So what, we retired at the peak of the bull market? Here are seven reasons why we’re not yet worried…

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.

The 2018 calendar year gains were almost wiped out in October. Ouch!

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:

Retire at Market Peak Chart01
Yield Curve slope (10Y vs. 2Y Treasury bonds) over time. NBER recessions in yellow. A powerful recession early warning signal!

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!

Retire at Market Peak Chart02
Unemployment Claims normally start rising sharply before a recession. Currently, they are still extremely low, by historical standards.

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.

Retire at Market Peak Chart03
The PMI (Purchasing Managers Index) will usually drop to below 50 at the onset of a recession. It’s currently, at 57.7

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:

  1. 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.
  2. 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!!!
  3. 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!

Retire at Market Peak Tabke01
The fall in the equity index is cushioned by the more advantageous equity valuation and higher CAPE-based SWR!                                          Note: The CAPE Ratios are calculated slightly differently from Robert Shiller’s method: Month-end equity index (as opposed to monthly average) and I fill in the more recent earnings with data from S&P Dow Jones.

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!

Retire at Market Peak Table02
Failure probabilities are impacted by the relative equity valuation! After a large enough S&P500 drop, even the 4% Rule becomes fail-safe again.       From: SWR Series Part 28, Numerical Example in the Google Sheet: 60-year horizon, 80% stock, 20% bond portfolio, modest additional cash flows.

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!

Conclusion

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!

Hope you enjoyed today’s post! Please leave your thoughts and comments below!

36 thoughts on “So what, we retired at the peak of the bull market? Here are seven reasons why we’re not yet worried…

  1. Well you seem to have every angle covered. Thanks for the assessment on the current state of the investment cycle, seems we are indeed still doing well be getting towards the end of it. Curious as to see what the trigger will be. Anyhow, enjoy the well deserved time off (and associated travelling)!

    Liked by 1 person

    • Thanks, TeamCF! Yeah, what will be the trigger this time? Maybe the Fed raising interest rates too aggressively?! Hard to make a forecast. But we should see it in the three series! 🙂
      In any case, greetings back to Europe! Let’s get together again next time we make it to the Netherlands!

      Like

  2. Another great post. I have always debated when I will be able to do a Roth conversion. Fortunately I make a great salary, but the downside is that the Roth conversion will not happen anytime soon.

    Congrats on the new home. We are currently debt and property free after selling our lot last month, Once we make our move across the country in December I suspect we will slowly be looking for a home. I am hoping for a slow down in home prices and suspect within 2 years prices will be cooling.

    Liked by 1 person

  3. I have 20+ years to go until retirement so I’m not worried about the declining stock market, but if I was in your situation my thought process would probably be different. Even though a declining stock market isn’t going to change my strategy, I still do find your assessment of the current market conditions and what it means to a possible coming economic downturn interesting, so please do have follow up posts as the conditions change!

    Liked by 1 person

    • Thanks! Oh, yes: a downturn during the accumulation phase, 20 years before retirement, is probably a good thing (if you can stomach the temporary drop). But things get a bit scarier in retirement. Which is why I monitor momentum and macro signals. I will certainly write something again if my assessment changes! 🙂

      Liked by 1 person

  4. It’s very reassuring to have you as the poster child for retiring potentially around a high of the market. Who better to live and tell the story. It is nice to know that your 3% withdrawal rate is very reasonable and safe. Not only that, but it sounds like due to your bonuses and such, this particular year you are not needing to sell much.

    Interesting that you purchased your home while you are traveling. I suppose that allows you to reduce your California state tax a small amount of the year. Knowing you, it might have been a factor.

    Liked by 2 people

    • Thanks, Susan! It turns out that the decision to buy a home was more mundane and had nothing to do with tax planning (we will simply claim our standard deduction this year). We simply found a nice home we liked and made an offer. We will have a home waiting for us when we come back from our trip. Not a bad price to pay: two months of a house sitting around vacant is nothing in the big scheme! 🙂

      Like

  5. We are a long way off too and will just have to enjoy the bump ride for another decade or two. I’m glad you are on “our side” and conjuring up a strategy with a high likelihood of success. Keep calm and withdrawal 3%! good luck! 🙂

    Liked by 1 person

  6. Great Analysis and I’m certainly hoping you’re right! I’m in the same boat with the recent draw down coming at a inconvenient time of no/minimal income. It sounds like you guys may have bought your house at a great time in terms of the market cycle in general though which is awesome.

