Retiring In Secular Cycles

[wabmester]

Just curious, for those in this group that expect average (10%) returns, what are your assumptions for the three components of total return:

1. EPS growth,

Long-term, about the same as GDP growth, which I think could well be lower than historical growth.

2. Dividend Yield, and

About the current yield.

3. P/E Change?

Absolutely no clue, which is why I have to stay in the market.

When was the last time the US market had a "reasonable" P/E? The last time P/E10 was anywhere near average (~15) was in 1990 -- 17 years ago!

So, if P/E[10] hasn't "worked" in almost 20 years, which valuation metrics should we use, and what should we do about it?

What are the alternative investments today with expected returns of, say, 4-7% real?

 

[crestmont]

Ed, the following is a legit question, not trying to bait you or be a pain: if I had used the information available post facto on the spreadsheet to move out of the market on the bear cusp, and into the market on the bull cusp, exactly as defined through Crestmont, how much better would an investor's backtested overall returns have been? I know we have no magic formula that would have given us that ability, but as I said above, the only reason I see to care about bull or bear or P/E versus historical seems to be to help decide to get in or out of the market, right?

But if the value of that would have been to avoid a two year period of -2% net, versus 2% real if I had been in bonds instead, I just don't see that as giving me a good payoff for the effort, worry, and non-zero chance of botching it up.

Let's visit the second question first: The secular cycle analysis is not intended to determine when to enter and exit the market (and I don't use it that way). Rather, it is to provide a general perspective on the level of returns that can be expected. It does not take us in or out of the stock market, yet it can change the way we approach the market. For example, if it's not likely to be a runaway like the 1990s and if we are more likley to have more down years, then increasing the frequency of rebalancing can help compounded returns. Also, adding option writing to part of the portfolio can provide additional 'yield'. Finally, it's helpful to align expectations with stock market pricing...investors don't doubt that bonds are set for below-average returns, yet many see the stock market as a machine that will somehow produce 10% returns if we wait long enough.

So I don't know how much timing would have added to return, yet I think you would find that there were better alternatives than just staying passively invested in stocks during past secular bear periods. Keep in mind, that Crestmont's work does not focus on the cyclical bulls and bears--the 2-year periods that you indicated--rather, it's about decade or longer periods of above- and below-average returns.

Absolutely no clue, which is why I have to stay in the market.

When was the last time the US market had a "reasonable" P/E? The last time P/E10 was anywhere near average (~15) was in 1990 -- 17 years ago!

So, if P/E[10] hasn't "worked" in almost 20 years, which valuation metrics should we use, and what should we do about it?

What are the alternative investments today with expected returns of, say, 4-7% real?

Why would you say that P/E(10) has not "worked"? It has a fairly good record of indicating relative valuation levels. From 1990 to the peak in 2000, P/E(10) rose and stock returns were well above-average. Since 2000, we've been reducing valuations from bubble levels and are today priced in the 20s at a level that is consistent with low inflation and low interest rates. P/E(10), or any version of P/E that I've ever seen, is a poor predictor of short-term (days, months, quarters, or even a few years) moves in the market. It is, however, a good indicator of longer-term returns (decades, more or less). I would say that even Ken Fisher agrees, as he says that P/E is not a good predictor of the stock market..."for periods of up to 5 years". The reason that even Mr. Bull Market includes that qualifier is that P/E (best using P/E[10] or other multi-year version) is good for longer periods.

I'm not trying to convince anyone to get out of stocks...actually stocks are great opportunities during almost all market conditions. I am saying that there are better ways to approach stocks when P/Es are not expected to double or triple over the next decade.

By the way, I think that current P/Es (adjusted for the business cycle, thus low/mid-20s) are reasonable. They are fairly priced for the current low inflation, low interest rate environment. But reasonable and fairly-priced doesn't mean that we'll get--or should expect--average returns. We should only get average returns when inflation is closer to average levels (3.5%) so that the market will be pricing stocks and bonds for near-average real (after inflation) returns. If inflation gets to 5% or more again, expect stocks to be priced for well-above average returns (bonds too). Yet, from where we are today with lower inflation and appropriately higher P/Es, returns over the next decade are very likely to be below-average.

 

[DRiP Guy]

Thanks, Ed -- great dialog.

8)

 

[audreyh1]

If inflation remains tame, I don't "need" above average returns in the stock market.

