Wait 5 Years?

I used the Scenario Surfer to determine whether to wait up to 5 years or to buy stocks immediately. I examined a very simple approach.

Scenario Surfer Runs

I set up the Scenario Surfer for P/E10=14 in a Bear Market. I started with a $100000 balance. I withdrew $5500 each year. I started with a stock allocation of 20%. I increased this to 100% stocks as soon as P/E10 fell below 11 or at Year 5, whichever happened first. The non-stock component was TIPS at a 2% real interest rate.

I have reported the results with an 80% fixed stock allocation for comparisons.

These are the balances at Year 10.

Run 1: Bargain Price
P/E10 Below 11: 93,009
80% stocks: 77,028

Run 2: Year 6 Purchase
P/E10 Below 11: 50,007
80% stocks: 66,833

Run 3: Bargain Price
P/E10 Below 11: 84,411
80% stocks: 62,303

Run 4: Bargain Price
P/E10 Below 11: 120,777
80% stocks: 81,855

Run 5: Bargain Price
P/E10 Below 11: 116,980
80% stocks: 70,366

Run 6: Year 6 Purchase
P/E10 Below 11: 63,773
80% stocks: 71,469

Run 7: Bargain Price
P/E10 Below 11: 103,545
80% stocks: 67,716

Run 8: Bargain Price
P/E10 Below 11: 64,037
80% stocks: 64,378

Run 9: Bargain Price
P/E10 Below 11: 128,831
80% stocks: 94,057

Run 10: Bargain Price
P/E10 Below 11: 32,524
80% stocks: 27,364
20% stocks: 53,169

Data Summary

In 6 out of 8 times when P/E10 fell below 11 by Year 5, switching to 100% stocks was better than maintaining an 80% fixed allocation.

In one out of 8 times when P/E10 fell below 11 by Year 5, switching to 100% stocks was slightly inferior to maintaining an 80% fixed allocation.

In one out of 8 times when P/E10 fell below 11 by Year 5, P/E10 continued to drift to even lower extremes, favoring a 20% fixed allocation over a high stock allocation.

In 2 out of 2 times when P/E10 failed to fall below 11 by Year 5, sticking with an 80% fixed stock allocation was better than shifting to 100% stocks.

Conclusions

If you could guarantee that stock prices will continue to fall rapidly, you would do well to stick with a low stock allocation for several years. But you cannot. You must prepare for the possibility that we are already close to the bottom. This suggests a middle level stock allocation (possibly 40% or 50%) at today’s prices.

You must also prepare for the possibility that stock prices will fall to historical lows such as P/E10=5 or 6. A dividend focus makes such decisions easier. When P/E10 falls below 11, the earnings yield of the overall market is around 9% or 10%. At such times, many high quality blue chip companies pay dividends of 6% that grow as fast as or faster than inflation.

As always, I recommend gradual allocation shifts.

Have fun.

John Walter Russell
December 4, 2008