    I love the picture. We arrived in Siem Reap yesterday and are heading to Angkor Wat this week, just trying to decide between the 1 or 3 day pass. What did you guys do and what would you recommend?

    Liked by 1 person

    • Thanks! Oh, wow, we missed each other by just a few weeks!
      We ended up getting a 1-day pass only. It’s enough to cover the main sites: 5 locations in one day (plus lunch in between). We rented a tuk-tuk for the day to drive us around ($20 plus we gave a generous tip).
      We were all totally spent and exhausted after that day and spent the other whole day at the hotel by the pool and in the city. 🙂
      But if you’re staying longer, maybe go for the 3-day pass?! Maybe explore on days 1 and 3 and take a rest on day 2?

      Liked by 1 person

      • I appreciate it! I was leaning toward the one day pass and just making it a really long day and seeing as much as possible so I like your idea. $20 for the day seems to be about the going rate for tuktuks here although we were considering doing a sunrise tour with a group which is about the same price.

        I checked your itinerary a while back and there were several places where we almost overlapped but never quite did. I hope you guys are having an awesome time!

        Liked by 1 person

  7. Wow, congrats on the new house and all the confidence (MMM must have gotten to you a little or maybe it is just math … it is probably just math). I can see why you are so comfortable given the US market history. This is another comprehensive and compelling post.

    I found something new (to me) and scary to keep me up at night and keep us working perhaps well beyond a 3 percent withdrawal rate. Do you have any thoughts on why the S&P 500 is not the Nikkei? As one of your previous posts points out 150 years of US equity returns is not that much when planning for a 60 year retirement. But looking at other developed countries for historical data is pretty scary for trying to plan for a reasonable safe withdrawal rate. Have you given some thought to if or how to include worldwide equity data into a retirement simulation? I would love to hear your thoughts in a future post.

    I can plan for a lost decade early in retirement, but it seems impossible to account for 29 lost years and counting. It is probably time to look into some of the diversification options you discuss here and earlier.

    Thanks!

    Liked by 1 person

    • What baffles me about the Nikkei’s issues is that you don’t hear many stories about struggling retirees there. In fact wealthy Japanese tourism has remained a ‘thing’ almost 30 years on. Where else were they earning returns besides the Nikkei?

      Liked by 1 person

      • The Japanese do not invest heavily in the Nikkei — they are generally risk averse and have a high personal savings rate. In fact I’d venture to say that very few nations have tied their retirement systems so closely to equity markets … which is how it was in the US a few decades ago and should be food for thought to all who think that the stock market is the most logical place to store one’s life savings.

        Like

        • Well, someone has to hold the $23 trillion or so of equity wealth in the U.S. Pension funds on the way out and the 401k money has to be invested somewhere.
          Besides, my research has shown (see SWR series) that the highest rate of success comes from investing a minimum of 70-80% in stocks, especially over long horizons!
          Given all that, I’d argue the stock market IS the most logical investment vehicle. Rental Real Estate might be even better but it’s not for everyone! 🙂

          Like

    • Thanks!
      The Japanase lost decades problem is something on my mind, too. Japan had pretty crazy lofty equity valuation at the peak, even wrose than the dot-com bubble in the U.S.:
      http://i0.wp.com/siblisresearch.com/wp-content/uploads/2016/10/Japan-Shiller-PE.png?zoom=1.25&resize=785%2C289
      That makes me a little bit less worried about a Japanese scenario for the U.S.
      I’m more owrried about a 1965-1982 repeat. A long span of so-so market returns with bad recessions in between. None of them as bad 2008/9 but the whole two-decade period would have destroyed a lot of FIRE dreams…
      But with a 3-3.25% SWR you would have survived! 🙂

      Like

    • Thanks, Joe! 3% seems pretty safe even in the most unpleasant market conditions. And who knows, maybe this was all just a blip because the S&P went above 2800 again today. I guess I posted this at the right time! 🙂
      About the house: I’m writing a post about that next month! Stay tuned!!!

      Like

  8. Re your point 1 above (Initial W/Rate (IWR) of c. 3%) and the comment about your “kind of flexibility” – I thought we agreed in discussion of your Part 25 that even at 4% IWR you’ll have to find about 2.5-3.0 times annual consumption of “flexibility” in the form of lower consumption, work or cash buffer. How people come up with it is up to individual preferences. And, of course, any less “flexibility” will not work. Or, did I misunderstand our discussion?

