For a brief moment I felt the joy of clearing my mortgage early. Now I have some explaining to do: because I’m not going to pay it off after all.

I have the opportunity. I own the full amount of my mortgage in cash and index trackers – split 50:50. The simple thing to do would be to flog off the trackers and hand over everything to the bank with a cheery: “Thanks for the loan, pin-stripes, you’ll never hear from me again!”

That would be simple. That would be safe.

It’s got a lot going for it.

But I can’t do it. Not with interest rates at an all-time low.

Interesting times

This feels like a historic opportunity to me. A chance to earn more by staying invested in the market over the next 10 years than I could gain by removing the mortgage-leech that’s latched onto my cash flow.

My assets currently yield double the amount I’m paying to service the debt. That alone stays my hand.

But this is a story about trading certainty for potential.

My current mortgage interest rate is 1.24%.1

The FCA is projecting nominal UK equity growth rates of 6.5% to 8% over the next 10 years. That would comfortably spank my tracker mortgage, as long as interest rates don’t go beserk.

Liquidating my equities now will deny me the potential for a decent return from the stock market for the next few years.

It would take several years to rebuild my position and I’ll always be saddled with the opportunity cost if the market marches on.

Yes, I could pocket the guarantee that my mortgage can’t get back off the floor like a B-movie baddie, but that comes at the expense of diversification. Most of my wealth would be concentrated into one, large, illiquid asset. With curtains.

And that asset comes with more baggage than the Sultan of Brunei. I suppose we could sell the house in the event of a crisis but the emotional fall-out would be huge.

Diverting cash or equities from the ‘mortgage jar’ would stick in the craw too, but at least I can do that in small chunks. It’s not like I can sell off the spare room to cover a period of unemployment.2

So the plan is to keep building my cash holdings over the next seven to eight years until I eventually hold my entire mortgage balance in safe assets.

Meanwhile, the equities that are currently earmarked for the mortgage gradually move into the retirement jar as they are supplanted by cash.

I win if they bring home nominal growth that outstrips my mortgage interest rate.

What does disaster look like?

I’m taking a risk here, I’m not kidding myself. There’s a danger of trying to be too clever and The Investor has neatly stacked up the case for investing versus mortgage taming before.

But risk needs to be couched in personal terms, and for me disaster is a five-way car crash that looks like this:

• Losing my job.

• Losing my redundancy pay.

• Not finding another job.

• Ms Accumulator losing her job, too, and not finding another job.

• Interest rates rising like a Saturn V rocket while equity prices plummet like Beagle 2.

Now that would be a divine comedy roast with sauce, but I reckon the risk of it all happening at once is relatively low. (At least I’d make a few quid as a cautionary tale in the newspapers, I suppose.)

If equities dip then I’ll be back in the mortgage red but I’m happy to ride that out. I only really need the equity funds in a hurry if I can’t service my interest payments3.

Of course, a serious crash is the bunkmate of mass unemployment so it’s worth noting that equities may offer scant protection just when I need them most.

If the scenario is soaring interest rates then I have a 50% cash cushion and a high savings rate to protect me.

As long as I remain in work, then I can always ease the pain by diverting monthly income not needed for essentials. That cash cushion should increase and I can always sell the equities if things get desperate.

Again, let’s acknowledge that equities are about as steadfast as a celebrity’s entourage once they can only get bookings at Butlins. The stock market is liable to be hammered when interest rates spiral so I could be forced to take agonising losses if things really go awry.

Is it worth it?

If I have seven years of bad luck and the markets decline then I’ll forever lambast myself: “You should have sold the trackers, paid the mortgage and invested future cash streams at ever cheaper prices.” Or words to that effect.

Psychologically I could rue this day for the rest of my life.

And there will be scares along the way. Scares that could last for months or years. I don’t think I’ll panic. I believe I’ll keep on paying down the mortgage like everyone else while waiting for equities to come back.

