Just because something has been above the mean for a very long time does not mean it can't still mean revert.

All that said, in retirement I'm thinking about worst case scenarios and those can happen at both high and low valuation, so the odds don't really matter.

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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by HomerJ » Tue Aug 14, 2018 6:30 pm

vitaflo wrote:
Tue Aug 14, 2018 6:13 pm
It's also possible we have a very painful 26 year mean reversion. I'm not saying I think that will happen, but it's another possibility. Just because something has been above the mean for a very long time does not mean it can't still mean revert.

All that said, in retirement I'm thinking about worst case scenarios and those can happen at both high and low valuation, so the odds don't really matter.
Yep, absolutely possible. I totally agree with you. CAPE model may indeed prove to be right. We absolutely could have one crazy horrible mean reversion. I'm not saying CAPE is 100% for sure wrong. I'm saying it's silly at this point to believe it is 100% for sure right.

I'm saying it hasn't done a good job predicting stuff since it was "discovered", so I don't put a lot of faith in it. And I think that's a reasonable position to take.

It may indeed be the WRONG position, but it's certainly reasonable after the past 26 years.

(And like you, I plan for worst case scenarios in any case, so even I'm wrong about CAPE, it won't really matter to me, since I'm already prepared for poor returns).
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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by KlangFool » Tue Aug 14, 2018 9:38 pm

HomerJ wrote:
Tue Aug 14, 2018 6:30 pm
vitaflo wrote:
Tue Aug 14, 2018 6:13 pm
It's also possible we have a very painful 26 year mean reversion. I'm not saying I think that will happen, but it's another possibility. Just because something has been above the mean for a very long time does not mean it can't still mean revert.

All that said, in retirement I'm thinking about worst case scenarios and those can happen at both high and low valuation, so the odds don't really matter.
Yep, absolutely possible. I totally agree with you. CAPE model may indeed prove to be right. We absolutely could have one crazy horrible mean reversion. I'm not saying CAPE is 100% for sure wrong. I'm saying it's silly at this point to believe it is 100% for sure right.

I'm saying it hasn't done a good job predicting stuff since it was "discovered", so I don't put a lot of faith in it. And I think that's a reasonable position to take.

It may indeed be the WRONG position, but it's certainly reasonable after the past 26 years.

(And like you, I plan for worst case scenarios in any case, so even I'm wrong about CAPE, it won't really matter to me, since I'm already prepared for poor returns).
+1.

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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by protagonist » Wed Aug 15, 2018 11:08 am

KlangFool wrote:
Tue Aug 14, 2018 9:38 pm
HomerJ wrote:
Tue Aug 14, 2018 6:30 pm
vitaflo wrote:
Tue Aug 14, 2018 6:13 pm
It's also possible we have a very painful 26 year mean reversion. I'm not saying I think that will happen, but it's another possibility. Just because something has been above the mean for a very long time does not mean it can't still mean revert.

All that said, in retirement I'm thinking about worst case scenarios and those can happen at both high and low valuation, so the odds don't really matter.
Yep, absolutely possible. I totally agree with you. CAPE model may indeed prove to be right. We absolutely could have one crazy horrible mean reversion. I'm not saying CAPE is 100% for sure wrong. I'm saying it's silly at this point to believe it is 100% for sure right.

I'm saying it hasn't done a good job predicting stuff since it was "discovered", so I don't put a lot of faith in it. And I think that's a reasonable position to take.

It may indeed be the WRONG position, but it's certainly reasonable after the past 26 years.

(And like you, I plan for worst case scenarios in any case, so even I'm wrong about CAPE, it won't really matter to me, since I'm already prepared for poor returns).
+1.

KlangFool
Plus we haven't had a major world war in over 70 years, which is beyond the scope of memory of most people reading this.

I know that seems facetious , and to many it may seem irrelevant, but major unpredictable global or national events (natural or manmade) drive history, they happen relatively frequently, and economies are a huge part of history. Most of the rest of what happens day-to-day....i.e. what we are used to.... is just noise. It is thus wise to be prepared for poor returns.