Audrey

 

[wabmester]

Why would you say that P/E(10) has not "worked"?

I haven't run the numbers myself, but it seems like the correlation between P/E and returns is pretty weak. Shiller tried to fix that by averaging earnings over 10 years, but it seems that 10 is a pretty arbitrary number, most likely a product of data mining, and it has failed to predict returns of the last 2 decades.

The only recent "success" as a predictor is when P/E values and every other valuation metric became completely wacky in 2000.

Anyway, I'm trying to get a take-home message from this thread. Your message seems to be:

1) High P/E values at the start of retirement are associated with retirement failure.

What are we really talking about here? You frame it in terms of a 79% success rate when P/E > 18.5, but when I run FIREcalc, I only see a couple of failure "nodes." One starting in 1929, and the other in a cluster from 1966-1972.

Those were interesting periods in history, and I don't think anybody would contend that P/E gives much insight into those singularities.

2) The current P/E is reasonable in the context of current inflation.

The last time inflation was this low was around 1986, the start of the biggest bull run in history. So, is it possible that mild inflation trumps P/E in terms of economic and market growth?

3) We should expect lower returns going forward.

But, if true, the only thing we can do about it is rebalance more frequently and sell call options?

I'm sure I'm misrepresenting your message here, but I'm having trouble coming up with anything actionable.

 

[haha]

I haven't run the numbers myself, but it seems like the correlation between P/E and returns is pretty weak. Shiller tried to fix that by averaging earnings over 10 years, but it seems that 10 is a pretty arbitrary number, most likely a product of data mining, and it has failed to predict returns of the last 2 decades.

The only recent "success" as a predictor is when P/E values and every other valuation metric became completely wacky in 2000.

Anyway, I'm trying to get a take-home message from this thread. Your message seems to be:<>

2) The current P/E is reasonable in the context of current inflation.

The last time inflation was this low was around 1986, the start of the biggest bull run in history. So, is it possible that mild inflation trumps P/E in terms of economic and market growth?

I know you have your answers to these questions. But the questions are well stated, so I'll give mine. A really wonderful situation is when inflation and interest rates have been high, causing financial asset prices to adjust downward so that they are competitive in the high interest rate environment. Then for whatever reason inflation rates start falling. Usually with some lag interest rates fall too. This causes the discount rate used to value cash flows to fall, and asset values to rise. That is the bond/equity rocket launcher that many of us (and all the younger members) have grown to know and love.

Unfortunately this Nirvana has an evil inverse twin, which is unknown in our recent experience. Since it has not been around for a very long time, and has not ever been around during the investing lives of many of us, it is hard to give it credence.

It occurs when a low interest rate environment and government policy brings about low interest rates and high asset prices. If we were in a mall looking at the map, a little red pin saying "You are here now" would decorate this space.

It may happen I suppose that interest rates stay low forever, or long enough that we will all be dead. This would something akin to a person staying young forever, IMO. If interest rates stay low forever, then we have so-so but not disastrous returns which as several have pointed out, is all that can be expected.

But look out below if the inflation/interest rate environment changes. Then we don't have low returns, we have terrible returns and disastrous losses until a new lower asset price equilibrium has been reached. A countervailing but slower acting force is that rising inflation should lead to rising sales and corporate profits, so that eventually although real values have fallen nominal prices might not be markedly lower.

These adjustments can be very rapid and brutal, as in 1973-’74.

3) We should expect lower returns going forward.

But, if true, the only thing we can do about it is rebalance more frequently and sell call options?

Of course as you know that isn’t the only thing that can be done. It depends on your level of commitment to a bear case. But it is something that could be done, and this “chicken bear” strategy might not be laughed off the board.

Ha

 

[Gone4Good]

Actually, the impact of reinvestment is attributed to the dividend category of total return. I believe that's why Ibbotson's tally reflects 4.5% from dividends. It doesn't get allocated to EPS growth or P/E change...starting valuation does impact the future impact from dividends. Nonetheless, as others have pointed out, most retirees will be using their dividends rather than reinvesting them.

Ok. But we can agree that historic average returns of 10% are not an illusion based on some arbitrarily low P/E starting date. right?

