Michael Kitces has written a fine article on Valuation-Informed Indexing and the New School of Safe-Withdrawal-Rate analysis. It is called Shiller CAPE Market Valuation: Terrible for Market Timing, But Valuable for Long-Term Retirement Planning.
Juicy Excerpt #1: Nonetheless, the reality is that while Shiller CAPE has little predictive value in the short term, its correlation to market returns is far stronger over longer time periods; Shiller CAPE shows its strongest correlation to nominal returns over an 8-year time horizon, and is actually most predictive of real returns over an *18* year time horizon… supporting Benjamin Graham’s old adage that the markets may be a voting machine in the short run, but they are ultimately a weighing machine in the long run as valuation eventually takes hold. On the other hand, over very long time horizons (e.g., 30 years) Shiller CAPE once again begins to lose its value as other longer-term structural market factors take hold.
Juicy Excerpt #2: Prior research from the May 2008 issue of “The Kitces Report” has shown that Shiller CAPE ratios have an astonishingly strong -0.74 correlation to safe withdrawal rates and can help predict a reasonable starting point for retirement spending; because the long-term sustainability of retirement spending is most sensitive to an unfavorable sequence of returns in the first half of retirement, Shiller CAPE’s predictive value aligns quite well and helps to provide valuable insight about whether the prospective retiree faces an important headwind or tailwind in the early years of retirement. Notably, the results indicate Shiller CAPE is more correlated to safe withdrawal rates than it is to market returns themselves!
Juicy Excerpt #3: Perhaps this distinction between valuation’s long-run-but-not-short-run predictive value was the very reason the Nobel Prize committee gave its award jointly to Shiller for his work on how stock returns can be predicted in the long run, while simultaneously giving it to Eugene Fama for his efficient markets research showing that stock returns cannot be effectively predicted in the short run!
Rob’s Comment: Thanks for writing the fine article, Michael. It is important and brave stuff. I don’t agree when you suggest in the headline that P/E10 is not a good tool for long-term market timing. I certainly agree that short-term timing doesn’t work. But there is now 33 years of peer-reviewed research showing that long-term timing ALWAYS works and it is important for people to know that. I understand why you don’t want to say openly that long-term timing always works. It upsets Buy-and-Holders when they hear that. But that is the case and it is a very, very big deal. The research that I did with Wade Pfau shows that investors can reduce the risk of stock investing by nearly 70 percent by giving up on Buy-and-Hold strategies and engaging in long-term timing instead. That’s a very big deal indeed.