Still, you can’t be sure.

Lining up the negatives like this is another way of testing my resolve and I must admit the “No” camp looks strong.

Especially when you consider that any triumph is likely to be small in comparison to the potential for failure. That’s humans for you. Hardwired to hate loss more than we love gain.

But I don’t take many risks. This is one I understand and am well prepared for. The satisfaction of being mortgage-free is not as important to me as knowing I have the resolve to get there.

I can be patient a little longer because the real win is achieving financial independence as soon as possible. That’s something I’m ready to throw the dice for.

Take it steady,

The Accumulator

1. I have a lifetime tracker: 0.74 over base. [↩]
2. Sure I can rent a spare room, but you get my liquidity point. [↩]
3. My mortgage is interest only. [↩]

Good reads from around the Web.

Anyone who gets all their financial information from Monevator – hi mum! – won’t know that the US Federal Reserve decided not to dial back QE3 this week.

I didn’t write a post about it beforehand. I didn’t write a post about it afterwards. I haven’t even included articles about it in our Weekend Reading roundups for the past few months.

Now that might not sound to you like a shocking dereliction of duty. Who cares if some Central Banker buys $10 billion fewer bonds a month in a multi-trillion dollar economy?

To which I say:

1) Congratulations, you’ve just said something more sensible than 90% of financial pundits on the subject.

2) You obviously haven’t watched CNBC or Bloomberg since May.

Since late May, the financial media and markets have ceaselessly speculated about “the taper” – not the Barry Manilow-snouted beast of South America, but the extent to which the Fed’s quantitative easing would be scaled back, and how this would effect financial markets.

I can hardly exaggerate the amount of coverage it has got. I wouldn’t be surprised to learn that 50% of CNBC’s daytime output was devoted to taper-talk.

Admittedly that’s like castigating EastEnders for focussing on Albert Square, not Syria. CNBC is about entertainment, not what matters most in markets and investing.

But even so, it’s sidesplittingly hilarious to me that after all that speculation, Bernanke didn’t taper.

Nearly everyone was wrong. What a waste of time and breath!

For the professional pundit of course, no news is good news. They can just re-run all their taper talk for another three months. It sure beats truly educating people about investing, or even companies.1

But I wouldn’t look for a volte-face from me, nor any sudden explosion of taper speculation here on Monevator. Here’s why:

• Low US interest rates matter much more than Fed bond buying. The Fed funds rate is going to stay low for years, because it’s explicitly linked to an unemployment rate trigger that’s far, far away.

• Even the part of QE3 that does matter – mortgage-backed security buying, which is mildly helping the US housing market – isn’t as important as core rates.

• Market rates – such as the 10-year Treasury yield – had approached 3% just on speculation about tapering. The rise did what Bernanke wanted without him doing anything, in my opinion.

• But my opinion on this isn’t worth any more than all those talking heads on CNBC, so I won’t be sharing it here much.

• They nearly all got it wrong. So who exactly am I going to be quoting?

• Whatever we do or say, you and I aren’t likely to outthink the US bond markets, which is one of the most liquid markets in the world.

Finally:

• The 90% of financial bloggers and commentators who’ll tell you the US and UK bull markets are a fantasy built entirely on easy money from the Federal Reserve are wrong. They are guys with hammers looking for nails. Of course low rates have been crucial triage for the banks, and for steadying the underlying economy, but it’s not magic or trickery, it’s what always happens. It’s a price our future selves pay for less pain today. Read some market history. Pundits always say the same things. Somehow we push on, make more products, boost productivity, have kids who want houses…

Here end-eth the macro post of the month.

[continue reading…]

1. Slight exception made for the daytime Fast Money, which is by far the best of CNBC’s output, although it’s only for active traders. [↩]

The straight P/E ratio is a poor forecasting tool when applied to the stock market.