    I am not a fan of the so-called 4% rule – but would just like to see the whole picture set out around “flexibility”.

    Liked by 1 person

    • That sounds about right. The 4% Rule works if you have a large enough cushion, but that means you’re using an EFFECTIVE withdrawal rate much lower than 4%.
      I don’t keep much of a cushion and simply keep our assets all in productive assets and start with a 3% SWR initially.

      Like

  9. A great post, again! Keep them coming, too!

    I learned that our company doesn’t allow to keep 401k with its administrator after we leave the company. It must moved to an IRA within a year. So, if I’m correct, this puts me at the big disadvantage from the tax perspective, correct? Any alternatives in such situation?
    Just to have a full understanding what I’m trying to say/ask, here’s a brief story.
    If I leave my job, I’m forced to move my 401k to an IRA within a year (or faster). In my understanding, it’s not worth (tax wise) to convert it to a Roth IRA as my spouse doesn’t want to retire and his income is much higher than mine.
    When both spouses retire and move their 401k’s to IRA’s, is there a benefit to convert them slowly into Roth IRA’s? If so, in what cases?

    I’m staying tuned for your article about the house. I will bet that you’re a resident of NV :-).

    Safe travels!

    Liked by 1 person

    • Well, it means that you should do the backdoor Roth before all that money comes from the 401k and into the Rollover IRA. Once the 401k becomes a Rollover IRA it’s counted when calculating the cost basis vs. taxable ratio for future Roth conversions.
      But it might still be attractive to do Roth conversions. It simply means almost all of it will be taxable as ordinary income…

      Like

      • A slight point of clarification here, but your pretax IRA basis is counted as of the last day of the year, so whether or not you do a back door conversion before or after your pretax 401k->IRA in that year doesn’t matter, you will be screwed by the pro rata rule. For example, see https://www08.wellsfargomedia.com/assets/pdf/personal/investing/retirement/taxes-and-retirement/pro-rata-rule.pdf (“… as of 12/31 of the distribution year.”). OP, see if you can have a side hustle and open your own self directed 401k and roll to that. As an aside, 401k might offer stronger creditor protection in some states, vs IRAs.

        Big ERN, you are my hero. Some others in the FIRE movement are credited with “godfather of the FIRE movement” and so on, and I think we should coin a title for you. Maybe “Quant of the FIRE movement”. Thanks for all your analysis on these pages.

        Liked by 1 person

  10. Very good article! Thanks for posting… I just turned in my notice today and definitely needed the reassurance that my decision is the right one given recent gyrations in the market. 30 days from now we’ll be joining you on the other side in my early 50s! After the holidays here in the States we’ll strike off for India in January and be in Cambodia in February, so it’s very cool to see Angkor Wat pictures as a preview of what we can expect… and I’m prepaying as much of that as I can now so that we enter the first days of early retirement without incurring big costs.

    Like

  11. Great post ERN. I’m a relatively new reader (UK resident with a couple of years to go before I quit). Planning a bit of a splurge during the first few years of retirement (from age 59) then settle back to 3.5% or thereabouts. Numbers looking good at the moment, but agonising about asset allocation! Happy travels!

    Liked by 1 person

  12. Interesting post – I recently discovered your blog and have spent many an hour reading your take on SWR’s and early retirement. Love to see your very analytical approach! I’m retiring on December 31 (age 51) and there is that concern about retiring at a market high. But of course, the market is often at an all time high so probably not that unusual. One question though – you are keeping a close eye on some of the macro-economic fundamentals. What do you intend to do if the signals point to an imminent recession? Move out of equities and into something else? Or just reduce your withdrawal rate?

    Thanks again for the thoughtful writing.

    Liked by 1 person

    • Excellent question about the impending recession signal. Right now I use this signal purely as a “don’t panic” signal to soothe my nerves that nothing truly bad is lurking around the corner.
      If we do get to the point where I convinced myself that things get bad I MAY consider moving part of the portfolio out of stocks and into bonds/short-term bills. But even that is not straightforward. What if stocks already fell by 30% at that time? Is it still worthwhile moving out at that time? I will think about the options when we get to that point! 🙂

      Like

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s