Just curious, for those in this group that expect average (10%) returns, what are your assumptions for the three components of total return:

1. EPS growth,
2. Dividend Yield, and
3. P/E Change?

1. According to S&P data, EPS growth has averaged about 8% for the past 60 years. Recent EPS growth has been higher than average, so one might expect below average growth in the coming years. However, our expansions have gotten longer and our recessions less severe over the past few decades (structural changes in the economy as well as better monetary policy are likely primary culprits). As a result, the rolling 10-year average EPS growth rate has shown a significant upward trend since the end of the WWII boom. I wouldn't bet against 8% EPS growth over the next decade.

2. Dividends - current ~1.75%

2a. Share repurchases - don't have an exact # but the aforementioned JoF article calculated that by ~2004 money spent on share repurchases was larger than dividends. Call share repurchase yield ~1.75%

3. P/E - best guess is that it declines to average of about 15x which would shave about 200bp off total returns over the next 10 years.

---------

P/E 10 seems to be an absolutely worthless statistic where the 10-yr period includes a 46x valuation bubble followed by an asset price correction.

 

[Gone4Good]

It may happen I suppose that interest rates stay low forever, or long enough that we will all be dead. This would something akin to a person staying young forever, IMO. If interest rates stay low forever, then we have so-so but not disastrous returns which as several have pointed out, is all that can be expected.

I don't think there is an inherent hyper-inflationary cycle. I think we have a much better understanding of inflation today then we ever have in history. An independent Fed, while not fool proof, does have the tools to address run-away inflation if needs be and they also better understand how the tools work then they did in the 70s.

It seems to me that "so-so" returns for the equity market are in the neighborhood of 10% over the long-term - similar to what we've seen over the past 100 years. If anything our economy has grown less cyclical with a greater bias toward non-inflationary growth. Back at the turn of the century the U.S. economy was regularly plagued by hyper-growth booms and deflationary busts. More recently, the U.S. economy has shown a staggering resiliency. People forget that the recent past wasn't exactly a walk in the park. Over the past seven years the economy has shrugged off:

1) Widespread corporate fraud that bankrupted some fortune 500 companies
2) A recession
3) The deflation of the internet bubble which wiped out trillions in net worth
3a) A 47% decline in the value of the S&P 500 over 2 years
4) The most severe attack on the U.S. homeland in 60 years
5) Two wars - still ongoing (peace dividend anyone?)
6) A natural disaster that destroyed the country's 31st largest city.
7) A 300% increase in the price of oil (similar in magnitude to the 1970's increase).

And notwithstanding all of those things, the SPX has generated average annual returns of 7.9% over the past decade. Pretty Extremely impressive. Perhaps astounding.

By the way, that 10-year period started with a P/E of 19x. I wonder what returns would have been like over the past decade had we not experienced even some of those disasters.

--------
More fun with #'s
Since 1906 the US economy has had 21 full-calendar year periods of negative real GDP growth. 15 of the 21 negative growth years took place between 1907-1956. Of the 6 that took place over the past 50 years, only 2 happened in the past 25. The last one was in 1991.

So against the backdrop of an economy relentlessly trending toward stable expansions, should we conclude that a marginally elevated P/E multiple and a deceivingly low dividend yield precludes even average future equity returns?

 

[haha]

I don't think there is an inherent hyper-inflationary cycle.

I don't either. But I would be amazed however if there is no cycle at all. I am reading J.K Galbraith's Money, Whence It Came, Where It Went. The last 20 years have been almost amazingly stable, as far as I can see like nothing ever seen before except during the gold standard. This could be as you suggest because central banks and world governments have learned how to control fiat money and do it right.

Overall, I favor other explanations.

Ha

 

[crestmont]

I know you have your answers to these questions. But the questions are well stated, so I'll give mine. A really wonderful situation is when inflation and interest rates have been high, causing financial asset prices to adjust downward so that they are competitive in the high interest rate environment. Then for whatever reason inflation rates start falling. Usually with some lag interest rates fall too. This causes the discount rate used to value cash flows to fall, and asset values to rise. That is the bond/equity rocket launcher that many of us (and all the younger members) have grown to know and love.

Unfortunately this Nirvana has an evil inverse twin, which is unknown in our recent experience. Since it has not been around for a very long time, and has not ever been around during the investing lives of many of us, it is hard to give it credence.