Even the ten-year cyclically-adjusted P/E ratio isn’t much cop, although it’s probably the best of a poor bunch of crystal balls should we be silly enough to try to outwit the market. (Reminder: Such guesswork is decidedly optional, especially for passive investors!)

There is an exception to the bit-of-a-crap-shoot principle, though.

Developed markets on very low P/E ratios have nearly always been amazing buying opportunities. If the P/E of the stock market ever again falls below 8, I’d buy all you can. Then sell your grandmother and buy some more.

The reason for the juicy returns are pretty obvious – on a P/E ratio of less than 8, the market is pricing in cataclysm. So far the worst hasn’t happened to Western markets, so anyone who was brave enough to buy when shares were at such bargain basement levels has been well rewarded.

Remember some markets don’t make it. The Russian and Chinese stock markets in the early 20th Century went to zero! If they passed through a P/E of 10, 8, or 2 on the way down it didn’t make any difference – you still lost all your money. There is always a risk of something similarly awful happening in the future, and that risk is essentially what buys your returns.

Absent a communist revolution though, a very low P/E ratio buys you a huge margin of safety, and a lot of future earnings on the cheap.

The stock market valuation bull’s eye

More interesting – and maybe more surprising – is what happens with returns when you buy above the “a P/E of what? Is that a misprint?!” range. These higher P/E ratios are a matter of practical importance, because you’ll far more often see a market on a P/E in double-digits than on a P/E of <8.

In fact, if you only invest in the market when P/E ratios are at the bottom of the barrel, you could be waiting for decades to strike – and depending on your selling rules you could be out again within a year.

Most of the time you’ll need to pay higher P/E multiples for your ongoing equity fix and the superior returns that shares can deliver. But how much is too much?

The following graphic from City Research sheds some light with respect to the S&P 500 index of leading US shares:

Source: Business Insider

This graphic ranks P/E bands based on the average subsequent 12-month returns since 1940. Citi Research’s Tobias Levkovich crunched 73 years worth of S&P 500 returns data to produce it, dividing returns into bands by P/E rating1, and putting the higher performing bands closer to the bulls eye.

Remember: The Vanguard research I linked to at the top of this post showed P/Es have a poor record of forecasting market returns. I highlight this data to show that very cheap is good, and very expensive (a P/E above 20x) has been poisonous. It’s also useful to see that, as I speculate below, low to mid-teen P/E ratios have not historically been a reason to bail out of stocks. But don’t mistake this for a solid prediction machine. (There isn’t one).

Looking at the dartboard, as you’d expect from my comments, very low P/E ratios are associated with the highest average returns the following year.

With a P/E below 8, you’re paying less than $8 for every $1 of earnings (for an earnings yield of 12.5%). When you buy the market at such fire sale prices, there’s a strong chance that good things will happen!

It’s a bit different with individual companies. A company on a low P/E ratio might well be correctly priced because its business is in difficulties, or because its profits will never grow much. Sometimes that’s not the case – that’s why the value premium exists – but pretty often it is, which is why we’re not all millionaires from simply buying low P/E shares.

A P/E of 8x or less for the whole market is another kind of animal. Here you’re buying a slice of all the earnings of all the companies. Your investment will be driven by the largest companies, sure, but you’re still getting a lot of diversification, and lots of companies that will recover, as well as the deadbeats.

For that reason, I’d argue a low P/E market is a very different bet to a single company on a lowly P/E rating, and a much surer indication of value.

Stock market returns by P/E ratio

What’s also interesting about the dartboard is that outside of the bulls eye, the next band in the dartboard is not the 8-10x band, but rather the 14-16x band.

Of course this could just be a reflection of what the Vanguard study found – that you can’t learn much from P/E ratios.

But I can’t help wondering if it reveals a little bit more?

By implication, markets sporting P/Es in the 8-10x range proved, with hindsight, on average more expensive buys, whereas the 14-16x band was on a short-term basis a solid buy.

