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Hi ERN,
For the duration of this blog, we've been in an abnormally low-rates and a TINA environment, but that may be about to change. If inflation is persistent despite the Fed's rate hikes, we could see rates higher than 4%, because the Fed's written policy is to set rates to slightly exceed inflation when inflation exceeds the target. In that scenario, the S&P500 should trade for a PE ratio in the mid teens like it has in historical times with those rates, right?
1) What do you think is an expected multiple at various possible levels for the 10 year treasury bond: 3%, 4%, 5%, 6%, 7%... This is another way of saying what is the historically expected risk premium of stocks over risk-free bonds in an environment where rate hikes, recessions, and wars are distinct possibilities? Today's earnings yield of 4.76% suggests about a 1.8% risk premium over 10y treasuries, and that seems low but I can't prove it.
2) What is the utility function for a person in the FIRE accumulation phase to sit in cash for a while, risking the market running away without them, to position themselves to grab on-sale assets at prices that would justify immediate retirement on a WR higher than 4%... e.g. 5% or 6%? If things got worse, this move would be brilliant. If not, you lose a couple of years. But what valuation would be a buy signal / retire signal at various WRs over 4%? Can I retire with a 5% WR if the PE or CAPE is below a certain level?
A former Fed official was quoted saying we need to be thinking more about 5-6% when thinking about the Fed's "neutral rate". If that came to pass in the next couple of years... I think we'd be talking a 2008-sized financial crisis.
The TINA equation is probably going to change. Agree. I think it's possible that the 10-y yield will eventually go above 4% again, and once inflation goes below 3% again (maybe in 2024 or even before if we have a major recession) then the positive real yield in bonds should make them more attractive again.
Good suggestion about the relative yield. If we assume a CAPE of 30, and CAPE yield of 3.3% and a 10y yield of 2.85% (5/12/2022), then with an excess yield of ~0.5% we're clearly below historical averages (~2%), but not wildly so.
I don't recommend the market timing strategy with "cash on the sideline". People will let the cash sit there, the market runs away and then FOMO kicks in and people buy at the top. I'd take the mind games out of the investments.
At what point would a 5% WR safe? See the chart in Part 50: ( 
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At about 6.5% CAPE earnings yield. That's a CAPE of 15. Long ways to go! 😉
@earlyretirementnowcom thanks for the excellent response.
I was thinking more along the lines of the Fed Model and the close correlation between the 10y treasury yield and the earnings yield (E/P ratio). CAPE is a very good way to estimate SWRs for 30-50 year timespans, which is no small feat, but in reality the SWR is in constant fluctuation as valuations go up and down. I.e. whatever the SWR happens to be at the moment, it was much lower in January 2022 than it is in May 2022! The investment regime is changing, rates are rising in response to inflation at 40 year highs, and for those reasons I'm leaning toward the Fed Model as a forecasting tool.
Today's 10 year treasury yield is ~3%, CAPE is 32 (CAPE yield about 3.1%), and the PE of the S&P500 is 20 (EY about 5%). If we assume the difference between the 10y treasury and the EY is the risk premium for stocks, we get about a 2% risk premium. If in the near future, treasury yields go up to 5%, we should expect the earnings yield on the S&P500 to reach 5+2= 7%, right? That would be a PE of about 1/7= 14. To get from PE=20 to PE=14, valuation would have to drop 30%*.
The point of question #2 was not to encourage market timing, it was a thought experiment for a rising rate environment. Suppose I am an early retiree spending $40k/year and possessing $1M in assets. Your research strongly suggests that it is not safe to retire on a 4% WR while valuations are as high as they are today so I have a "long ways to go"! However, with things changing so quickly, there could soon come a time when retiring on a 4% or 4.5% WR is safe, presuming I still have my $1M at that time of course! So I have two options:
1) Stay invested and aim for a 3.25% withdraw rate, as is appropriate for today's valuation regime. Accept the risk of markets going down while I am aiming for a higher target.
2) Go to cash or highly hedged positions during this rate hike cycle (historically not a bad move during rate hike cycles) and trade off the option value of possibly being able to retire on a higher WR if markets tank for the option value of whatever upside the market have if markets go up instead.
Option 2 is attractive to anyone who thinks that treasury rates have a big influence on PE's, who assigns a high probability that interest rates are going to keep rising, and who accepts a valuation-driven WR as suggested by the chart above. The expected value of Option 2 is something to think about. If the odds of a multi-year bear market at at least 50%, it's worth at least as much as option 1.
The S&P's PE is 25% above its long-term mean, but the CAPE is 90% above its long-term mean. In a world where earnings have grown over the years, CAPE is more volatile than PE, because the average of the past 10 years' earnings is smaller than the past 1 year's earnings. Thus if stocks were to fall 20-30% in response to rising rates and a recession, CAPE could fall very rapidly into the 20's or below. That would be a great time to pounce if one could see it coming and preserve assets until then. At other times when CAPE was this high, better times were just around the corner, in terms of valuation at least! If a person pursued option 2, they'd be attempting to exploit, rather than being exploited by, the tendancy to retire in bull markets described in SWR #22.
*Earnings increases might mean nominal stock prices drop less than 30% even if PE drops 30%.