It occurs when a low interest rate environment and government policy brings about low interest rates and high asset prices. If we were in a mall looking at the map, a little red pin saying "You are here now" would decorate this space.

It may happen I suppose that interest rates stay low forever, or long enough that we will all be dead. This would something akin to a person staying young forever, IMO. If interest rates stay low forever, then we have so-so but not disastrous returns which as several have pointed out, is all that can be expected.

But look out below if the inflation/interest rate environment changes. Then we don't have low returns, we have terrible returns and disastrous losses until a new lower asset price equilibrium has been reached. A countervailing but slower acting force is that rising inflation should lead to rising sales and corporate profits, so that eventually although real values have fallen nominal prices might not be markedly lower.

These adjustments can be very rapid and brutal, as in 1973-&#146;74.

Of course as you know that isn&#146;t the only thing that can be done. It depends on your level of commitment to a bear case. But it is something that could be done, and this &#147;chicken bear&#148; strategy might not be laughed off the board.

Ha

Ha, your comments deserve to be framed and mounted...that's a terrific explanation.

There are two general types of comments that are emerging in this thread: (1) those that see the fundamental relationships and principles of economics and finance and the impact of them on stock market (and bond market) returns, and (2) those that find examples or statistics from history and seek to apply them to the future.

Other than reiterate the points made before or suggest additonal writings in the Stock Market section at www.CrestmontResearch.com (not selling, it's free), I hope that investors are not baking in to their SWR an expected 10% stock market return or an 8% historical bond market return.

There are clearly many more alternatives for enhanced returns and risk management than the two simple example that I offered previously. That's not my business, but I'm sure that all of you know or could find someone qualified to help if you're not already doing it on your own.

I'm sure hoping that those of you that are advocating a 10% average annual compounded return will be right...but my plan is to bank on the fundamentals for a while longer.

By the way, I received a note from Rob Arnott (Editor Financial Analysts Journal and other distinctions) about "Destitute". He concurs and offered his KISS formula: the withdrawal rate should not exceed your liquid assets divided by the time period over which it is needed. So for today's retiree with 30 years to go, the starting rate would be 3.3%...and five years later, you can take 4% of the then balance (which should end up being slightly more than the inflation adjusted dollar withdrawal...if all goes well). It's an interesting and easy-to-apply formula. He also, in much more sophisticated and academic terms, sent an article that reiterated the well-below-average return expectation for the stock market based upon current valuations. Time will tell whether starting valuation matters this time...

 

[DRiP Guy]

By the way, I received a note from Rob Arnott (Editor Financial Analysts Journal and other distinctions) about "Destitute". He concurs and offered his KISS formula: the withdrawal rate should not exceed your liquid assets divided by the time period over which it is needed. So for today's retiree with 30 years to go, the starting rate would be 3.3%...and five years later, you can take 4% of the then balance (which should end up being slightly more than the inflation adjusted dollar withdrawal...if all goes well). It's an interesting and easy-to-apply formula.

Hmmm.. sounds like pretty cool idea to learn more about. I'll have to look for some writing on that method. Thanks for the tip!


Edited to add -- here is a recent column that tends to support the idea you mentioned him proffering. Scott Burns (to his credit) seems to have dabbled with many different ideas on how to lock in a safe withdrawal rate in retirement. I just wandered across the second (now dated) link regarding Peter Lynch.
http://www.dallasnews.com/sharedcon...ns/2007/stories/010406dnbusburns.30fe75b.html

Batting around the idea of 7% and 6% SWRs back in '95!!!
http://www.dallasnews.com/s/dws/bus/scottburns/columns/archives/1995/951008SU.htm

5% in 2001:
http://www.dallasnews.com/s/dws/bus/scottburns/columns/archives/2001/010626TU.htm

5% in 2004...
http://www.dallasnews.com/sharedcon...ders/stories/SBportfoliosurvival.f5a90da.html

More than 4% in 2004:
http://www.uexpress.com/scottburns/?uc_full_date=20041130

Less than 4% in 2006:
http://www.dallasnews.com/sharedcon...N-burns_04bus.ART.State.Edition1.30fe75b.html

3.3% in 2007 -- from Ed's info....


I'd better retire soon, I won't be able to take out squat at this rate of SWR attrition!!!!