In fact, the 12-month returns for the 14-16x band were better than the entire range from P/E 8-14, as you can see in the data below:

P/E range	Average	Median
<8x	18.6%	18.8%
8-10x	8.9%	6.7%
10-12x	9.7%	9.6%
12-14x	11.2%	13.4%
14-16x	12.6%	14.6%
16-18x	5.4%	9.1%
18-20x	5.9%	6.5%
>20x	-.43%	4.43%

Source: Citi Research / Business Insider

Once the P/E ratio gets above the 8 threshold, median returns for the S&P 500 over the next 12 months creep higher and higher, but they don’t peak until the 14-16x range.

Above 16x they swiftly collapse again, on a median return basis. And if anyone ever calls the market a screaming buy on a P/E of over 20x, scream back at them. (And keep your money away!)

Reassuringly expensive

What gives? Is this random, or can we speculate about why the more expensive P/E ratios are delivering higher 12-month median returns?

Very possibly not. Even 70 years of returns only encompasses a few market cycles, and the stock market constantly reacts and changes, too. It might have been luck that the data fell this way, and even if it wasn’t that’s no guarantee it will hold in the future.

Remember too that these are averages and median figures. They will conceal big variations, including negative periods of returns where shares were in the dumpster for the following 12 months.

One thing it does tell us is to be wary of people who warn of imminent crashes just because the P/E ratio has gone up from a lower level.

Looking at the data, a higher P/E ratio has been associated with higher median returns all the way from 8-16x. The data doesn’t necessarily imply any inevitable smooth rise like that – but I do think it’s one in the eye for the doomsters who claim markets are expensive just because they’ve bounced off their lowest levels, especially with interest rates so low.

Finally, if I put my speculation hat on, I think it’s a good reminder that cheapness isn’t the whole story.

I’d hazard a guess that P/E ratios of 14-16x are associated mostly with expansionary phases for economies. At such times, people are getting more confident and bidding up shares – remember, the market discounts the future, not the past – but not yet to crazy bubble levels.

Because stock markets climb slowly but jump off a cliff on the way back down, I doubt the market spends much time in the giddy 14-16x band unless the news is at least fairly optimistic.

To return to the individual shares analogy, paying a P/E of 14-16x for the market is the equivalent of stock pickers who look for Growth At A Reasonable Price (or GARP for short).

GARP investors want to see further expansion and higher profits ahead. They don’t want to pay through the nose for it, because they believe very high rates of growth are not typically sustainable for long enough to make up for paying a very high multiple on purchase. But modestly high P/E ratings are a positive with the GARP methodology, since it indicates the expectation of higher earnings.

It comes down to the ‘E’ part of the ratio – the earnings. Higher earnings will bring a P/E ratio down – or hold it steady – just as surely as lower prices (the P) part will. So if you think earnings will rise, you might bid up for them in advance.

People are far more obsessed with fluctuating share prices than with the prospects for underlying earnings, so they often forget this.

P/E is not a prediction

Remember that as well as being extremely difficult, valuation isn’t the same as forecasting.

One weakness in this study, to my eyes, is that the subsequent returns are just tracked for a year. Most of us should be investing with a far longer time horizon if we’re in shares. A 12-month period of slightly lower returns doesn’t matter if it means we’re all set when things pick up after that.

As always, I think most people are best off ignoring all this and investing passively. But for those who do want to flex their inner Master of the Universe, I think valuation – as in not paying over the odds – is a better path, and a better use of this sort of data – than trying to forecast short-term returns.

Some may say I’m quibbling over semantics and it amounts to the same thing, but I think the mindset is different: I believe an active strategy based on trying to get a good deal when you buy is one that will serve you better than a strategy that tries to guess what the deal will be in a year.

1. I am 99% sure this data is based on forward P/E ratios, which is to say it’s looking at how the market is priced based on analysts forecasts (and some won’t like it for that reason). If anyone has access to the Citi Research directly and can confirm in the comments, please do! [↩]