Muddling Along

Jonathan Clements

TEN-YEAR TREASURY notes are currently yielding 1.9%. That means today’s buyers will likely lose money, once inflation and taxes are figured in—and yet demand remains robust, as evidenced by 2016’s rise in Treasury bond prices.

The healthy appetite for Treasurys partly reflects the vast amount of excess capital sloshing around the global financial markets, as well as the tiny payouts on alternatives such as money-market funds and savings accounts. But it also reflects the current fear engendered by both stocks and lower-quality bonds. Are those worries about stocks justified? I tackle that issue below, and also discuss an intriguing approach to retirement income.

Four Big Questions

If investors were convinced the U.S. economy was headed for recession, share prices would be a lot lower. If they believed corporate earnings would quickly recover from their current swoon, stocks would likely rocket past their May 2015 peak. But instead, we’re muddling along, with the S&P 500 down 6% over the past nine months. To me, that seems about right. The economic fundamentals aren’t that bad—but they aren’t that great. In particular, there are four big questions confronting investors, and the uncertainty will likely make for volatile markets and muted long-run returns.

1. Is the economy slowing? In 2015, U.S. gross domestic product grew 2.4%, after adjusting for inflation, the same as in 2014. But 2015’s fourth quarter was notably weak, with GDP growing at a 1% annualized rate. The fear: Slower growth abroad, especially in China, coupled with the hit to energy companies caused by collapsing oil prices, will drag the U.S. economy into recession.

Part of the problem, I believe, is that our expectations are unrealistic. We’re used to 3% GDP growth—but we aren’t likely to get it. As I explained in September’s newsletter, half of that historical 3% growth has come from increasing the number of workers and half from increasing the productivity of workers. But with the civilian labor force projected to grow at 0.5% a year over the next decade, rather than 1.5%, we should be pleased with growth above 2%—which means 2014 and 2015 were actually pretty good years for the U.S. economy.

2. Will profit margins shrink? With economic growth constrained by slow growth in the labor force, we’re also likely to see slow growth in corporate earnings. But lately, earnings haven’t been slowing—they have been falling.

Based on trailing 12-month reported earnings, the per-share profits of the S&P 500 companies peaked in September 2014. Fast forward one year, to September 2015, and trailing 12-month earnings were 14% lower. It appears corporate profits fell another 3% in 2015’s fourth quarter. A big contributor has been plunging profits at energy companies, which account for 7% of the S&P 500’s market capitalization.

If that is all that’s going on, we should be relieved. My worry as an investor: With February’s unemployment rate at 4.9%, companies may need to raise wages to attract workers, which would put pressure on corporate profits. Indeed, we could be witnessing a reversal of the sharp rise in corporate profit margins that’s occurred over the past dozen years. As of mid-2015, after-tax corporate profits accounted for 9.9% of GDP, down from 10.8% at year-end 2011, but still well above the 20-year average of 7.7%. If profit margins reverted to that average, it would knock more than 20% off current earnings.

3. Has capital spending been neglected? Historically, existing shareholders have seen their claim on total corporate profits diluted at a rate of 2 percentage points a year, as new companies emerge and existing companies issue additional shares. In other words, if corporate earnings rise 7%, earnings per share might climb just 5%—and that, in turn, means more modest share price appreciation.

But there’s been a remarkable change over the past dozen years: Companies have become big buyers of their own stock, so shareholders haven’t suffered much, if any, dilution. Will dilution return? The money lately lavished on buybacks appears to have come at the expense of capital spending, which presumably isn’t quite so necessary in a slow-growth economy. But have companies been skimping too much? We could see a big jump in capital spending, necessitated either by years of neglect or a pickup in economic growth—and for shareholders that may mean a return to 2% annual dilution and perhaps worse.

4. Are valuations permanently higher? I regularly keep tabs on the S&P 500’s cyclically adjusted price-earnings ratio, or CAPE, the measure developed by economists Robert Shiller and John Campbell. The CAPE ratio involves comparing current stock prices to inflation-adjusted earnings for the past 10 years. That means it’s less sensitive to short-term dips in corporate earnings, such as the one we have seen over the past five quarters.

