Guessing the Future

Prices are high. P/E10=27.6. There are many ways for valuations to return to normal. Yet, discerning the best course of action is remarkably straightforward.

Four Articles

You can find my earliest articles in the Guidelines section, under “Getting Started.”

Here is my personal opinion from What Do I Really Think About Dividends? I investigated owning 100% TIPS, followed by 100% high dividend stocks from high quality companies when dividends become sufficiently attractive.

“Dividends raise today’s Safe Withdrawal Rate to 5.4% (plus inflation) of the portfolio’s initial balance.”

“Dividends extend the portfolio lifetime indefinitely, well beyond 40 or 50 years.”

In spite of this, I believe that it is prudent for retirees to exercise caution. One way to do this is to limit withdrawals in the first few years. Depending upon one’s ability to adjust at a later date, all initial withdrawal rates from 4.0% to 5.4% can make sense. However, there is never a need to reduce withdrawals below 4.0% of the original balance (plus inflation).

What Do I Really Think About Dividends?

I carried pessimism to an extreme in What If There Is A Bubble? I have taken this from the “Summary;”

“If a retiree starts out entirely in TIPS at today’s 2%+ interest rates and withdraws 4.0% of his original balance (plus inflation) for 20 years before he finds suitable high dividend stocks, he will still end up with a continual, long-lasting income stream greater than 3.55% of his original balance (plus inflation). Most likely, his income will increase to 4.45% of his original balance (plus inflation). His income stream could be as high as 5.35% of his original balance (plus inflation).”

What If There Is A Bubble?

More recently, in Slowly Rising Earnings, I began:

“Today’s market is expensive. P/E10=27.6.”

“There are lots of ways for earnings to return to historical levels. What if prices remained stagnant while earnings continued to grow?”

“Would it happen? Could it happen? What would be the consequences?”

In the “Summary,” I concluded:

“Assuming that prices stagnate for 20 years, dividend investors will do well. If they start out entirely in high dividend paying stocks from high quality companies, they will be able to start withdrawing close to 4.0% (of the original balance plus inflation) immediately from dividends alone and exceed 4.0% (plus inflation) within two or three years. They can do better if they start with some of their money in 2% TIPS, switching to dividend paying stocks when yields are attractive.”

In addition, I mentioned that, using a conventional S&P500 stock portfolio and varying stock allocations according with P/E10, would do reasonably well. Using a fixed stock allocation of 50% would do poorly. Using a fixed stock allocation of 80% would be a disaster.

Edited: Slowly Rising Earnings
Slowly Rising Earnings

I looked at a more balanced approach in Dividend Growth to the Rescue. I examined what happens with a portfolio of 50% TIPS and 50% high dividend stocks from quality companies. From the “Summary:”

"This should comfort those who start out with a 50% TIPS-50% stock portfolio. You can withdraw 4.0% (plus inflation) far into the indefinite future. Even if stocks never become attractive enough to purchase, dividend growth can do the job all by itself. According to my spreadsheet, a dividend growth rate of 2.0% faster than inflation extends full withdrawals to year 39. A dividend growth rate of 2.5% extends full withdrawals indefinitely and generates a surplus beginning in year 40."

Dividend Growth to the Rescue

Conclusions

Dividend based strategies continue to be the best. Varying one’s actions in accordance with valuations can enhance one’s performance substantially.

In terms of what I expect to happen:

It is best to start out entirely in TIPS. Later, when yields are sufficiently attractive, it is best to replace them with high dividend stocks from high quality companies.

It is always prudent to consider alternatives. There is always the possibility of a hidden flaw in a study, regardless of the quality of research. There is always the possibility that the stock market will behave in a manner substantially different from a statistical characterization of the past.

Limiting initial withdrawals to 4.0% (plus inflation) is sufficient to protect against a semi-permanent higher price plateau of two decades.

It is OK to start out with high dividend stocks from quality companies with stock allocations between 0% and 100%. The remainder would be in TIPS. Because of dividend growth, this does well even if the market moves sideways up to two decades. When (or if) dividend yields become attractive enough, a retiree should replace his TIPS with stocks. Starting with a higher TIPS allocation is better if stock prices fall more dramatically.

This alternative starts with an initial withdrawal rate of 4.0% of the original portfolio balance (plus inflation).

The Best Approach

Your best course of action is to follow a dividend based strategy. Invest in TIPS and stocks from high quality companies that pay high dividends. When yields become attractive enough, replace TIPS with high dividend stocks from high quality companies. Depending upon your outlook and ability to recover later, you can start with any stock allocation. Some would choose 50%. Benjamin Graham recommended stock and bond allocations from 25% and 75%. Using such a strategy, you can always start with a withdrawal rate of 4.0% of the original portfolio’s balance (plus inflation). [WARNING: If you use a traditional S&P500 stock portfolio and maintain a fixed allocation, you need to reduce the withdrawal rate.]

Have fun.

John Walter Russell
December 3, 2006