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Financial Advice

Reader Mailbag: Future of Advice, Earnings

John Rekenthaler tackles reader questions from his recent columns.

Sidetracked I’m nursing my wife, who demonstrated, once again, how Hollywood differs from reality. In films, ladies swoon into a gentle, comfortable heap. It’s all quite elegant. Not so much when the fainting occurs in fact, and the floor is marble.

She will be fine. However, the event has prevented me from researching a topic for today’s column. In my stead is the substitute teacher: you. Below are excerpts from some reader emails, followed by my comments. Thanks much for the contributions! This article would not exist otherwise.

The Future of Advice On my proposal that financial advisors be tiered not by how much fiduciary responsibility they will accept (the current system) but instead by their educational requirements, Joel S. asks, “Do you really think this is something that would happen in the semi-near future? I am struggling to determine who is a fiduciary and who isn’t, as I am currently looking for an advisor.”

No, I do not believe that requiring everybody who gives financial advice to work solely in their clients’ best interests, then distinguishing between advanced-level "counselors" and basic-level "brokers" based on the amount of training that an advisor has received, will occur any time soon. Or probably, ever. As far as I know, I am the only person on this planet to propose such a thing. (Surely not; but being an outsider, I am not very familiar with the financial-advice debates.)

But my goodness, as partially baked as my proposal is, it can't help but to be an improvement. Consider Joel's situation. He has learned enough about the subject to realize that there are various types of financial advisor, and yet he still can't figure out one version from another. And this has been going on since forever. The financial-advice industry confuses its customers, year after year, decade after decade. The smoke never clears.

Good luck, Joel. You will need it.

Fantasy Earnings Last week’s “Many Bubbles, Few Troubles” column addressed a paper from Research Affiliates, which suggested that today’s U.S. stock market had become so expensive as to be a bubble. My column expressed doubt. Perhaps today’s stock prices have reached bubble heights, perhaps not. Different calculations of equity values give different conclusions.

Research Affiliates' chairman Rob Arnott had but one disagreement with that column: its use of forward-earnings estimates when calculating the stock market's price/earnings ratios. Writes Arnott:

"Certainly, forward-looking earnings will make [stock market] valuations seem more reasonable. But forward-looking earnings measures will seldom suggest a bubble or even much overvaluation, as analyst forecasts are prone to the same overoptimism and extrapolative behavior at economic peaks, propelling market prices ever higher as bubbles begin to brew. They even made valuations in early 2000 seem semi-reasonable at about 20 times. Put another way, no matter how high the price, you can nearly always justify it with an optimistic forward earnings estimate.

"Forward earnings haven't yet happened, almost always exceed the future reality, and are generally rather fanciful. We never use forward earnings, not because they don't support our case but because they are a flawed tool for this sort of analysis. I often like to say that price/forward equals price/fantasy."

Less politely, but making the same argument, screen name Cire states, "Comparing apples to oranges? Market cheerleader? Perma bull? Vested interests? You know you're comparing apples to oranges. Forward P/Es are always based on overly optimistic projections from stock market cheerleaders. The predictions almost always prove too high."

It is true that forward earnings estimates tend to overshoot the mark. I wouldn't put great faith in the accuracy of one-year figures (which the column cited) and any faith at all in the five-year numbers. (Somehow, every company is expected to double its earnings, if not more.) However, as long as the overconfidence is consistent over time, it doesn't negate a ratio's usefulness as a relative measure. That the current forward-looking P/E ratio matches that of 2003-04, when the stock market was clearly not in a bubble, seems a reasonable counterargument to the claim that stocks are now clearly in a bubble.

Whither Earnings? After, yes, chiding me for using forward-looking earnings, John Coumarianos writes, "So is this a bubble? Maybe, maybe not. But it's hard to say prices aren't high (in a reasonably objective sense), and that returns won't be low. And that's worth shouting about a little."

Hmmm. Let's put it this way. One of these years the economic cycle will turn, thereby making projected corporate earnings wildly overstated rather than moderately so. Stocks will get crushed. If that happens in 2018 or 2019, then equity prices will indeed have been high, and returns will indeed be low. If the economy holds out until 2020 or longer, though, then today's values should look reasonable.

Thus, my agnosticism. The critical data point for determining if stocks are too costly (or, perhaps, even at bubble levels) is when the economic cycle turns, and that we do not know.

Consider the Safety Net In "Why Buy Annuities?" I complimented single premium immediate annuities (SPIAs)--which provide a lifetime income stream--but lamented that upon the owner's death, that money is gone. True, the SPIA holder can alleviate that problem by buying a death benefit, but that benefit's cost generally outweighs its advantage.

George Harris, CFP, disagrees:

"There are many options available on SPIAs whereby the money does not disappear. I employ a strategy of "joint life with refund." In this strategy, two people enjoy the payouts for as long as either one of them is alive, regardless of the number of years. Then if there is any principal left, as in the case of an early death, the remaining principal would be paid to beneficiaries. That would be either in a lump sum or in installments, depending on the owner's choice. The cost is not necessarily high."

Upon further review, and discussion with Morningstar’s retirement researchers, I concur. To be sure, some death benefits are unattractively priced, but there are enough good packages out there to falsify my generalization. So, I retract that statement. Those who buy SPIAs may wish to consider adding a death benefit.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar’s investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

The opinions expressed here are the author’s. Morningstar values diversity of thought and publishes a broad range of viewpoints.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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