(Seriously, I do appreciate all the ideas, and I think we are a far cry from the first rough cuts that were done on this way back when! I still shudder at the idea of annuities, which Burns touts in other columns, but hey, I'll go where the numbers tell me to!)

 

[jdw_fire]

By the way, I received a note from Rob Arnott (Editor Financial Analysts Journal and other distinctions) about "Destitute". He concurs and offered his KISS formula: the withdrawal rate should not exceed your liquid assets divided by the time period over which it is needed. So for today's retiree with 30 years to go, the starting rate would be 3.3%...and five years later, you can take 4% of the then balance (which should end up being slightly more than the inflation adjusted dollar withdrawal...if all goes well). upon current valuations. Time will tell whether starting valuation matters this time...

Ed, how do you personally determine "the time period over which it is needed" "for today's retiree"?

 

[Gone4Good]

I'm sure hoping that those of you that are advocating a 10% average annual compounded return will be right...but my plan is to bank on the fundamentals for a while longer.

To second Wab's question . . . how do you plan on doing that?

 

[FIRE'd@51]

On the inflation front, in addition to the more "monetarist" policies (and rejection of the Phillips curve) followed by the last three Fed chairmen, there has been another important structural change - the indexation of our income taxes. This coupled with the indexation of SS and most government pensions has made it a whole lot less advantageous to our government to inflate the way it did in the late 60's and 70's. IMHO, I think this is a sort of built-in check against the type of inflation we experienced in the 70's and early 80's re-occurring.

 

[haha]

On the inflation front, in addition to the more "monetarist" policies (and rejection of the Phillips curve) followed by the last three Fed chairmen, there has been another important structural change - the indexation of our income taxes. This coupled with the indexation of SS and most government pensions has made it a whole lot less advantageous to our government to inflate the way it did in the late 60's and 70's. IMHO, I think this is a sort of built-in check against the type of inflation we experienced in the 70's and early 80's re-occurring.

1) Income taxes are imperfectly indexed-see AMT.

2) Capital gains are not indexed.

2) How about all the nominal bonds outstanding? Doesn't that give incentive enough?

Anyway, incentive or no, let's not forget that we are waging an expensive protracted war on credit. I don't know how a country can crawl out from under that other than inflating.

Ha

 

[crestmont]

Ed, how do you personally determine "the time period over which it is needed" "for today's retiree"?

To second Wab's question . . . how do you plan on doing that?

Mortality tables or expected lifespan...for today's retiring couple, that's about 30 years on average for the last-to-die. But be careful, because that's an average and about half will live longer (thus needing it to last a bit longer).

For each person or couple, you may want to look beyond the tables. Depending upon your health conditions, family factors, etc., lifespan could be longer or shorter and may impact you lifespan assumption in SWR.

Keep in mind that there are two factors driving SWR down: (1) the outlook for returns, and (2) lifespan. Our parents didn't need the nest egg to last nearly as long. The success rate for the same SWR over 15 or 20 years is a lot better than 30...or longer. For those retiring early, it can be 40 years... Thus, even excluding the returns environment, today's SWR at 3-3.5% was dad's 4%+ and grandpa's 5%+... (those are illustrations, not analytically determined numbers).

 

[wabmester]

So, let's say that we agree that high P/E is a valid indicator. A red light is flashing on the dashboard.

But 80% of the time, it has been OK to ignore the flashing light. Everything came up roses despite the warning. The two times something seriously bad happened were very different. One was a depression with a period of deflation. The other was stagflation / hyperinflation.

That's all we have to go on from our short history as a country.

Ha thinks inflation is going to bite us again. The market obviously doesn't agree, since long-term bonds are estimating inflation at about 2.5% over the next 20+ years. Is Ha right or is the market right? I don't know. Let's say each has a 50/50 chance of being right.

Then the question is "when will it happen?" And the follow-on question is "what should we do about it?"

If we generously give Ha 50/50 odds of getting these two right, he has 1 in 8 odds of getting the triad right. A 12.5% chance of success vs an 80% chance of high P/E being a false alarm.

So, is my math bad, or do the odds favor doing nothing?

And the P/E data mining here is just looking at the S&P500. I think just about everybody here has bought into diversifying across asset classes and countries by now.

 

[haha]

If we generously give Ha 50/50 odds of getting these two right, he has 1 in 8 odds of getting the triad right. A 12.5% chance of success vs an 80% chance of high P/E being a false alarm.

