Good reads from around the Web.

Lee and Rob, two up-and-coming personal finance bloggers in the UK, are calling for better financial education in schools.

Over on Five Pence Piece, Lee writes:

Right now students leave the family unit to enter further or university education – or the even more daunting world of work – with only the vaguest hint of how to manage their money, wages, taxes and bills.

The little that is taught is about the math and not about the personal responsibility, the benefits of being financially astute and the dangers of not. It does not present the knowledge in a fun and ‘wow’ style; it’s just all about the numbers in the maths lesson.

Rob continues the theme on his own blog:

I was never taught anything about personal finance and to be honest with you I wish someone had at least taught me how to fill in a tax form or taught me my responsibilities with capital gains tax.  These are all things I had to teach myself when I didn’t see why they weren’t taught at school.

The two would like other personal finance bloggers to share their own views on educating youngsters in the ways of debt, APRs, and interest only mortgages.

I’m happy to highlight their campaign. But I’m not sure they’d want me on their team!

I’m skeptical of school-taught education, to be honest, especially pseudo-practical knowledge that is theoretical until you’re faced with buying your first house, say, or taking out car insurance.

I’ve seen plenty of people’s eyes glaze over as I’ve tried to explain how mortgage repayments work over the years. I don’t think little Johnny gives a monkey’s.

But to not be totally negative (who could argue with the aims?) I would certainly teach kids about compound interest, perhaps by alluding to the still-magical £1 million figure. That could capture the imagination.

Beyond that, I’d probably try to find something that appealed to the here and now, rather than to their future selves.

Lessons in the second series of The Wire gripped the young proto-gangsters with the economics of a corner drug dealing spot, but I’d hope things are not so bleak yet in the UK.

Perhaps using the personal finances of a top-flight footballer or a reality TV winner might do the trick?

The bottom line is our education system is teaching kids to start working life mired in debt by going to university without evaluating the return, so I don’t think Rob and Lee should hold their breath.

[continue reading…]

Companies have good and bad years, which temporarily elevate or depress their earnings ¹ and so skew their P/E ratios.

When added to the vagaries of forecasting, this prompts some investors, led by 1930s legends Graham and Dodd, to instead compare prices with average earnings across multiple years (taking into account inflation) to derive a cyclically-adjusted P/E ratio (also known as CAPE).

By comparing a company’s current multiple-year P/E ratio to its historical average, you can then try to decide whether the shares are cheap without being misled by short-term blips.

Ten years seems to be the most favoured timescale, though some people work with five or even three-year histories.

Newsflash: Company earnings oscillate

What a company earns in any particular year is dependent on many different factors. These range from how well it executes its business plan and the trading conditions in its sector to the performance of rivals, the mid-life crisis potential of the MD, and even dumb luck.

But nearly all companies’ earnings are also affected by the ups and downs of the business cycle.

Stock market indices are just a collection of listed companies. When you add up a weighted average of the earnings generated in a single year by all the companies in a particular index, individual factors such as management skill or new product developments just disappear into the noise.

On this aggregate view, the earnings total varies mostly with the wider economic cycle, since nearly all companies are affected by it to some extent.

Earnings are cyclical: Over a period of years, the total earnings from all companies in an index will tend to rise during economic expansion, and fall sharply in slowdowns or recessions. For successful companies, the trend will be upwards over the decades. But most will suffer setbacks en-route.

If companies are cyclical, so are stock markets

Because earnings are cyclical, we might decide to calculate a rolling P/E for the whole market based on an average of multiple years of earnings, just as Graham and Dodd did for companies.

The resultant cyclically-adjusted P/E ratio is most often calculated over ten-year periods. It’s often known as PE10 as a result, which is less of a mouthful!

PE10 is also dubbed the Shiller PE, in honour of the US academic Robert Shiller, who popularized PE10 when he used it to predict the stock market crash of 2000 on the basis of an elevated P/E ratio versus ten-year earnings.

But whatever you choose to call it and however many years you look at, the idea is the same – to try to see if a market looks good value compared to history, perhaps also by considering where you think we are in the economic cycle.

(The start of) the trouble with PE10

I want to stress immediately that in that last throwaway comment is one of the big problems with PE10: It’s rarely clear what the economy will do in the next year.

• For example, it’s often joked that economists predicted 12 of the last six recessions.

