Edited: Why People Ignore Valuations

I have recently built the Variable Terminal Value Rate Calculator C. It calculates the optimal fixed allocation of stocks and TIPS.

It calculates the Safe Withdrawal Rate (95% chance of success), the Reasonably Safe Rate (80% chance of success), the Coin Toss Rate (50% chance of success), the Likely Failure Rate (20% chance of success) and the Almost Certain Failure Rate (5% chance of success).

Numbers

P/E10=20 and 1.0% TIPS

When I enter a P/E10=20, a TIPS interest rate of 1.0% and a Terminal Value at year 30 equal to 50% or 100% of the initial balance (plus inflation), all of the optimal fixed stock allocations equal 80%, the maximum that I allow.

This is very significant since commercial paper acts similar to 1.0% TIPS.

Historically, P/E10=20 has been considered high and dangerous.

P/E10=15

When I enter P/E10=15 and a TIPS interest rate of 2.0% or less and a Terminal Value percentage from 0% to 100%, all optimal fixed stock allocations equal 80%.

Historically, P/E10=14 has been typical.

Today’s Market

Today’s level of P/E10 is 26.8. Today’s TIPS interest rate is 2.4%.

At a Terminal Value percentage of zero, only the Likely Failure Rate and Almost Certain Failure Rate have high optimal fixed stock allocations. The best allocation for the Coin Toss Rate is 24.0%. The best allocations for the Safe Withdrawal Rate and the Reasonably Safe Rate are both 20%.

Increasing the Terminal value percentage to 100% increases the optimal fixed stock allocation of the Coin Toss Rate to 63.5%. The optimal fixed stock allocation at the Safe Withdrawal Rate is 48.7%.

What Has Changed

What is the best stock allocation? In the past, there was a single answer: 80% stocks. Most often, it was the right answer. Valuations had little effect.

Today, there are differences. Today’s valuations are outside of the traditional range. They are well above the traditional danger level, P/E10=20. Today’s TIPS are yielding 2.4%.

What is the best stock allocation? Today, we have many answers. They depend upon the amount of safety that we demand. They depend upon the TIPS interest rate. They depend on the Terminal Value percentage. Most of all, they depend upon P/E10 (valuations).

Why Do People Ignore Valuations? In the past, it did not matter. It did not affect stock allocations. Today, it does.

Have fun.

John Walter Russell
May 30, 2006