I don't think it is an either or question. I have been taking expected inflation into account for years now, and my returns are as high or higher than they would have been with most asset allocation strategies. My gold mining positions are all on house money and then some. I don't "believe in gold". What I do believe is that people intermittently go crazy, and that they might go really crazy on gold if some things come together right. There are not many ways that a 5% or so bet could make a big contribution to one's stake. Gold mining equities in a gold mania are one such.

My O&G positions are all cash flow producing companies, not speculations on oil going to $100, though that would certainly help. I love pipelines, when they can be bought cheap. At one point I held 30% REITs, but in retrospect sold out way too early. My non-resource stocks have high ROE and high free cash flow, something which makes them able to pay good and rising dividends.

So I think one needs to look at it from a game theory perspective. Assume the market knows your positions, and is out to get you. Then see what you can do to reduce your vulnerabilities. My only real loser has been puts, but as I say, I want to reduce my vulnerabilities, rather than necessarily keep the pedal to the metal

As an aside, I do not believe that long term interest rates are today necessarily an inflation prediction mechanism. Institutional factors and derivatives overwhelm fundamentals.

Ha

 

[crestmont]

So, let's say that we agree that high P/E is a valid indicator. A red light is flashing on the dashboard.

But 80% of the time, it has been OK to ignore the flashing light. Everything came up roses despite the warning. The two times something seriously bad happened were very different. One was a depression with a period of deflation. The other was stagflation / hyperinflation.

That's all we have to go on from our short history as a country.

Ha thinks inflation is going to bite us again. The market obviously doesn't agree, since long-term bonds are estimating inflation at about 2.5% over the next 20+ years. Is Ha right or is the market right? I don't know. Let's say each has a 50/50 chance of being right.

Then the question is "when will it happen?" And the follow-on question is "what should we do about it?"

If we generously give Ha 50/50 odds of getting these two right, he has 1 in 8 odds of getting the triad right. A 12.5% chance of success vs an 80% chance of high P/E being a false alarm.

So, is my math bad, or do the odds favor doing nothing?

And the P/E data mining here is just looking at the S&P500. I think just about everybody here has bought into diversifying across asset classes and countries by now.

Without getting into the math and statistics, especially once assumptions are chained together to get a result (usually providing a distorted scenario), each person needs to determine their own risk parameter. For some, a 90% chance of success seems high. For others, they will see the consequences of failure to be devastating...particularly because it would likely occur when they have fewer options to address it.

If one agrees that the current level of valuations in the financial markets (yield for bonds & P/E for stocks) is an indicator that future returns from today are very likely to be below-average, then we have agreement on the single issue driving the discussion and conclusions in "Destitute". Almost all SWR studies, including FIREcalc, relate to all periods. When the historical universe is separated into halves, or quartiles, or otherwise, the success rate for the higher valuation periods are lower than for all periods. As a result, the user that sets their personal success rate (and related SWR)--in today's environment--has a lower chance of success than they wanted. So for most, that means setting a slightly lower initial SWR than the model indicates.

If we don't agree that valuation matters and one believes that 10% is realistic (and likely) from here, then those people should ignore the article and the SWR results...since 10% compounded returns will support a lot more than 4% SWR over the next 30 years.

 

[wabmester]

Ed, could you give us more details about the failure sequences at high P/E in your runs? Are they different than the FIREcalc failure sequences at 4% SWR w/100% S&P500?

I ask because it wasn't lower expected returns that caused the failures I'm aware of. Everybody could retire happily with, say, 5% real returns instead of the 7% real average. The failures I've seen were catastrophic: depression and hyperinflation.

We could easily see Something Bad happen again, and I think it's prudent to have both a conservative allocation and a conservative SWR, but not because of lower expected returns due to P/E values.

 

[haha]

Almost all SWR studies, including FIREcalc, relate to all periods. When the historical universe is separated into halves, or quartiles, or otherwise, the success rate for the higher valuation periods are lower than for all periods. As a result, the user that sets their personal success rate (and related SWR)--in today's environment--has a lower chance of success than they wanted. So for most, that means setting a slightly lower initial SWR than the model indicates.