• As for growth, Western markets took far longer than expected to emerge from the global slump of 2008.

In the absence of a functioning crystal ball, we are left with forecasts, best guesses, and playing the odds if we want to try to time our entry and exit into the stock market by the PE10 measure.

Given that capitalist economies have historically tended to expand for more years than they’ve contracted, you might decide to assume any current expansion will continue into the near future.

But be under no illusions. Boom and bust will never be abolished, and some years you’ll find an apparently healthy economy collapses out of the blue, taking company earnings with it.

Sourcing PE10

I’m not going to tell you how to calculate an accurate cyclically-adjusted PE ratio.

I’ve never personally done the maths, and others have explained in great detail how they calculate PE10 if you’re keen and something of a maths masochist.

Unfortunately for lazy souls like me though, PE10 data is hard to come by for almost all markets, as far as I’m aware.

The exception is for the S&P 500 in the US, where many people track the PE10 ratio. There’s even a regularly updated graph plotting PE10 for the US index:

PE10 for the S&P 500. Yes, most of the falls look obvious in retrospect, but they're not so clear at the time. (Chart from multpl.com)

You sometimes see investment banks quoting PE10 ratios for the UK market, but I don’t know of a go-to source. Macro hedge funds and the like compute this sort of data for themselves, but they don’t make it publically available.

Richard Beddard of iii provides a somewhat jerry-rigged version of PE10 for the FTSE All-Share index. Another UK blogger used to offer self-calculated updates of a shortish-run PE10 ratio for the UK. Sadly his last post on the matter was in summer 2011. ²

If you know of other sources, please do share in the comments below.

Not the droid you’re looking for

I wouldn’t get too caught up on seeking a spurious level of accuracy when looking at PE10, anyway.

A figure from a reliable-sounding authority quoted in the press is good enough for me for six months or so, assuming no major earnings shocks in the interim.

That’s because I doubt that PE10 is the fine-tuned timing tool that certain of its adherents claim it is. I therefore don’t need it to three decimal places.

Just as one year’s earnings are a unique event, so are the past ten years. A longer-term timescale is usually better in the mean-reverting world of investment, but there’s no magical reason why looking at ten-year data suddenly becomes extremely accurate for forecasting.

As I write in 2012, for instance, the ten-year history includes two big earnings collapses, one of which was the largest since the Second World War. That’s unusual, and the ten-year history might therefore be unduly depressed, in turn over-inflating the PE10 ratio. I think the next ten years could be better.

On the other hand, perhaps earnings over the past ten years were illusory, having been fueled by credit expansion in the first half of the decade that led to unsustainable consumer spending and indebtedness. If so, then to what extent we still need to work off the excess remains to be seen.

Moreover, many companies took on too much debt in the go-go years. The PE10 ratio looks at market capitalisation not enterprise value (the latter would factor company debt in the numerator, the ‘P’ part of the ratio), so it doesn’t tell you anything about changes in balance sheets.

Again, this is another hindrance to the usefulness of looking at ten-year figures.

To counter that point in turn, some of the most indebted companies went bust or were radically devalued in the slump (property companies, for instance). Perhaps ongoing earnings will be of a higher and more sustainable quality, justifying a higher PE10 ratio?

I could go on. The point is that contrary to what some imply, PE10 will not see you dive effortlessly in and out of the market like a seagull stealing chips.

Even Professor Shiller concluded his original paper with humility, warning that PE10’s apparent predictive abilities might just be a coincidence. ³

More concerns about PE10

My point here isn’t to tell you the market is cheap or expensive. It’s to warn you that cyclically-adjusted PEs may be a useful tool, but I don’t think they’re the silver bullet they’re sometimes touted as.

PE10 became much more popular in the choppy post-2000 investing climate, not least in the light of Shiller’s seemingly vindicated prediction. Understandably (if optimistically) people looked for ways to better time their entry into the stock market, and to get a sense of when to take money off the table.

There has been some research suggesting a valuation-based timing strategy might improve risk-adjusted returns compared to fixed asset allocations, but the margin seems slender to me.

Other respected voices have flatly dismissed PE10. Passive investing guru Rick Ferri says times have changed:

“Shiller’s method is fine in a bear market when people feel compelled to justify low prices, and had it existed, PE10 may have worked okay prior to 1950 when dividends were high and earnings payouts were also high.

