Tag: CAPE

Building a Better CAPE Ratio

October 5, 2022

After a bit of a hiatus from the blog – thanks to our ambitious summer travel schedule – it’s time for another post. Over the years, I’ve gotten a lot of questions about the Shiller CAPE Ratio and if it’s still relevant. If you’re a regular reader of my blog, you’ll likely be familiar with the CAPE concept, but just as a refresher, Prof. Robert Shiller, economist and Nobel Laureate, came up with the cool idea of calculating a Price-Earnings (PE) ratio based not just on 1-year trailing earnings, which can be very volatile, but on a longer-term average to iron out the corporate earnings fluctuations over the business cycle. Hence the name Cyclically-Adjusted Price Earnings (CAPE) Ratio. If we use a 10-year moving average of inflation-adjusted earnings as the denominator in the PE ratio, we get a measure of market valuations that’s more informative in many instances. For example, historically the CAPE ratio has been significantly negatively correlated with subsequent equity returns. It’s not useful for the very short-term equity outlook, but over longer horizons, say 10+ years, the CAPE ratio has been highly informative. Especially retirees should take notice because your retirement success hinges a lot on those first 10 or so retirement years due to Sequence of Return Risk. In fact, all failures of the 4% Rule occurred when the CAPE was above 20! A high initial CAPE ratio signals that retirees should probably be more cautious with their withdrawal rate!

But the CAPE has been elevated for such a long time, people wonder if this measure is still relevant. In the comments section, people ask me all the time what kind of adjustments I would perform to “fix” the CAPE. Can we make the Shiller CAPE more comparable over time, to account for different corporate tax environments and stock buybacks and/or dividend payout ratios over the decades? Yes, I will present my ideas here today. And even better, I will post regular updates (potentially daily!) in my Google Drive for everyone to access for free.

So, what do I find? The adjustments certainly lower the CAPE, but don’t get your hopes too high. Even after the adjustments, the CAPE is still a bit elevated today! Let’s take a look at the details…

Continue reading “Building a Better CAPE Ratio” →

Nervous about sky-high stock prices? Five ways to cope with “CAPE Fear”

Another month, another record close for the major stock indices on November 30. How long can this go on? Is this a bubble? The Shiller CAPE Ratio certainly looks “bubbly,” now that it’s solidly above 30, see the chart below. It’s almost as high as in September 1929, right before the crash. And significantly above the 2007 peak right before one of the stock crashes in recent history. Should we scale back our equity positions now? It sounds tempting now that we are so close to retirement. As of Wednesday morning, while doing the final edits it definitely looks as though stocks are off to a bumpy start in December!

CapeChartNov2017
Shiller CAPE: Closing in on the 1929 peak!

But hold your horses! Let’s look at some of the reasons not to throw in the towel yet…

Continue reading “Nervous about sky-high stock prices? Five ways to cope with “CAPE Fear”” →

The Ultimate Guide to Safe Withdrawal Rates – Part 21: Why we will not have a mortgage in early retirement

Update 12/4/2020: I’ve been getting a lot of inquiries lately: Has my assessment changed in light of the record-low interest rates? My answer: Not really. Mortgage rates are low but so are my equity expected returns and bond yields. Right now I see 2.375% for the 15y and 2.75% for the 30y mortgage, so we’re about 1.0% lower on the mortgage rate. But with the CAPE>30 we also have a 1% lower equity expected return. It’s almost a wash. So, the gist of the article is still intact: Ask yourself, are you comfortable with a mortgage and 100% equities? I would not. If you do have bonds and a mortgage, is the bond yield lower than the mortgage rate? (Currently, it is: <1% for the 10y bond used in my simulations.) So, you’re better off paying off the mortgage with the bond portfolio.

Welcome back to the newest installment in our Safe Withdrawal Rate Series! If you are new to our site please go back to Part 1 to start from the beginning. Or check out the designated landing page for the SWR Series here.

But back to the topic at hand. It’s been on my mind for a long time. It’s relevant to our own situation and it’s come up in discussions on other blogs, in our case study series and in numerous questions and comments here on the ERN blog:

Should we have a mortgage in Early Retirement?

The case for having a mortgage is pretty simple: You can get a 30-year mortgage for about 4% right now. Probably even slightly below 4% when you shop around. Equities will certainly beat that nominal rate of return over the next 30 years. Open and shut case! End of the discussion, right? Well, not so fast! As we have seen in our posts on Sequence of Return Risk (Part 14 and Part 15), the average return is less relevant than the sequence of returns. Having a mortgage in retirement will exacerbate your sequence of return risk because you are frontloading your withdrawals early on during retirement to pay for the mortgage; not just interest but also principal payments. In other words, if we are unlucky and experience low returns early during our retirement (the definition of sequence risk) we’d withdraw more shares when equity prices are down. The definition of sequence risk!

How badly will a mortgage mess with sequence risk and safe withdrawal rates? That’s the topic for today’s post… Continue reading “The Ultimate Guide to Safe Withdrawal Rates – Part 21: Why we will not have a mortgage in early retirement” →

The Ultimate Guide to Safe Withdrawal Rates – Part 20: More Thoughts on Equity Glidepaths

Welcome back to the 20th installment of the Safe Withdrawal Rate series. Check out Part 1 to jump to the beginning of the series and for links to the other parts! This is a follow-up from last week’s post on equity glidepaths to address a few more open questions:

  1. Some more details on the mechanics of the glidepath and why it’s so successful in smoothing out Sequence of Return Risk.
  2. Additional calculations requested by readers last week: shorter horizons, other glidepaths, etc.
  3. Why are my results so different from the Michael Kitces and Wade Pfau research? Hint: Historical Simulations vs. Monte Carlo Simulations.

