Sunday, February 5, 2017

Is the Trump Rally Warranted?

Hopes, dreams, aspirations, and animal spirits are what drive the market over the short term making predictions a fool’s endeavor.  However predicting returns over the long term (more than seven years) for dollars invested today or stocks held at this level going forward predicting can be done with enough accuracy for financial planning.  The reason for this optimism markets over long periods of time will regress either up or down gravitating to their mean.  Simple algebra is required along with historical data to draw from forming a very close estimation for future returns.  For those of you who freak out at any level of math not to worry as moneychimp.com has an interactive calculator to do all of the work for you.

Ok so where to we stand now?  As of 2-03-17 the S&P 500 is at 2297 with a dividend yield of 1.99% and a Shiller PE10 at 28.47 times earnings.  Put the data into moneychip.com’s calculator and accepted their historical 5% (before inflation) historical earnings growth and drum roll please…the 10 year annualized estimated total return is 1.56%!  The market will be 100 points below 10 years from now!  WOW!  What a barn burner!  This return is before fees, commissions, trading impact costs, and the 800 pound gorilla – INFLATION.

Let’s break down the tyranny of costs:

(1.)       Commissions: Hopefully all of you are using no load mutual funds or if buying individual stocks are using a discount trading house.  I’ll assume there are no up front fees.  However money managers at mutual funds will have to pay commissions on their trades on your behalf that will reduce your return by the amount paid.  I’ll be very conservative and assume that an actively managed fund manager is not a gun slinger dancing in and out of the market at a moments notice or better still you are using an index fund dropping commission costs substantially.
Cost 0.1%

(2.)       Fees - Expense ratio:  Fancy language for what percentage the mutual fund is going to charge you.  This can range greatly from 0.05% (Vanguard’s S&P 500 index fund) and many as high as 2.0% along with a scattering at 2.5% or higher.  Staying conservative I’ll assume everyone has the average mutual fund expense ratio of 1.25%
Cost 1.25%

(3.)       Trading Impact Costs:  Every time a money manger begins to sell or buy into a stock or bond he will drive up or down the price by his own doing.  This has happened due the immense size of the funds as he majority of funds are in the multi billion dollar range.  Even index funds will suffer from this but at a far lesser degree as they deal with monies entering or exiting the fund.  Active managers who aggressively move in and out of stocks (or bonds) unwittingly generate this drag on performance increasing the odds for index funds beating their performance over rolling 5, 7 and especially 10 year returns.  Simply put the tyranny of lesser costs compounds in the favor of index funds.
Cost 0.50%

(4.)       Inflation:  The 800 pound gorilla brought to you by our central bank and chronic deficit spending reducing our future purchasing power all based on the misguided believe (propaganda) you can achieve something for nothing.  I’ll leave that discussion for another post.  The Federal Reserve is hell bent on delivering 2% inflation but as we all know the books are cooked so if they say 2% it is more likely 3% right along the average since 1913.
Cost 3.0%
Average Annual Inflation by Decade

That all adds up to 4.85% as compared to our estimated return of 1.56%.  So…4.85% minus 1.56% equals negative 3.29%.  State and local government workers have the old style retirement plans.  This is why government pensions are underfunded as most mangers have made a return assumption of 8%!  This will only get worse as the market valuations remain at nose bleed levels and then to add insult to an already deplorable situation as the market sells off 45% to 60%.  A major pension crisis is here now and is going to get worse over the next 10 to 15 years!  Those who are self funding using such plans as 401k’s, IRA’s, etc. are in the same boat as well.  There is now a pension crisis that is only going to exacerbate in the years ahead.

This is why our model portfolio has zero stocks due to massive overvaluation of the market propelling returns after costs negative.  It is simple as that.  So when everyone is losing their heads with the Trump rally don’t go and lose yours.  This rally is a good time to reduce your holdings of common stocks.
  Updated Monthly

AGGRESSIVE PORTFOLIO - ACTIVE ALLOCATION - 2/1/17

Active Allocation Bands (excluding cash) 0% to 60%
75% - Cash -Short Term Bond Index - VBIRX
20% -Gold- Precious Metals & Mining - VGPMX
 5% -Lt. Bonds- Long Term Bond Index - VBLTX
 0% -Stocks- Total Stock Market Index - VTSAX
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DYI
  

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