Wow, did you see the big stock market move in October? The worst monthly S&P 500 performance since 2011! When you’re still working and contributing to your retirement savings it’s easy to lean back and relax: you can buy equities at discount prices and you buy more shares for the same amount of savings when prices are down, a.k.a. dollar-cost-averaging. Now that we’re retired things are different. Sequence Risk creates the opposite effect of dollar-cost-averaging: you deplete your money faster while the portfolio is down. I have been writing about this theme for almost two years now and now it looks like I might become my very own poster child of Sequence Risk.
So, are we worried having retired at (or close to) the peak of the market? Well, take a look at the title image: an ERN family selfie while vacationing in Angkor Wat (Siem Reap, Cambodia) in October. It doesn’t look like we’re too concerned about the stock market! And here are a few reasons why…
1: We don’t apply the naïve 4% Rule
Retiring at the stock market peak is only scary if you start withdrawing too much money. My research shows that by shifting the initial withdrawal rate closer to 3% works wonders in securing long-term retirement security. By simply withdrawing around 20-25% less than under the naive 4% Rule (my kind of flexibility!) you’d easily hedge against even the worst historical return patterns, e.g., a Great-Recession-style stock market drop or a repeat of the 1970s and early 1980s. In other words, even if we were at the precipice of a stock market cliff like September 1929, a low enough withdrawal rate, somewhere in the low-3% rage would survive for long enough.
Of course, I’d have to lie if I told you that I’d be completely cool and collected and emotionally unaffected by a prospect of a Great-Depression-Repeat even when using a 3% initial withdrawal rate! But are we even close to the precipice? Nobody can say for sure! And keep in mind that back in 1929 a lot of “experts” agreed that the prospect of a stock market crash was extremely slim. But I’m still going out on a limb here and argue that we’re probably not that close to a repeat of the Great Depression. And that brings me to reason #2…
2: Macro fundamentals are still solid
As I wrote in a post earlier this year, macroeconomic fundamentals matter for equity expected returns. Granted, there are a lot of naysayers who, quite correctly, point out that the correlation between growth and equity market performance seems quite spurious. But that’s a red herring! It’s missing the forest for the trees! I never claimed that during economic expansions the stock market can only go up. Quite the opposite, even outside of recessions we can have sharp drawdowns, e.g., October 1987, the Asian crisis in 1997, the LTCM crisis in 1998, and more recently the Chinese devaluation in 2015, the Fed scare in early 2016, and again in 2018. I mostly said that the stock market drops that eventually became a Sequence Risk nightmare all have one thing in common: the stock market drop coincided with a recession. And not just any garden-variety recession; we’re talking about a deep recession like the Great Depression or the 1970s/80s!
So, let’s look at the three macro indicators that I like to monitor. One is looking a little bit shaky but the other two are still extremely strong:
1: The yield curve is not (yet) inverted. But it’s getting close! The gap between the 2-year and 10-year Treasury bond yields has narrowed quite a bit since I wrote the post earlier this year. But I can show you plenty of examples in the past where the yield spread had narrowed to around 30bps and the next recession was still many years away, see chart below:
2: Unemployment claims are at historical lows. And so is the unemployment rate. If a major economic downturn was around the corner one would expect to see this series moving upward very steeply. Certainly at the start of a recession and sometimes even noticeably before the recession. That hasn’t happened yet. So, we’re probably still safe!
3: Business confidence (as measured by the PMI index) is still very strong. A level of 57.7 as of October 31. This does not yet look like a late-cycle slowdown of business activity. And notice that this is despite the uncertainty about tariffs and trade wars, uncertain midterm election outcomes, etc.! That said, business confidence can change rapidly. There have been precedents in the past where the PMI melted down from above 60 (=strong expansion) into the low 40s (=likely recession) within a few months. So, I’ll be monitoring this indicator carefully.
Granted, these are only three indicators. But trust me, I developed much more complicated models when I was still working in finance, monitoring dozens or even hundreds of indicators, using all sorts of sophisticated statistical tools. And I can happily report that the Pareto Principle is alive and well. Looking at the three indicators you gain 80% of the information for 20% of the effort. Actually, much less than 20%, maybe 0.2% of the effort.
3: I diversify with Real Estate
Real Estate is only a small part of our portfolio but it’s growing. I like the asset class because it will likely provide stable cash flow and diversification benefits. Our real estate holdings right now are comprised of the following components:
- We hold several private equity real estate funds, mainly invested in large multi-family housing properties. We enjoy the steady cash flow and tax advantages through depreciation allowances early during the ownership. I haven’t written much about our experience on the blog here but I’m working on a more detailed post coming up in the future. For now, if you like a sneak peek, listen to the Fire Drill podcast episode where I talked about the topic with Gwen and J.
