Two Level Switching in a P/E10=14 Bear Market

I examined two threshold allocation shifts at today’s valuations.

Remarks

We are in a long lasting (secular) Bear Market. P/E10=13.

I conducted an optimization similar to that in Current Research B: Keeping In Tune with the Human Element.

I evaluated the results on the Investment Strategy Tester at Year 10. I started with an initial balance of $100000 and withdrew $5000 each year (plus inflation). I assumed 2% TIPS. I selected a P/E10=14 Bear Market.

I optimized based on the Unlucky results (lower 20% of outcomes). Otherwise, an all-TIPS portfolio would always be optimal at Year 10 but lead to disaster at Year 30.

I verified that my results were superior at Year 10 to using a fixed allocation.

Results

The optimal allocations were 100%-40%-20% with thresholds at P/E10=9 and 21. The exact values are not critical.

This supports a 30-year Safe Withdrawal Rate of 5.1% (plus inflation) in a P/E10=14 Bear Market. The Safe Withdrawal Rate is above 5.5% (plus inflation) in a P/E10=14 Normal Market.

This compares with 5.3% (plus inflation) for the full up baseline portfolio in a P/E10=14 Bear Market. [The full up baseline has stock allocations of 100-80-50-20% and P/E10 thresholds of 6-8-18.]

Insights

The exact numbers are much less important than the insights that we can gain. After all, the future will be a particular outcome, not a range of probabilities. Moreover, there can be changes underlying investments in general.

The long lasting (secular) Bear Market shifts the lower threshold down when compared to SwAT2 from Current Research B. We see the same effect in the full up optimized program.

This is a caution to prepare for further price drops in the current market.

There are a variety of ways of handling a price drop. Staying on the sidelines works well if we can assume that we have not hit bottom already. But we cannot make that assumption. We must avoid being out of the market altogether. We need a reasonable allocation today while waiting for a likely price drop latter on.

This places a lot of emphasis on the short term.

We are close to a turning point. It may have happened already. More likely, however, we will not see a bottom until 2012-2020 based on demographics. In any event, it does not pay to wait beyond 4 to 7 years to be fully invested.

Have fun.

John Walter Russell
March 22, 2009