Why People Ignore Valuations

I have recently built the Variable Terminal Value Rate Calculator C. It allows you to specify P/E10, the TIPS interest rate (real) and the (real) balance at year 30 as a percentage of the initial balance. It displays the S&P500 value that corresponds to your P/E10 input. It calculates the optimal fixed allocation of stocks and TIPS subject to constraint B.

Constraint B limits the allocation of stocks and TIPS to 20% to 80%. The allocation is kept fixed through annual rebalancing.

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 allowable under constraint B. The Safe Withdrawal Rate with a 50% Terminal Value at year 30 is 3.5% (plus inflation). The Reasonably Safe Rate with at 50% Terminal Value at year 30 is 3.9%.

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

Whenever P/E10 is 20, the optimal stock allocation with commercial paper is 80% under constraint B.

Only when we allow the final balance to fall all of the way to zero does the Safe Withdrawal Rate allocation fall below 80%. It falls to 69.3%. The Safe Withdrawal Rate is 4.0%. The other allocations remain at 80%.

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%.

When I increase the TIPS interest rate to 2.4% and lower the Terminal Value percentage to zero, the Safe Withdrawal Rate falls to 71.5%. Other allocations remain at 80%. With Terminal Value percentages of 50% and 100%, the optimal fixed stock allocations remain at 80%.

Historically, P/E10=15 has been considered reasonable, but a little bit high. 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 at 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 50% increases the optimal fixed stock allocation of the Coin Toss Rate to 49.3%. The optimal fixed stock allocation at the Safe Withdrawal Rate is 28.2%.

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

Over a very wide range of conditions, historically, the optimal fixed stock allocation (subject to constraint B) was 80%. Only when we demanded the highest levels of safety or when TIPS were especially attractive have lower stock allocations made sense.

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%, much better than commercial paper has been historically.

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