If you look at a [chart] of real earnings growth and real price growth there wasn’t much from the mid-1800s to the mid-1900s. But there was dividends.

After 1950 […] fewer companies paid dividends (only about 30% of companies pay dividends today), and the dividend payout ratio is also low (about 35% today).

Since the 1960s people have expected earnings growth due to earnings reinvestment and stock buybacks, and they got it. So, today, PEs should go higher than the 125 year ‘average’ PE 10 when the economy begins to recover.”

Taking another tack, my blogging friend Mike at Oblivious Investor has pointed out that if PE10 worked in the past, then it probably won’t in the future. This is because such inefficiencies tend to be ironed out once they become well-known.

As for me, I think valuations do matter to future returns, and PE10 gives us another way of measuring them.

But I also think that the average person – and quite possibly everyone else, discounting for luck – is poorly placed to make a finely graduated call based on it.

In the March 2009 stock market lows, for example, what looked a high PE10 ratio compared to the bear market bottom of the 1970s was frequently given as a reason to steer clear of US equities.

The US market went on to double within less than three years!

For those who do want maths to tell them what the market will do in the future, the excellent Moneychimp offers a simple calculator that uses PE10 to estimate future returns for the US market, and also to adjust for dividends.

It’s a bit larky, which is how you should treat PE10 in my opinion.

A useful measure, in perspective

Personally I keep an eye on both simple and cyclically-adjusted P/E ratios. But I don’t take either too seriously.

Making up some numbers for a fictitious market for illustration: I wouldn’t sweat it if a market was on a PE10 of say 20 versus its historical average PE10 level of 15. But if its PE10 got towards 25 for any extended time in this illustrative instance, I’d consider that fair warning.

Your own mileage may vary. Passive investors are strongly advised to ignore the whole sideshow in favour of fixed allocations and mechanical rebalancing, except perhaps at times of seemingly extreme over-valuation – the year 2000, say, not the hindsight overvaluation of 2007.

And those don’t come along very often.

1. A quick reminder: Earnings in this context are basically the same as profits. Dividing the share price of a company by its earnings per share in a particular year gives you its P/E ratio.[↩]
2. The blogger remains a Monevator reader however and sometimes does requests, if you ask nicely.[↩]
3. He wrote that in 1996 and his prediction pretty much proved right, though, so he might be more strident now.[↩]

Many passive investors are in a pickle over gilts (or US Treasuries or whatever your domestic government bond might be, if you’re tuning in from outside the UK).

Mechanical asset allocation rules dictate that we must sink a proportion of our savings into government bonds, according to our individual risk tolerance. But aren’t we on a hiding to nothing, as gilt prices have soared and yields dwindled thanks to government manipulation of the market?

It certainly seems so when an investing legend like Warren Buffet comments:

Today, a wry comment that Wall Streeter Shelby Cullom Davis made long ago seems apt: “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.”

Surely the only way for gilts to go is down as interest rates rebound? Surely some kind of ‘active’ evasive manoeuvre is required?

What are gilts for?

Let’s ignore for now the fact that similar fears were widespread a year ago, only for the UK gilt sector to return 15% in 2011 and the index linked gilt sector to weigh in with a 21% rise.

Let’s even assume that this chart-topping performance makes it all the more likely that gilts must drop.

Before leaping into action we need to consider a few questions:

• How catastrophic will the ‘inevitable’ bonfire of the bonds be?

• Why do I have a gilt allocation anyway?

• What if things don’t turn out according to the forecasts?

To answer the first question, the role of government bonds for investors who are building their capital is to reduce the risk of underperformance by equities.

The more your portfolio is insulated with gilts, the less violently it should convulse as it’s held to the bare wire of the market.

Hence ‘merely human’ investors are less likely to go panic-sell crazy during market turmoil, and you’re better diversified should equities not live up to their long-term performance billing.

These important protective features of gilts remain true even in the face of the current market situation, and particularly given the economic uncertainty faced by the world.

If we should slip into a Japanese-style economic ice age, your gilt positions will provide a stable source of income and a welcome redoubt against deflation.