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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by KlangFool » Wed Aug 15, 2018 1:11 pm

protagonist wrote:
Wed Aug 15, 2018 11:08 am
KlangFool wrote:
Tue Aug 14, 2018 9:38 pm
HomerJ wrote:
Tue Aug 14, 2018 6:30 pm
vitaflo wrote:
Tue Aug 14, 2018 6:13 pm
It's also possible we have a very painful 26 year mean reversion. I'm not saying I think that will happen, but it's another possibility. Just because something has been above the mean for a very long time does not mean it can't still mean revert.

All that said, in retirement I'm thinking about worst case scenarios and those can happen at both high and low valuation, so the odds don't really matter.
Yep, absolutely possible. I totally agree with you. CAPE model may indeed prove to be right. We absolutely could have one crazy horrible mean reversion. I'm not saying CAPE is 100% for sure wrong. I'm saying it's silly at this point to believe it is 100% for sure right.

I'm saying it hasn't done a good job predicting stuff since it was "discovered", so I don't put a lot of faith in it. And I think that's a reasonable position to take.

It may indeed be the WRONG position, but it's certainly reasonable after the past 26 years.

(And like you, I plan for worst case scenarios in any case, so even I'm wrong about CAPE, it won't really matter to me, since I'm already prepared for poor returns).
+1.

KlangFool
Plus we haven't had a major world war in over 70 years, which is beyond the scope of memory of most people reading this.

I know that seems facetious , and to many it may seem irrelevant, but major unpredictable global or national events (natural or manmade) drive history, they happen relatively frequently, and economies are a huge part of history. Most of the rest of what happens day-to-day....i.e. what we are used to.... is just noise. It is thus wise to be prepared for poor returns.
I am buying more gold jewelry now in order to prepare for that.

KlangFool

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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by protagonist » Wed Aug 15, 2018 4:11 pm

KlangFool wrote:
Wed Aug 15, 2018 1:11 pm
protagonist wrote:
Wed Aug 15, 2018 11:08 am
KlangFool wrote:
Tue Aug 14, 2018 9:38 pm
HomerJ wrote:
Tue Aug 14, 2018 6:30 pm
vitaflo wrote:
Tue Aug 14, 2018 6:13 pm
It's also possible we have a very painful 26 year mean reversion. I'm not saying I think that will happen, but it's another possibility. Just because something has been above the mean for a very long time does not mean it can't still mean revert.

All that said, in retirement I'm thinking about worst case scenarios and those can happen at both high and low valuation, so the odds don't really matter.
Yep, absolutely possible. I totally agree with you. CAPE model may indeed prove to be right. We absolutely could have one crazy horrible mean reversion. I'm not saying CAPE is 100% for sure wrong. I'm saying it's silly at this point to believe it is 100% for sure right.

I'm saying it hasn't done a good job predicting stuff since it was "discovered", so I don't put a lot of faith in it. And I think that's a reasonable position to take.

It may indeed be the WRONG position, but it's certainly reasonable after the past 26 years.

(And like you, I plan for worst case scenarios in any case, so even I'm wrong about CAPE, it won't really matter to me, since I'm already prepared for poor returns).
+1.

KlangFool
Plus we haven't had a major world war in over 70 years, which is beyond the scope of memory of most people reading this.

I know that seems facetious , and to many it may seem irrelevant, but major unpredictable global or national events (natural or manmade) drive history, they happen relatively frequently, and economies are a huge part of history. Most of the rest of what happens day-to-day....i.e. what we are used to.... is just noise. It is thus wise to be prepared for poor returns.
I am buying more gold jewelry now in order to prepare for that.

KlangFool
I'm not suggesting gold jewelry or cash under the mattress....far from it. Just to be aware that the kind of returns we are used to are hardly a given, and one should not make assumptions about the world 20 or 50 years from now and consider their predictions scientifically valid.

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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by willthrill81 » Wed Aug 15, 2018 4:16 pm

KlangFool wrote:
Wed Aug 15, 2018 1:11 pm
protagonist wrote:
Wed Aug 15, 2018 11:08 am
KlangFool wrote:
Tue Aug 14, 2018 9:38 pm
HomerJ wrote:
Tue Aug 14, 2018 6:30 pm
vitaflo wrote:
Tue Aug 14, 2018 6:13 pm
It's also possible we have a very painful 26 year mean reversion. I'm not saying I think that will happen, but it's another possibility. Just because something has been above the mean for a very long time does not mean it can't still mean revert.

