When the Market is Normal

Stock market valuations are close to normal. I investigate what this means to retirees who use Valuation Informed Indexing.

A Normal Market

In a normal market, P/E10=14. Stocks return more than 6% (plus inflation) annualized over a decade. If it were not for price fluctuations, you could expect to withdraw 6% (plus inflation) annually, indefinitely, using a straightforward liquidation strategy (i.e., sell as needed).

I took data using the Scenario Surfer.

P/E10=14 Bear Market

I invested entirely in stocks and TIPS. I started with a $100000 balance. P/E10=14 Bear Market initially. I withdrew $6000 (plus inflation) each year. I set the TIPS interest rate to 2.0%. Here are the Year 30 balances. I have included fixed allocation results for comparison.

Run 1. 167,006.
20% rebalanced: bankrupt in year 24.
50% rebalanced: 4,312.
80% rebalanced: 58,277.

Run 2. bankrupt in year 27.
20% rebalanced: bankrupt in year 22.
50% rebalanced: bankrupt in year 24.
80% rebalanced: bankrupt in year 25.

Run 3. 157,446.
20% rebalanced: bankrupt in year 22.
50% rebalanced: bankrupt in year 24.
80% rebalanced: bankrupt in year 24.

Run 4. bankrupt in year 24.
20% rebalanced: bankrupt in year 22.
50% rebalanced: bankrupt in year 24.
80% rebalanced: bankrupt in year 26.

Run 5. bankrupt in year 28.
20% rebalanced: bankrupt in year 21.
50% rebalanced: bankrupt in year 21.
80% rebalanced: bankrupt in year 20.

What sticks out with the P/E10=14 Bear Market is that P/E10 stays at very low levels for a long time. We have not seen this historically.

P/E10=14 Normal Market

I invested entirely in stocks and TIPS. I started with a $100000 balance. P/E10=14 Normal Market initially. I withdrew $6000 (plus inflation) each year. I set the TIPS interest rate to 2.0%. Here are the Year 30 balances. I have included fixed allocation results for comparison.

Run 1. 27,867.
20% rebalanced: bankrupt in year 22.
50% rebalanced: bankrupt in year 24.
80% rebalanced: bankrupt in year 25.

Run 2. bankrupt in year 28.
20% rebalanced: bankrupt in year 22.
50% rebalanced: bankrupt in year 24.
80% rebalanced: bankrupt in year 25.

Run 3. 50,716.
20% rebalanced: bankrupt in year 21.
50% rebalanced: bankrupt in year 22.
80% rebalanced: bankrupt in year 22.

Run 4. 163,527.
20% rebalanced: bankrupt in year 23.
50% rebalanced: bankrupt in year 29.
80% rebalanced: 24,104.

Run 5. bankrupt in year 24.
20% rebalanced: bankrupt in year 23.
50% rebalanced: bankrupt in year 27.
80% rebalanced: 5,496.

Withdrawal Rates

Based on the Scenario Surfer, Valuation Informed Indexing is vastly superior to annual rebalancing. In addition, a normal market will not support a 6% (plus inflation) withdrawal rate.

Using the “Year 30 Retirement Risk Evaluator” (“Year 30 SWR” button), we see that 6% (plus inflation) has been reasonably safe in the past. That is, it has about an 80% chance of success with a high (80%) stock allocation.

I believe that the more optimistic outlook is accurate. The reason is dividends. If valuations were to become really low, dividends would be sufficient to cover withdrawals even from the S&P500 index. Selected dividend paying stocks do even better.

Dividend growth, however, can be erratic. This causes us to look closely at the different ground rules for evaluating success.

Liquidation approaches assume stock sales each year as needed to match inflation. Dividend strategies allow for a temporary shortfall, at times, so long as the dividend growth snaps back enough to match or exceed the inflation rate.

Have fun.

John Walter Russell
October 15, 2008