So, let’s get to work …

Continue reading “The Ultimate Guide to Safe Withdrawal Rates – Part 20: More Thoughts on Equity Glidepaths” →

The Ultimate Guide to Safe Withdrawal Rates – Part 19: Equity Glidepaths in Retirement

One of the most requested topics for our Safe Withdrawal Rate Series (see here to start at Part 1 of our series) has been how to optimally model a dynamic stock/bond allocation in retirement. Of course, as a mostly passive investor, I prefer to not get too much into actively and tactically timing the equity share. But strategically and deterministically shifting between stocks and bonds along a “glidepath” in retirement might be something to consider!

This topic also ties very nicely into the discussion I had with Jonathan and Brad in the ChooseFI podcast episode on Sequence of Return Risk. In the podcast, I hinted at some of my ongoing research on designing glidepaths that could potentially alleviate, albeit not eliminate, Sequence Risk. I also hinted at the benefits of glidepaths in Part 13 (a simple glidepath captures all the benefits of the much more cumbersome “Prime Harvesting” method) and Part 16 (a glidepath seems like a good and robust way of dealing with a Jack Bogle 4% equity return scenario for the next 10 years).

The idea behind a glidepath is that if we start with a relatively low equity weight and then move up the equity allocation over time we effectively take our withdrawals mostly out of the bond portion of the portfolio during the first few years. If the equity market were to go down during this time, we’d avoid selling our equities at rock bottom prices. That should help with Sequence of Return Risk!

GlidepathPlot
Static Asset Allocation vs. Glidepath in (early) retirement. 80% static equities vs. a glidepath going from 60% to 100%.

So, will a glidepath eliminate or at least alleviate Sequence Risk? How much exactly can we benefit from this glidepath approach? For that, we’d have to run some simulations…
Continue reading “The Ultimate Guide to Safe Withdrawal Rates – Part 19: Equity Glidepaths in Retirement” →

The Ultimate Guide to Safe Withdrawal Rates – Part 18: Flexibility and the Mechanics of CAPE-Based Rules

Welcome back to the newest installment of the Safe Withdrawal Rate Series. To go back and start from the beginning, please check out Part 1 of the series with links to all the other parts as well.

Today’s post is a follow-up on some of the items we discussed in the ChooseFI podcast a few weeks ago. How do we react to a drop in the portfolio value early on during our retirement? Recall, it’s easy not to worry too much about market volatility when you are still saving for retirement. As I pointed out in the Sequence of Return Risk posts (SWR series Part 14 and Part 15), savers can benefit from a market drop early during the accumulation phase if the market bounces back eventually. Thanks to the Dollar Cost Averaging effect, you buy the most shares when prices are down and then reap the gains during the next bull market. That has helped the ERN family portfolio tremendously in the accumulation phase in 2001 and 2008/9.

But retirees should be more nervous about a market downturn. Remember, when it comes to Sequence of Return Risk, there is a zero-sum game between the saver and the retiree! A market drop early on helps the saver and thus has to hurt the retiree. What should the retiree do, then? The standard advice to early retirees (or any retiree for that matter) is to “be flexible!” Great advice! But flexible how? We are all flexible around here. I have yet to meet a single person who claims to be completely inflexible! “Being flexible” without specifics is utterly useless advice. It’s a qualitative answer to an inherently quantitative problem. If the portfolio is down by, say, 30% since the start of our retirement, then what? Cut the withdrawal by 30%? Keep withdrawals the same? Or something in between?

How flexible do I have to be to limit the risk of running out of money?

That’s today’s post: Using dynamic withdrawal rate strategies, specifically CAPE-based withdrawal rules, to deal with the sequence of returns risk…

Continue reading “The Ultimate Guide to Safe Withdrawal Rates – Part 18: Flexibility and the Mechanics of CAPE-Based Rules” →

The end of CAPE Fear? What happens to the Shiller CAPE ratio when we roll out the weak 2008/09 earnings?

In last week’s post on dynamic withdrawal rates, one of the withdrawal rules we actually liked quite a bit was based on the Shiller CAPE ratio. One disadvantage of any such rule: The CAPE is at a high level by historical standards, 29.30 to be precise as of this morning (March 22, 2017). Today’s CAPE-based withdrawal rates will be very stingy, only around 3% per annum.

So, what to do about our CAPE Fear? One reader recently made an interesting observation: The CAPE uses ten-year rolling S&P500 earnings. So, once we roll out the low earnings from the Global Financial Crisis (GFC) in 2008/9, average earnings should move up again and the CAPE should come down. But by how much? Probably not below 20. Still, how much of a decline in the CAPE can we realistically expect: 10%? 20%? We have to start a new Excel Spreadsheet for that. Let’s get cranking!

Continue reading “The end of CAPE Fear? What happens to the Shiller CAPE ratio when we roll out the weak 2008/09 earnings?” →