Edited: Since You Can’t Count on 7%

Today’s stock market valuations are sky high. The outlook for today’s buy-and-hold investor is poor. But by waiting for favorable valuations, it is likely that he will double his 30-year balance.

What about those people who wish to retire ten years from now? What is their payoff for waiting? How about those who are just starting out? What should they do?

Ten Years Before Retirement

I will not go into the details of investing over the next ten years. I addressed that in my first article: You Can’t Count on 7%.
You Can’t Count on 7%

What I will point out is how much better the outlook will be ten years from now.

If you vary your stock allocation with valuation (switching allocations of stocks and 2% TIPS) your Safe Withdrawal Rate improves dramatically. Reference: Safe Withdrawal Rates with Switching.
Safe Withdrawal Rates with Switching

From that article:

Using the 1923-1980 data, the formula for the Calculated Rate is: y = 0.3276x+3.9729. R-squared is 0.5815. My eyeball estimates of the confidence limits are plus 1.3% and minus 0.7%. [I place my greatest emphasis on data with earnings yields of 10% and lower.]

Today’s earnings yield is close to 3.5%. Using the 1923-1980 data and a 3.5% earnings yield, the Calculated Rate is 5.12%. Today’s Safe Withdrawal Rate, which is the lower confidence limit, is 4.4%. Today’s High Risk Rate, which is the upper confidence limit, is 6.4%.

From You Can’t Count on 7%: Dollars:

Now consider what I learned from Professor Robert Shiller’s data:

“P/E10 was 8.7 in 1983..The last time that it was 15 was in 1989..If the rise and fall of P/E10 were symmetrical, P/E10 would fall below 15 around 2011. P/E10 would continue down to 8.7 in 2017. Historically, declines have been faster than rises.”

It is a little bit optimistic, but reasonable and realistic, to assume that we will be able to buy 2% TIPS for ten years and then buy stocks when P/E10 = 8.7. This is an attractive valuation. But it is comfortably within the historical range.

Combining the two:

If P/E10 = 8.7, the percentage earnings yield 100E10/P is 11.5%. Using x = 11.5% in the formula with switching, the Calculated Rate is 7.74%. The lower confidence limit is 0.7% below this or 7.0%. The lower confidence limit is the Safe Withdrawal Rate. The upper confidence limit is 1.3% above the Calculated Rate or 9.0%. The upper confidence limit is the High Risk Rate.

If you wait for favorable valuations and if you switch portfolio allocations, your Safe Withdrawal Rate increases from 4.4% to 7.0%. That is quite an improvement.

It is a coin toss (50%-50%) whether you could withdraw at the Calculated Rate for 30 years. The Calculated Rate increases from today’s 5.12% to 7.74%.

The Luxury of Favorable Valuations

It turns out that a fixed, high stock allocation should be better than switching when P/E10 is 8.7.

At today’s valuations, a fixed allocation of stocks and 2% TIPS (with annual rebalancing) reduces today’s Calculated Rates to 4.36% with 50% stocks and 4.12% with 80% stocks. It reduces the Safe Withdrawal Rates to 3.6% with 50% stocks and 3.0% with 80% stocks.

At a P/E10 level of 8.7 (and an 11.5% earnings yield), a fixed allocation of stocks and TIPS (with annual rebalancing) improves the Calculated Rates to 7.58% with 50% stocks and 9.53% with 80% stocks. It results in Safe Withdrawal Rates of 6.8% with 50% stocks and 8.4% with 80% stocks (compared to 7.0% with switching).

Dollar Cost Averaging

If an investor chooses to invest in stocks, his balance at year 10 is likely to be between 57% and 188% of the balance that he would have by investing in 2% TIPS. He gains only 6% (on average) for tolerating this wide range of outcomes.

[Relatively few people would subject their retirement prospects to this amount of uncertainty for such a little gain, knowing that they have safe alternatives.]

Using the 1923-1972 formulas from You Can’t Count on 7%, the most likely 10-year return when P/E10 = 8.7 is 13.0%. The confidence limits are plus and minus 6%. The most likely 20-year return when P/E10 = 8.7 is 11.0%. The confidence limits are narrower (plus and minus 4%). The most likely 30-year return when P/E10 = 8.7 is 8.5%. The confidence limits are plus and minus 2%. Investors who start from a favorable valuation of P/E10 = 8.7 are (almost) assured of an annualized, real, total return of 7% over 10 to 20 years and 6.5% over 30 years.

Converting these to dollar amounts, starting from a decade of investing in TIPS (and a balance of $127.1K), we end up with likely balances of $431K (or 3.39*$127.1) at year 20, $1024K (or 8.06*$127.1K) at year 30 and $1474K (or 11.6*127.1K) at year 40.

What Does This Mean?

This is very good news for those who wish to retire early, but who cannot do so today. Today’s retirees face a strong headwind caused by high prices. After ten years (or a little bit longer), retirees will enjoy a strong tailwind from bargain prices.

Hang in for a few years. Your Safe Withdrawal Rates will jump.

The size of the jump depends upon your investment strategies and choices. If you invest heavily in stocks, your Safe Withdrawal Rate could rise from 3% to 8%+. If you vary stock allocations according to P/E10, your Safe Withdrawal Rate will rise from 4.4% to 7.0%.

You might start out by varying stock allocations according to P/E10. Later, after your portfolio has grown, you might change to using a fixed, high stock allocation. The primary problem with high stock allocations is volatility. If your portfolio is large enough, you can tolerate high volatility.

For those who are just now starting out, this is a good time to gather as much as you can. This is NOT a good time to invest. This is a good time to SAVE. Stock market investing, even with dollar cost averaging, has a tremendous range of uncertainty. Ten years from now, you could end up with (almost) twice as much as from savings or (almost) one half as much. On average, you can expect a net gain (cumulative) of only 6% or so.

After ten years (roughly), expect to enjoy a prolonged period of high stock returns.

Have fun.

John Walter Russell
August 20, 2005