You can’t time the market. Nobody can. This is why your investment process must prioritize risk management.
Safe withdrawal rate research demonstrates how risk management can:
- Maximize cash flow early in retirement
- Maintain consistent cash flow throughout retirement
- Minimize short-term drawdowns and long-term erosion
Risk management accomplishes all of the above by reducing market risk. Reduced market risk decreases the sequence of returns risk and volatility tax.
While risk management is always important there are times when risk is higher. Market valuation research measures market risk.
There are many measures of market valuation. There is no perfect market valuation metric.
The most popular measure of market risk is Robert Shiller’s Cyclically Adjusted Price to Earnings (CAPE) Ratio. It’s also known as Shiller P/E 10.
You can find many arguments against the validity of the Shiller P/E 10. Whether it’s the best measurement or not, it doesn’t matter. Most market valuation measurements point in a similar direction.
The future remains unknowable. The Shiller’s research results in a high correlations with forward expected returns over a 7-15 year time frame. It doesn’t provide any value for short-term returns of less than 7 years.
Market valuation metrics create a framework to develop forward-looking return expectations. You should always expect a range of outcomes.
My preference is to focus on Shiller’s P/E 10 because of its strong correlation to safe withdrawal rates.
Safe withdrawal rates are based on “worst-case scenario” returns. “Worst-case scenario” returns correlate to market valuations.
When we review my 20 Years of Safe Withdrawal Rate Research Calculator it lists how different factors influence your safe withdrawal rate.
The last item listed on the spreadsheet is “valuation environment.” It wasn’t listed last due to its importance. If it was listed in importance then it needs to move at or near the top.
When market valuations are high, the safe withdrawal rate is the lowest. Average and low market valuations lead to higher safe withdrawal rates.
When you want to retire you have no control over the current market valuation. It’s the hand you were dealt.
Why do high market valuations cause lower safe withdrawal rates?
To answer this you first need to know the total return equation:
Dividends + Economic Growth +/- Market Valuation = Total Return
The formula above is a framework to develop an expected forward-looking rate of return.
Over a 30-year timeframe the total return is a reflection of dividends and economic growth.
Over a 7-15 year timeframe the total return is heavily influenced by the change in market valuation.
The sequence of returns risk shows us that bad returns early in retirement matter most. The first 15 years of retirement are critical.
Market valuation research shows that markets will likely revert to their long-term average.
Therefore, when valuations are high, then expected market returns are lower because of the expectation that valuations will fall back to an average valuation.
Here is an illustration to show the math works:
Click here to access the full worksheet and resource links.
This is a tool to gauge market risk over the next 10 years. It does not predict the future. Open it up and play around with the numbers. Maybe you think the average Shiller PE 10 should be higher. Make that change and get a feel for how history tells us returns will move.
An above-average market valuation doesn’t mean the market won’t continue to go higher. If we look worldwide we would see that the highest recorded market valuation was with Japan who reached 100!
If market valuations continue moving up then the calculation above will appear wrong in hindsight. Would that make this a useless exercise?
Absolutely not.
An investment process leads us to an outcome with the highest probability of success. Lessons learned from history create framework for future decisions. History doesn’t repeat but it always rhymes. History shows us that over time the market reverts to the mean.
If market valuations revert from today’s 35.10 back to history’s average of 17.1 then we can expect negative forward-looking returns.
Maybe you believe today’s low interest rates mean the average valuation should be 25 instead of 17. If market valuations revert from today’s 35.1 back to a Shiller PE 10 of 25, then you can expect a positive annual return.
No matter what, if returns revert to the average (or a “higher average”) the return expectations for the S&P 500 still look poor.
Poor expected returns indicates a high risk for a bad sequence of returns. This indicates a high risk for a lower safe withdrawal rate.
That said, this is only one example of one market. This should not be relied upon as investment advice. There is absolutely no implication that you should avoid owning something overvalued. It only states that if you own highly valued investments, then history tells us to expect lower future returns.
If your investment process relies on higher returns of a highly valued investment then adjust your expectations. Better yet, adjust your investment process to manage that risk.
We have no idea when or to what level the market will revert to its long-term average. Maybe it will revert with a sharp decline…or stagnate returns… or an extended bear market… or something else.
All we can do is manage risk.
Manage market risk and increase your cash flow in retirement.
