Returns On Stocks Based On Initial P/E Ratio: Can Bonds Beat Inflation?

Includes: ACG, BOND
by: Alberto Quintana

In our article, "3 legs," we exposed one of the main problems related to retirement calculations: returns on stocks depend on initial P/E (more about P/E, here). Right now, the P/E10 is high, so to get 7% a year could be a dream. How can we estimate the stocks' yield?

Crestmont Research has done an amazing job with its stock matrix (link here). How do we use it? We choose a period with similar P/E on the left, and, following the same row, check out the annual returns after 20, 30 years. For instance, from 68 till 98, the yield is around 8% a year. We can appreciate that when the P/E ratio is high, the following years it is difficult to obtain high returns (red and pink colors). However, after a certain number of years, in most of the cases, we get 5% at least (6% probable). So, in our retirement calculators (we have a Simple Retirement Calculator here), we could choose 5% for the box "Annual Yield on Balance" if we are going to be retired for a long time. It took 60 years to get that kind of return after 1929 (3% in 40 years), though.

But this leg is not finished. We could decide not to risk all our wealth in the stock market to avoid "black swans" (our logo) or the 1929 case. It makes sense to diversify, even though some gurus are betting just on stocks (they find huge risks on bonds).

(Click to enlarge)

Do bonds have positive real yields (more than inflation)? Above, we can study a graph of historical inflation. During the tough period of recession after 1929, inflation was not so low as we could have imagined (huge peak on 1946), but in any case, until 1970, it was less than 5% on average. In our article, "Average Inflation," we showed that unofficial data could duplicate the inflation data from BLS. A conservative proxy for real inflation could be 7% (it could seem high but we cannot bet our retirement in a casino).

It´s very difficult to invest in bonds. Easily we can guess we are not going to get more than 7% annual return. Inflation-linked bonds are related to "official" inflation, so we will still lose money. However, funds like Pimco Total Return has obtained an annualized yield of 7% during the last 10 years. Recently it has created an ETF matching the fund (TRXT) If we invest in the fund, we get even with inflation. Also, closed end funds, such as AllianceBernstein Income Fund (NYSE:ACG) (we will talk about it in a future article), can do a good job to get even with inflation with the use of leverage. Choosing the right currencies and real data for inflation (not official one), it´s possible to lose just 1.5% a year of purchase power buying bonds. Let´s imagine that with the adequate percentage we are just down 1%. So, if REAL INFLATION is estimated to 7%, a good choice for bond yield is 6%, which, by the way, matches the historical data from NYU Stern (link here).

After stocks and bonds, we just need to forecast the real return of real estate and mix the three together.

Disclosure: I am long TRXT, ACG.

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