I believe that this is similar to trying to decide what group constitutes the "base case" in a Bayesian sense. Say we have a 65 year old man and we are trying to predict his life expectancy. Not the most conservative prediction, as one might do for Firecalc, but the most accurate. The class of all 65 year old US males may have an average life expectancy of (say) 18 years. But our guy has diabetes, high blood pressure, high LDL cholesterol and triglycerides and low HDL. Additionally he has a terrible temper, drinks too much and is given to bar fights.

Does he belong in this base group of all US men? Or should be placed in a higher risk grouping, that would suggest though not ordain that a shorter life expectancy might be likely for him?

Ha

 

[rmark]

"how do you personally determine "the time period over which it is needed" "for today's retiree"?"

I use the IRS life expectancy tables for rminimum distributions.

at age 62 a married couple has a joint life expectancy of 29 years, by age 70 is about 22 years.

 

[crestmont]

Ed, could you give us more details about the failure sequences at high P/E in your runs? Are they different than the FIREcalc failure sequences at 4% SWR w/100% S&P500?

I ask because it wasn't lower expected returns that caused the failures I'm aware of. Everybody could retire happily with, say, 5% real returns instead of the 7% real average. The failures I've seen were catastrophic: depression and hyperinflation.

We could easily see Something Bad happen again, and I think it's prudent to have both a conservative allocation and a conservative SWR, but not because of lower expected returns due to P/E values.

As far as history goes, all of the past secular bear markets ended with P/Es below 10...in really bad economic conditions. We've not had an extended period of stable, high P/Es to "demonstrate" the impact of 6.5% returns (which would actually provide success as long as there was not a big drop in the early years). The bigger risk is not an extreme period (i.e. either stability or 10 P/Es), rather it would be enough decline to reduce real returns to 3% or 4%. If history is a guide--unless today's historically high profit margin are surprisingly sustained--a modest decline in P/E over the next decade or so could readily cause returns to be muted and success rates to decline.

Remember, this is not about the 90%, 92%, 95% of the time that you die with a gazillion dollars, SWR is all about the small, yet devastating chance that you're still 5 or 10 years away from death and find that you're selling the old homestead and downsizing your wife's (or husband's) lifestyle.

You are absolutely right that the math comes down to real return...and today, the expectation for real returns from stocks is well above (irrationally) the expected return from bonds....when you consider the historical propensity for financial assets to revalue (and the skewed bias from these levels is a downward change in revaluation). I (and others) contend that this reflects unrealistic expectations rather than ongoing market inefficiencies.

Historically, the average is more than 4% (near 5%-6%)...yet with a range that is either well-above or well-below. If valuation matters, then this is likely a circumstance of well-below. Even at 4%, if there is any variability, the constantly growing withdrawal has an adverse effect if cumulative losses occur early in the sequence.

Thanks for the challenging thoughts...

 

[wabmester]

OK, I'm enlightened now. I think.

Ed has a great matrix on his site that gives real returns for every period in US history:

pdf link

There have been many periods that started with a high P/E that turned out fine in the long run. But there were a couple that both started with a high P/E and ended with a very low P/E.

You can see the failure cases pretty easily. If your retirement period ended in a pink or red square with long-term real returns < 2, you were hosed.

So, starting retirement in a high-P/E environment is sort of a caution flag. All of the failures (really only two clusters out at 30-years) started with this caution. But it took some *very* bad times to drive P/E values to below 10 during those failure sequences.

The risk, as I see it, isn't high P/E values. If E/P implies a 5% earnings yield, that's pretty damn good since it's a *real* yield. The risk is a bad start that includes an economic disaster during retirement.

I think it's important to look at the human component that drove P/E values below 10. These were not ordinary times, and low P/E's are not a natural consequence of high P/E's, IMHO.

The example I like is the Great Depression. The problem with returns wasn't the 1929 crash or monetary policy. The problem was that the government became socialistic to help those in trouble, and investors had a real fear that public companies would be taken over by the state. Who in their right mind would want to invest in stocks if they thought companies would become state-run enterprises?

Anyway, I think the matrix chart is a better illustration than the 79% success rate at P/E > 18.5. Maybe Ed could make a new chart that showed returns after a 4% SWR.

 

[DRiP Guy]

Fun chart, very interesting!

I like the historical events list, too... well, mostly.... "Pluto retires..."


And "Roaring Twenties" looks to have been aptly named... sure could use a ten year span like that to cap off accumulation phase...