As of today’s market close, the CAPE ratio was 25.4, well above the 50-year average of 19.7—but below the 25-year average of 25.7. So should we be worried that price-earnings ratios will fall or not? Nobody knows for sure, of course. But my hunch is that—in a world where there’s too much capital chasing too few investment opportunities—stocks will tend to trade at valuations that are higher than the 50-year average. That’s good news if you’re worried about a big short-term market hit, but bad news if your hope is to buy stocks at bargain prices and enjoy healthy long-run gains.

So what does all this mean for investors? I continue to fund my retirement plan because, even if the markets are uncertain, the tax advantages aren’t. Thanks to the market’s decline, I’m a little underweighted in stocks right now, so I’ll probably rebalance in the months ahead—but I’m not in a big rush. What would it take for me to overweight stocks? I would like to see the S&P 500 at 1550—or 23% below today’s market close.

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Betting Your Life

A few weeks ago, I received an intriguing email from Paul Sklar, age 56, who lives in Pittsburgh and has spent his career working on brand management and innovation for consumer health-care products. Sklar was puzzling over how much retirees should withdraw from their portfolio each year, given the uncertainty over how long they’ll live. His notion: Retirees should start by explicitly deciding how much longevity risk they’re willing to take.

For instance, you might manage your money as though you’ll live longer than 85% of retirees. For a 65-year-old man, that would be age 96, while for a 65-year-old woman it would mean age 98. Only 15% of retirees would live to these ages or beyond. Keep in mind that these figures reflect the life-expectancy assumptions used by insurance companies when pricing annuities. Insurers know that annuities are bought by healthier individuals, who might live perhaps three or four years longer than the typical 65-year-old.

What if you were willing to take a little more longevity risk, and assume you’ll live longer than 70% of retirees? If you’re 65 today, that would put you at age 93 if you’re a man and 94 if you’re a woman. What if you roll the dice—and want to bet you’ll only live as long as 50% of retirees? Based on the life-expectancy assumptions used by insurers, that would mean age 88 if you are a man and age 90 if you’re a woman. (For comparison, the Social Security Administration’s website—which has life-expectancy data for all retirees, not just the healthy folks who buy annuities—says 50% of 65-year-old men will live to age 84 and 50% of women to age 87.)

Let’s say you decide to manage your money as though you’ll live until age 93, or 28 years beyond age 65. Sklar suggests you might then spend 1/28th of your savings in the first year of retirement, 1/27th in year two and so on. This is sometimes referred to as the 1/n strategy, with the “n” representing the number of years. As you age, Sklar advises periodically revisiting your life-expectancy assumption, to reduce the risk you’ll outlive your money.

Because you’re recalculating how much you should withdraw each year based not only on your assumed life expectancy, but also on your portfolio’s year-end value, you’re forced to raise or lower your withdrawals depending on how your investments performed over the prior year. Sklar’s method also compels those who retire early to reduce their annual withdrawals, because they would be drawing down their portfolio over more years.

If you spent 1/28th of your portfolio in the first year of retirement, you would be withdrawing 3.6% of your portfolio’s value, less than the 4% withdrawal rate that has become a popular rule of thumb. Could you withdraw more? The 1/n rule would give you the same inflation-adjusted withdrawal each year if your portfolio’s annual return is the same as the inflation rate. But if you thought your investments could outpace inflation over the long haul, you might tack perhaps half a percentage point onto your withdrawal rate, so your first-year withdrawal rate would be 4.1%, rather than 3.6%.

I’m sure there are those who will dismiss Sklar’s strategy as too complicated or too conservative, because the odds are you’ll die with a fair amount of money. But I think it’s clever: I like the way it forces retirees to consider longevity—and I especially like the way it compels folks to adjust their spending along with their portfolio’s performance.

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