All that said, in retirement I'm thinking about worst case scenarios and those can happen at both high and low valuation, so the odds don't really matter.
Yep, absolutely possible. I totally agree with you. CAPE model may indeed prove to be right. We absolutely could have one crazy horrible mean reversion. I'm not saying CAPE is 100% for sure wrong. I'm saying it's silly at this point to believe it is 100% for sure right.

I'm saying it hasn't done a good job predicting stuff since it was "discovered", so I don't put a lot of faith in it. And I think that's a reasonable position to take.

It may indeed be the WRONG position, but it's certainly reasonable after the past 26 years.

(And like you, I plan for worst case scenarios in any case, so even I'm wrong about CAPE, it won't really matter to me, since I'm already prepared for poor returns).
+1.

KlangFool
Plus we haven't had a major world war in over 70 years, which is beyond the scope of memory of most people reading this.

I know that seems facetious , and to many it may seem irrelevant, but major unpredictable global or national events (natural or manmade) drive history, they happen relatively frequently, and economies are a huge part of history. Most of the rest of what happens day-to-day....i.e. what we are used to.... is just noise. It is thus wise to be prepared for poor returns.
I am buying more gold jewelry now in order to prepare for that.

KlangFool
While I'm not a 'gold bug', gold has without a doubt been a better diversifier than international equities, assuming one's AA is mostly in U.S. stocks.

You aren't interested in coins, rounds, or bars? Only jewelry?
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by KlangFool » Wed Aug 15, 2018 4:54 pm

protagonist wrote:
Wed Aug 15, 2018 4:11 pm
KlangFool wrote:
Wed Aug 15, 2018 1:11 pm
protagonist wrote:
Wed Aug 15, 2018 11:08 am
KlangFool wrote:
Tue Aug 14, 2018 9:38 pm
HomerJ wrote:
Tue Aug 14, 2018 6:30 pm


Yep, absolutely possible. I totally agree with you. CAPE model may indeed prove to be right. We absolutely could have one crazy horrible mean reversion. I'm not saying CAPE is 100% for sure wrong. I'm saying it's silly at this point to believe it is 100% for sure right.

I'm saying it hasn't done a good job predicting stuff since it was "discovered", so I don't put a lot of faith in it. And I think that's a reasonable position to take.

It may indeed be the WRONG position, but it's certainly reasonable after the past 26 years.

(And like you, I plan for worst case scenarios in any case, so even I'm wrong about CAPE, it won't really matter to me, since I'm already prepared for poor returns).
+1.

KlangFool
Plus we haven't had a major world war in over 70 years, which is beyond the scope of memory of most people reading this.

I know that seems facetious , and to many it may seem irrelevant, but major unpredictable global or national events (natural or manmade) drive history, they happen relatively frequently, and economies are a huge part of history. Most of the rest of what happens day-to-day....i.e. what we are used to.... is just noise. It is thus wise to be prepared for poor returns.
I am buying more gold jewelry now in order to prepare for that.

KlangFool
I'm not suggesting gold jewelry or cash under the mattress....far from it. Just to be aware that the kind of returns we are used to are hardly a given, and one should not make assumptions about the world 20 or 50 years from now and consider their predictions scientifically valid.
protagonist,

I know that you are not suggesting. But, I believe in preparation. If I am worried about something, I will prepare for it.

KlangFool

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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by KlangFool » Wed Aug 15, 2018 4:57 pm

willthrill81 wrote:
Wed Aug 15, 2018 4:16 pm
KlangFool wrote:
Wed Aug 15, 2018 1:11 pm
protagonist wrote:
Wed Aug 15, 2018 11:08 am
KlangFool wrote:
Tue Aug 14, 2018 9:38 pm
HomerJ wrote:
Tue Aug 14, 2018 6:30 pm


Yep, absolutely possible. I totally agree with you. CAPE model may indeed prove to be right. We absolutely could have one crazy horrible mean reversion. I'm not saying CAPE is 100% for sure wrong. I'm saying it's silly at this point to believe it is 100% for sure right.

