Price/Earnings Ratios (P/E) as defined by Investopedia- "The P/E is sometimes referred to as the "multiple", because it shows how much investors are willing to pay per dollar of earnings."
Another way to say it...
The P/E Ratio reveals how many years of earnings it would take for a shareholder to get a 100% return on investment. As snapshot for a study, as of March 30, 2011, the PE Ratio for the entire S&P 500 was 15.25. That means at that time, earnings the 500 companies listed in the S&P 500 would take 15.25 years to double your money. That's the same as earning 4.65% over the 15.25 years.
Why would an investor put their money at risk with a projected return as low as 4.65%? In the days entering August, the S&P 500 had plummeted from 1345.02, - to 1199.38. That's a drop of 9.54% in just a few days. While this loss may be recouped rapidly in the future there is, of course, no guarantee in a bid market. In fact, since May of 2011, the Volatility Index (VIX) has risen from 15.99 to 32.00!
So volatility has been on the rise, that's really no surprise. Let's go back to the question asked earlier that has yet to be answered. Why would an investor risk the volatility when the S&P 500 P/E Ratios imply a 4.65% return on investment?
Investors must believe that these 500 companies are going to accelerate their profits so that the return comes back much faster than 15.25 years. That would be the only justification to pay a multiple of 15.25 today; OR - is it even possible that investors don't consider this fundamental when investing? Is it possible that they leave it up to the fund managers to make these complicated decisions hoping that the manager is smarter than all other investors and competitor funds allowing them to get a faster return on their money? Surely the fund managers must know, with all their careful study and analysis what stocks to buy to get a faster return on the money.
Unfortunately nearly all fund managers underperform the S&P 500 over a 10-year period or more. Don't forget, all along the way the investor must also pay fund management fees and trading costs regardless of the return.
This challenge for the investor has been going on for years as record numbers of baby boomers head into retirement. They are now "decumulating" not accumulating as they spend in retirement. Economic challenges and global competition are also taking their toll.
Are P/E ratios telling us something? In the first quarter of the year 2000, the S&P 500 stocks were trading at 27.79 times earnings. Paying 27.79 times current earnings for a stock makes a 2.5% return on investment. Perhaps the P/E Ratios in 2000 were correct and the forecasts of rapidly growing profits were wrong!
A long memory of the past and a short vision of the future...
Generally, investment pundits continue to live, off a story that stopped being true over a decade ago. If we look just a bit further in the past, the truth becomes revealed. The run up in stocks between 1980 and 2000 represent the most dynamic period of stock ownership in world history. Knowing how this happened will allow you to understand the present and prepare for the future. By the year 2000, the largest group of high income earners in history had been systematically contributing a portion of every paycheck for 20 years focused on the acquisition of one type of investment, individual shares of stock.
In 1950, just 4% of all Americans owned at least one share of stock, and by 1980, 13% of all Americans owned at least one share of stock. In the early 80s, 401(k)s became available as a payroll deduction product where 401(k) deductions are sent to fund managers to purchase stock. In 1980 the oldest baby boomers were 34 years old and during the next 17 years over 77 million boomers would enter the market in their 30s. By 1998, 52% of all Americans owned at least one share of stock, and by 2000, the oldest baby boomers were 54 years old. Between 1980 and the year 2000, the largest groups of the highest income earners in world history were systematically contributing a portion of every paycheck focused on the acquisition of one type of investment; individual shares stock. As more and more investors systematically entered the same market, the price of stocks naturally went up.
As stock prices went up, people began to redefine what it meant to take on RISK in their portfolios. According to Webster's dictionary, the first definition of RISK is the, "possibility of loss or injury." The fourth definition is, "the chance that or, investment will lose value." At no time does the word RISK equate, to opportunity yet today, many people believe that RISK means more return. The next time you are with a group of people, ask them to finish this sentence, "The greater the risk, the greater the _____.” You will find that almost everyone replaces the blank with the word "return" as if it somehow risk assures a better return. Almost no one will say, the "possibility of loss or injury." Today, we are seeing the results of this long-term memory of the past where it appeared that publicly traded stocks simply went up (1980-2000). People have yet to fully embrace the previously discussed facts above. The elements that drove stock market performance in the past, no longer exist. The very components that caused this dramatic growth now serve to increase volatility and the true experience of RISK which is the possibility of loss. In addition, many have no clue of our fiscal problems even though ratings services are threatening another credit down grade and the printing or digitizing of 85 billion per month that is propping up the stock and bond markets.
Even today, financial authors like Dave Ramsey gives excellent advice about getting out of debt but Mr. Ramsey curiously continues to talk about mutual funds that earn between 11 and 12% over the, long haul. Let's do a little reality check here; this 11 ½ year roller coaster ride has ended with a resounding thump at the bottom. Investors who systematically supplement their income from these mutual funds have watched a tremendous amount of their wealth deplete with no chance of a return.