- We just became homeowners again! In two previous posts, I detailed why I think owning a house can (but doesn’t have to) be a good investment (“See that house over there? It’s an investment!” and “My best investment ever: Homeownership?!“). Especially for early retirees, exchanging a big chunk of money (ideally at the stock market peak!) and transforming it into an asset that reduces your retirement expenses by not having to pay rent can be a pretty good investment. I think of homeownership as getting tax-free rental income from ourselves. It’s a hedge against rental inflation and especially Sequence of Return Risk because we eliminate a large mandatory budget item! What we bought and where and why will be a topic for a future blog post, stay tuned!!!
- We are also in the market for sampling some of the crowd-funding platforms and their offerings of both equity and debt deals. Stay tuned!
4: More diversification: volatility can be great for alternative investments such as option trading
Talking about diversification, one other technique I’m using in my retirement planning is option-writing. I wrote about this topic before, two years ago! In fact, the post where I detail my own options trading strategy is the one single post with the most comments (300+ and counting). It has even more comments than any single post in the safe withdrawal series (though the SWR series still has more comments combined, of course). Well, long story short, the options trading strategy actually performed pretty well despite the drop in the stock market. Selling naked put options is a great way to generate income in sideways or even downward moving markets. Especially, when the rise in volatility is gradual and doesn’t come out of the blue like in early February this year. In October I was able to sell puts with strikes far enough out of the money that even the big drops didn’t cause any sizable losses and we eeked out a net gain for the month!
But just for the record, exotic investments such as put writing or related strategies should be used only by experienced investors and only with the proper risk controls. Last year, I warned about a Credit Suisse fund using a “short-VIX strategy” (related, but not identical to naked put selling) and sure enough, that was the fund that blew up on February 5 this year and wiped out 96% of investor money!
5: The Shiller CAPE ratio is heading down
One advantage of the drop in stock prices: The Shiller CAPE Ratio will move down into a more reasonable range. From its temporary high of almost 33 right around the peak of the market, it’s now moved to just above 30. If you’re using a CAPE-based safe withdrawal rate the drop in the equity portfolio is partially offset by the slightly better-looking valuation. For example, if you’re using a CAPE-based Rule
SWR = 1.5% + 0.5*(1/CAPE)
then the safe withdrawal rate went up from 3.03% to 3.15%. Doesn’t sound like much, only 12 basis points, but it’s a 4% increase in the withdrawal amount. It offsets more than half of the drop in the equity portfolio!
And even better, as I’ve written about previously (see this post, item #4), in the Shiller CAPE ratio, we’re now replacing the really low earnings from 10 years ago with much better-looking numbers, so the denominator in the CAPE ratio will continue to rise and likely (hopefully!) push the CAPE below 30 again before too long!
6: After a large enough drop, even the 4% Rule of Thumb becomes sustainable again!
In historical simulations, you’ll notice that the 4% Rule fails mostly around the market peaks. After a large enough drop, of course, even the 4% Rule of Thumb becomes safe again, see the output from the Google Sheet in “An Updated Google Sheet DIY Withdrawal Rate Toolbox (SWR Series Part 28)” below. Failure probabilities and the fail-safe withdrawal rates are grouped by where the S&P500 stands relative to its most recent peak: at the all-time-high or at various percentage ranges below the peak. At the peak, the 4% Rule has an unacceptably high failure rate of almost 20%. But at 10-20% down from the peak the failure probability is down to 3% and at 20-30% below the peak it’s almost down to zero! Of course, let’s hope we won’t see a drawdown by 20-30% because that would put us in the range of 2,050 to 2,350 in the S&P500! But if it does the 4% Rule looks pretty safe again!
7: Roth conversions become cheaper
For tax purposes, the year 2018 is – pardon the pun – still a complete write-off for us. I got my base salary, a large bonus, deferred compensation and all of that puts us into a very high marginal tax bracket for the 2018 tax year. But come 2019, we’ll start from scratch with no (or very low) W-2 income and we’ll look into doing some tax moves like Roth conversions. Just as a recap, in a Roth conversion, we’d move pre-tax money from a 401k into a Roth and owe the tax the conversion amount. For us, the arithmetic is pretty simple: Unattended, our 401k accounts will likely grow to a large enough account by age 70 that will likely create required minimum distributions so large that we’ll get pushed into the third tax bracket, currently the 22% marginal federal tax rate (and maybe more in 25 years!). Any conversion we can perform now that keeps our current taxable income below that dreaded third federal income tax bracket seems like a great idea.
Anyhow, if our plan is to shift a certain dollar amount of our 401k every year starting in 2019 then a slightly decimated 401k will mean we can shift a larger portion of the pre-tax retirement savings into the safe haven of the Roth every year. Of course, the market might have recovered already by 2019 and this whole point is moot. But if this drop in equities becomes a drawn-out correction or even a bear market we can find some (small) solace in being able to perform Roth conversions at a faster pace. It’s the last bit of “dollar-cost-averaging” we can still use while in retirement!
So, there you have it! Seven reasons to not get worried too much about the October market volatility. I’ll keep you updated and let you know if and when we change our mind!