And if you pare back your gilt allocation to a point where your portfolio is riskier than you can truly stand, you may well do far more damage to your long-term prospects than you would in that much-feared gilt bear market, if instead equities fall, your nerve snaps, and you belatedly sell your shares at low prices.

This is because bear markets in bonds are generally pretty tame in comparison to equity nose-dives.

How bad can the losses be?

According to Vanguard, the largest annual loss that a 100% UK bond portfolio would have suffered in the last 30 years is -6.27% (in 1994).

Compare that with the -29.93% sliced off UK equities in 2008.

Better still, gilt funds ¹ come with an in-built recovery mechanism. As the price declines, yields rise, so as your bonds mature they can be reinvested for a lower price into new gilts that pay higher levels of interest.

As Vanguard ² points out, this mechanism eventually works in our favour:

Over the long term it’s interest income – and the reinvestment of that income – that accounts for the largest portion of total returns for many bond funds. The impact of price fluctuations can be more than offset by staying invested and reinvesting income, even if the future is similar to the rising rate environment of the 1970s and early 1980s.

Duration is the key characteristic on your gilt fund factsheet that shows how badly it will be affected by a rise in interest rates and long it will take to recover.

For example, if a gilt fund has an average duration of 7 years then it will lose (or gain) approximately 7% of its net asset value (NAV) for every 1% rise (or fall) in interest rates.

A duration of 7 also means that the fund will recover its original value within seven years as higher interest payments compensate for falls in price (though the recovery can be faster in practice).

What action can I take?

One thing you can do, therefore, is to make sure you only invest in gilt funds with a duration that’s no longer than your time horizon. That way you can’t suffer a capital loss on your portfolio’s gilt allocation.

And if you’re strapping in for the long term then you can take comfort from the fact that you’re likely to be able to ride out sharp rises in interest rates.

Interestingly, though a rapid rise in interest rates would seem to be a nightmare scenario for bond investors, the Vanguard study I quoted above found it actually delivered the highest expected return over 10-years (in simulations upon intermediate holdings of US Treasuries) in comparison to scenarios that are more bond-friendly in the short-term.

But if such reassurance is not enough to stay your hand, then it is possible to maintain your allocation to defensive assets while reducing your exposure to a price drop (otherwise known as maturity risk).

You can do this by increasing your allocation to shorter-dated gilt funds at the expense of longer dated funds.

This works by shifting some of your allocation from a long dated gilt fund to an intermediate fund, or from an intermediate fund to a short-term fund.

The table below shows what kind of difference that would make in terms of duration, using some example UK-listed gilt funds:

If interest rates rise by 1% then the iShares ETF’s duration reveals that it will only lose 2.57% of its value in comparison to a 9.5% loss for the Vanguard intermediate fund.

But if interest rates fail to budge, we can see from the yield-to-maturity that the short-term fund will pull in less than a third of the income of its intermediate rival.

If you’re more worried about volatility than long-term returns, a shift of this kind could make sense – particularly if you already have a high allocation to fixed-income.

Another way to trim your exposure to maturity risk would be to increase your allocation to cash.

The best instant access bank accounts yield 3% and you can get a two-year fix at 4%. That’s considerably better than the current yield on gilts, your portfolio will be less volatile, and there’s no risk of a capital loss.

As ever, the risk with cash is that it has delivered the worst historical return over the long-term and is highly susceptible to inflation.

The slippery slope

The elephant in the room for passive investors is that once you start trying to outsmart the market, how will you know when to stop?

Interest rate forecasts are a total lottery. After the credit crunch, it was widely predicted that interest rates would rise in 2010, then 2011, and now 2013. I’ve seen commentary that predicts a flatline until 2015.

Once rates do rise, when will be the right time to get back into gilts? Will you be able to do it when equities are crackling like a fried egg in Death Valley? Or will you be too busy diving in and out of gold?

If you’re a long-term investor, you shouldn’t dump your gilt funds. Historically, they’ve always been a drag on a portfolio, but they’re not there to boost returns. Gilts are there to diversify risk.

If your risk tolerance hasn’t changed, then your allocation to gilts shouldn’t change either.

Take it steady,

The Accumulator

1. I’m going to refer to gilt funds throughout the rest of this post, as I assume that most passive investors won’t want to strain themselves buying and managing their own gilt ladders.[↩]
2. The study is based on the US market, but the UK is analogous enough for our purposes.[↩]