I'm saying it hasn't done a good job predicting stuff since it was "discovered", so I don't put a lot of faith in it. And I think that's a reasonable position to take.

It may indeed be the WRONG position, but it's certainly reasonable after the past 26 years.

(And like you, I plan for worst case scenarios in any case, so even I'm wrong about CAPE, it won't really matter to me, since I'm already prepared for poor returns).
+1.

KlangFool
Plus we haven't had a major world war in over 70 years, which is beyond the scope of memory of most people reading this.

I know that seems facetious , and to many it may seem irrelevant, but major unpredictable global or national events (natural or manmade) drive history, they happen relatively frequently, and economies are a huge part of history. Most of the rest of what happens day-to-day....i.e. what we are used to.... is just noise. It is thus wise to be prepared for poor returns.
I am buying more gold jewelry now in order to prepare for that.

KlangFool
While I'm not a 'gold bug', gold has without a doubt been a better diversifier than international equities, assuming one's AA is mostly in U.S. stocks.

You aren't interested in coins, rounds, or bars? Only jewelry?
willthrill81,

1) I have greater trust in Goldsmith.

2) You can wear gold jewelry. And, that is normal behavior when you travel. You cannot wear coins, rounds, or bars easily.

KlangFool

smitcat
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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by smitcat » Thu Aug 16, 2018 8:19 am

Silver and Palladium are other options - I do not favor gold over the years.
No real interest in jewelry.

CULater
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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by CULater » Thu Aug 16, 2018 8:47 am

I don't see that there is any logic in saying that CAPE is broken and then optimistically assuming that equity returns can continue to be just as generous has they've been historically in the U.S. It's just as logical to say that if CAPE is broken, stock returns could turn out to be pathetic in the future. If there's a total disconnect between CAPE and future equity returns (which might be the case) then future equity returns can be anything. If you really need equity returns to be high, then you're at the mercy of luck. Maybe we've always been at the mercy of luck but were too dumb to realize it. Luck is not a good plan. It would be better to have a diversified plan that doesn't depend largely on luck to succeed. Investing in common stocks in order to give up working for a living as soon as possible is a relatively modern invention. It has worked for a couple of generations, but maybe it's becoming an overgrazed path to wealth. Maybe the juice has been sucked out of it. Now we have all the "factor" theorists out there trying to figure out more ways to scavenge more juice from old wells -- maybe a sign the well is drying up?
May you have the hindsight to know where you've been, The foresight to know where you're going, And the insight to know when you've gone too far. ~ Irish Blessing

Random Walker
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Joined: Fri Feb 23, 2007 8:21 pm

Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by Random Walker » Thu Aug 16, 2018 9:00 am

CULater wrote:
Thu Aug 16, 2018 8:47 am
. Investing in common stocks in order to give up working for a living as soon as possible is a relatively modern invention. It has worked for a couple of generations, but maybe it's becoming an overgrazed path to wealth. Maybe the juice has been sucked out of it. Now we have all the "factor" theorists out there trying to figure out more ways to scavenge more juice from old wells -- maybe a sign the well is drying up?
As the markets have evolved there have been many innovations which have made investing safer, so the expected returns quite likely should be lower in the future. From what I remember some of these innovations have been better Fed policy, smaller bid-ask spreads, more liquidity, decimalization.

Factor theorists I don’t think are trying to “scavenge juice from old wells”. I think they are trying to explain the returns that do occur.

Dave

marcopolo
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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by marcopolo » Thu Aug 16, 2018 9:15 am

Random Walker wrote:
Thu Aug 16, 2018 9:00 am
CULater wrote:
Thu Aug 16, 2018 8:47 am
. Investing in common stocks in order to give up working for a living as soon as possible is a relatively modern invention. It has worked for a couple of generations, but maybe it's becoming an overgrazed path to wealth. Maybe the juice has been sucked out of it. Now we have all the "factor" theorists out there trying to figure out more ways to scavenge more juice from old wells -- maybe a sign the well is drying up?
As the markets have evolved there have been many innovations which have made investing safer, so the expected returns quite likely should be lower in the future. From what I remember some of these innovations have been better Fed policy, smaller bid-ask spreads, more liquidity, decimalization.