During his entire career since Mr. Ramsey launched his "Financial Peace" concept in 1992, the S&P 500 has not even come close to his story of an 11% to 12% return. The actual performance has been half of these numbers even before subtracting fees and trading costs.
Why is Dave Ramsey recommending mutual funds constantly? Because mutual funds are huge sponsors of his website, advertising, radio and television show. All of Dave's –Wealth Coaches" are required to sell for these mutual funds as a condition of being named as a "Wealth Coach." Dave Ramsey has been an excellent lead generating tool for mutual fund companies and their sales representatives because he continues to rely on people's long memory of the past and their lack of understanding of the future. Now please don't get me wrong. Ramsey's ideas on eliminating debt are absolutely fantastic. The claims he makes about mutual funds are not. Savers must stop looking at the period from 1980 to 2000 as something that is going to happen again in the stock market.
Demographic conditions (retiring boomers) and government spending programs have forever changed the outcome going forward. Ask yourself, do I see the next decade being more like the last decade or more like the decade of the 80s and 90s? Another thing to ask is do you think taxes are going to remain the same, go up or down?
It is essential to understand the challenges of managing assets in retirement, including how early losses can undermine long term planning. According to the prevailing wisdom on investing, ones asset allocation choices should gradually change to a more conservative stance as we approach the end of our working years. Proper asset allocation in our later working years can lead to more effective retirement income planning.
Most employer sponsored retirement plans and 401ks are designed for the accumulation phase of retirement planning and offer limited investment options for the conservative allocation of their employees’ portfolio. If your plan does not offer adequate investment choices, there may be a penalty free way to move some of those assets into a self directed IRA so they can be properly allocated.
In an effort to reduce the number of lawsuits from fiduciary neglect, many employers are amending their plan document to allow “in-service withdrawals” to give employees the opportunity to re-allocate some of their assets to safer more conservative choices. Not all employer sponsored retirement plans offer these withdrawals but if your 401k plan allows for in-service, non-hardship withdrawals, you won’t have to retire or separate from service to begin developing your retirement income plan. The first step is to learn if your company allows these distributions.
To do this, we need to review your Summary Plan Description (SPD) and speak with your employee benefits department. In doing so, you can learn if there are any restrictions or special requirements associated with these distributions.
Many 401(k) plans allow participants to take in-service withdrawals (withdrawals while currently employed) if they provide proof of hardship. Generally those distributions must be used to pay qualified expenses, such as medical or educational costs, or to purchase a primary residence.
But some 401(k) plans allow in-service, non-hardship withdrawals. This special provision allows participants to take withdrawals without providing proof of hardship if they have reached 59 ½ or have met the requirements specified by the plan document.
To find out if your 401(k) plan has a provision for in non-hardship withdrawals, ask for a copy of the plan’s Summary Plan Description, which must he provided upon request to plan participants. Also you can look on your year end 401(k) statement. If the plan allows such withdrawals, the statement might have a separate column that indicates the dollar amount of funds available the in withdrawals.
It’s important to understand that this type of withdrawal when receiving constructive receipt of the funds is typically treated as ordinary income and could trigger a tax liability. In addition, if you’re under age 59 ½ you could be subject to a 10% early withdrawal penalty.
However by taking the distribution and rolling it over into an IRA, you will continue to benefit from tax-deferred growth without an immediate tax liability or penalty. If the plan document permits, in-service rolling over of company retirement account assets to an IRA can be a very viable strategy that many 401k participants are unaware of.
In-service, non-hardship withdrawals can be moved to choices more suited to your risk tolerance and objectives. To avoid income tax withholding, you must not take receipt of the proceeds, but rather roll them over directly to an IRA or another qualified plan.
We work with the largest and best service providers of company retirement plans that are experts in distribution rules and rollover regulations. Whether there is a question about your Summary Plan Description or an individual with a vesting question if we don’t know the answer we can and will easily find out for you.
Some people even have no risk tolerance when they are younger. They do not want to be put in the position of having to wait through another seven to ten year stock market cycle to regain a paper loss of 20 to 50% of their hard earned money. They rightfully feel it is a futile exercise and they will never be able to replace that time in their financial lives.
The well thought out placement of a fixed annuity into your portfolio offers a conservative balance for your asset allocation strategy, and using this as a substantial foundation of safety is a very smart move considering today’s economy. A healthy portfolio should have a conservative component and regardless of what you may have heard elsewhere, a fixed annuity is a good choice. Keep in mind; a variable annuity is not guaranteed and subject to market risk and loss of principle, not to mention operating expenses and administrative fees, whereas a fixed annuity is a guaranteed safe financial instrument and can be set up without any fees. The opinion of some media experts has shown an obvious misunderstanding between the two plans.
* There is no substitute for the professional advice of an annuity expert. If the other advisors have not brought this to your attention, do you think they would like to be put on the spot with something they only have a vague idea about?