Stock Market Monkeys

Once upon a time a man appeared in a village and announced to the villagers that he would buy monkeys for $10 each.

The villagers, seeing that there were many monkeys around, went out to the forest, and started catching them. The man bought thousands at $10 and as supply started to diminish, the villagers stopped their effort. He further announced that he would now buy at $20. This renewed the efforts of the villagers and they started catching monkeys again.

Soon the supply diminished even further and people started going back to their farms. The offer increased to $25 each and the supply of monkeys became so little that it was an effort to even see a monkey, let alone catch it!

The man now announced that he would buy monkeys at $50! However, since he had to go to the city on some business, his assistant would now buy on behalf of him.

In the absence of the man, the assistant told the villagers. “Look at all these monkeys in the big cage that the man has collected. I will sell them to you at $35 and when the man returns from the city, you can sell them to him for $50 each.”

The villagers rounded up with all their savings and bought all the monkeys.

Then they never saw the man nor his assistant, only monkeys everywhere!

Now you have a better understanding of how the stock market works.

Source: Unknown H/T Prieur

Duration or if you prefer the Price-to-Dividend Yield

Duration is an economic/finance term used to describe when the average payment will be made on a bond. This is a gross simplification, but useful to describe it in lay terms. So if you have a zero-bond, that is one that does not pay out a coupon, the only payment is when the security matures and then pays its face value. So if it is a 5 year zero, then obviously you on average get your repayment in the 5th year. Simple, eh? Well, when you have coupon payments this averages move up closer to the present day depending on the relative size of the coupon to the final payment. The ultra-cool aspect of this is that when you match when you need your money back to a security's duration than interest rate changes will not affect you, that is you are immunized. This is because the loss that you are receiving by the relatively lower coupon rate when interest rates rise is made up by the reinvestment of the coupons in the higher current interest rate. However, I didn't want to follow fixed income with this post and instead wanted to look at equities.

So you can also apply this logic to equities. So I did so for the S&P500 index. I went to Standard and Poor's website, http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indices_500/2,3,2,2,11,29,2002,0,0,0,1,0,0,0,0,0.html and searched around a bit to find the historical dividends and the price index. So I looked at the year-end price level and the year-end dividends paid in the past 4 quarters. Here is the chart I made.
The axis starts with the current price-dividend ratio and goes back until 2002. As you can see over the past 7 1/2 years the ratio has been above 50 until 2008, this era covers post-9/11 and the dot-bomb era. More incredulous when the trough of the equity market was in 2003 the ratio was at its highest level. So maybe the rally over the past 5 years did not really make much sense. Hindsight being 20-20 and all.

So applying the immunization concept to these numbers, it means that on average you would receive your money back by investing in the S&P500 anywhere from 50 to 60+ years in the future. Mad! Now the ratio fell to its lowest in December where it was 31.82 and now is at 35.03. That means if you plan on retiring in 35 years, the change in interest rate levels will not affect your investment. This makes the huge implicit assumption that the dividends and prices will remain at a constant ratio over that period. Neither I, nor anyone else should, believe that to be the exact case but this is a useful exercise in maintaining our bearing when viewing the equity markets. This information is most useful to investors who are about 30 years old, any older than that and you would need to have considerable more invested in shorter duration bonds to match your expected retirement date.