Factor theorists I don’t think are trying to “scavenge juice from old wells”. I think they are trying to explain the returns that do occur.

Dave
If you believe equity returns in the long run is driven by economic growth, it is not clear to me why the actions you listed above, which might reduce volatility, has to necessarily dampen returns. We have all seen the long time charts that show a steady increase in equities of the last couple hundred years, with what looks like noise (volatility) around a pretty consistent upward trend. That period has also included actions that created more efficient markets. It is possible we will continue along the same trend line, with perhaps less drastic swings? I am not counting on that in my plan, but I do believe that is a possibility.
Once in a while you get shown the light, in the strangest of places if you look at it right.

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k66
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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by k66 » Thu Aug 16, 2018 9:16 am

HomerJ wrote:
Tue Aug 14, 2018 3:25 pm
Random Walker wrote:
Tue Aug 14, 2018 2:39 pm
And why wouldn’t Markets spend some time below the Mean PE? It is a mean after all.
This is why the CAPE model appears to be broken. It's been above its mean 98% of the time for the past 26 years.

And it's not like it didn't have chances to revert. We had two stock crashes in that time period, one of which was nearly a full-out financial panic.

Even during that, it barely crossed below the historical mean.

I think it's certainly reasonable to wonder if the model is broken, if some variable is unaccounted for, if something has changed.
...
Good point. Doesn't the Gordon Equation have a third term which is the rate of change of growth and typically assumed to be zero; e.g. R = y + y' + y", where we set y" to zero and use CAEP10 as the proxy for y'?

I believe that I read this some time ago (Bernstein??) but cannot for the life of me find a usable reference! Maybe someone else can shed some light on my poor memory, lol!
LOSER of the Boglehead Contest 2015 | lang may yer lum reek

michaeljc70
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Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by michaeljc70 » Thu Aug 16, 2018 9:17 am

HomerJ wrote:
Tue Aug 14, 2018 10:37 am
CULater wrote:
Tue Aug 14, 2018 9:51 am
Perhaps CAPE is no longer a useful measure of valuations and expected 10-year returns from stocks. This time is different. The backtesting data are not relevant. Maybe that's the case. But why does it make sense to believe that the 4% rule is still carved in stone? This time is the same. The backtesting data are all good. We choose to believe what we choose to believe, inconsistent as that might be.
CAPE10 has failed to predict returns accurately since it was discovered. For 26 years, CAPE has been predicting low returns, and we've gotten decent-to-good returns instead.

4% hasn't failed yet.
I agree on CAPE10. It is given too much credit. I think the 10 year look back is way too long to be real useful.

Random Walker
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Joined: Fri Feb 23, 2007 8:21 pm

Re: Importance of sequence of real returns for SWR, CAPE valuation, and Luck

Post by Random Walker » Thu Aug 16, 2018 4:10 pm

marcopolo wrote:
Thu Aug 16, 2018 9:15 am
Random Walker wrote:
Thu Aug 16, 2018 9:00 am
CULater wrote:
Thu Aug 16, 2018 8:47 am
. Investing in common stocks in order to give up working for a living as soon as possible is a relatively modern invention. It has worked for a couple of generations, but maybe it's becoming an overgrazed path to wealth. Maybe the juice has been sucked out of it. Now we have all the "factor" theorists out there trying to figure out more ways to scavenge more juice from old wells -- maybe a sign the well is drying up?
As the markets have evolved there have been many innovations which have made investing safer, so the expected returns quite likely should be lower in the future. From what I remember some of these innovations have been better Fed policy, smaller bid-ask spreads, more liquidity, decimalization.

Factor theorists I don’t think are trying to “scavenge juice from old wells”. I think they are trying to explain the returns that do occur.

Dave
If you believe equity returns in the long run is driven by economic growth, it is not clear to me why the actions you listed above, which might reduce volatility, has to necessarily dampen returns. We have all seen the long time charts that show a steady increase in equities of the last couple hundred years, with what looks like noise (volatility) around a pretty consistent upward trend. That period has also included actions that created more efficient markets. It is possible we will continue along the same trend line, with perhaps less drastic swings? I am not counting on that in my plan, but I do believe that is a possibility.
Maybe so. Will certainly be fascinating to see!

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