You Can’t Afford to Ignore Market Valuations

Financial independence suggests retirement is feasible at a comparatively early age based upon the mathematics of compounding returns. Certainly all the numbers look completely rosy when using a historic average rate of return, and currently a portfolio milestone might be celebrated as the official retirement moment where one may live a life of leisure. The problem with that assumption is market valuations matter. They impact (almost entirely) long term portfolio returns.

You simply cannot have a robust retirement plan without considering the possibility that the end of this current business cycle is likely to severely affect portfolios.

The 2000 Downturn

It is possible to describe this phenomenon in terms of how financial planners would normally describe it, but graphics do a much better job than financial lingo.

Let’s assume an early advocate of FIRE had $1 million dollars in January 2000. Costs were optimized and cut to a comparatively modest $40,000 a year. Thinking the game won, our advocate then chucked the savings into the S&P 500 and embarked on a worldwide travel tour, failing the whole while to see what unfolded.

Alternatively, this individual might have considered that numerous indicators were suggesting stocks were extremely overvalued and the business cycle at its absolute zenith in early 2000. Rather than buying stocks, this person bought a boring old three year treasury note which paid a 6% coupon while waiting to re-evaluate how things turned out in January 2003.

In both scenarios, the portfolio must sustain the spending draw down of $40k annually. The differences in the outcomes is staggering.

Why Valuation Matters

Failing to wait for decent equity prices leaves a $2.3 million digger on the portfolio. More importantly, current expenses constitute 16% of the portfolio value of the 2000 portfolio and only 2.5% of the 2003 portfolio. The former will almost assuredly run out of money in the next decade entirely, the latter can sustain itself indefinitely.

Of course, 2000 is recognized in hindsight as the most irrationally exuberant time period in the history of the US equity market. The total returns of the S&P 500 only permanently broke above the high water mark of the 2000 market in 2011 in nominal terms, which means money in equities literally just deflated away over an 11 year time period.

The following chart is a high-level indication of stock market valuation favored by Warren Buffett. It takes the total value of US stocks and divides it by US economic output. The 2000 peak is clearly seen, but current observations of the metric suggest US stocks are very richly priced.

This matters because there is an amazingly strong relationship between this metric and subsequent portfolio returns. The more expensive the valuation, the worse the subsequent return. While stock markets are amazingly random in the short (1-3 year timeframe), they are actually amazingly predictable on a long-term basis. 

What To Do About It

Disclaimer: I do not recommend a specific course of action for anyone. Please discuss with your financial planner.

The most important course of action is to consider how robust your lifetime financial plan is to a 2000-2011 market. If such a market arrived, what would you do? It is certainly easier to plan during the current boom times than at the barrel of a gun during the darkest hours of a recession. Potential mitigants to the impact of a terrible bear market could be:

  • Lowering equity exposure and waiting for a more attractive valuation
  • Lowering the amount of portfolio drawdown during a bear market:
    • Cutting spending
    • Increasing income through part-time work

By having a well-reasoned strategic plan, you can avoid making some terrible panic-driven mistakes when a crisis happens.

This topic is formally called ‘sequence of return’ risk and will be the subject of Quant School Post #2 (forthcoming the weekend of September 15th).

1 Response

  1. October 3, 2018

    […] You Can’t Afford to Ignore Market Valuations […]