Rob to Michael Kitces: “The Other Big Issue Here Is WHY Do Things Go As You Properly State They Do — Why Do High Valuations Predict Different Things in 10 Years and in 30 Years? This Is Just What We Should Expect to See If Shiller Is Right That It Is Investor Emotions That Serve As the Primary Determinant of Stock Prices Rather Than Economic Developments. Investor Emotions Follow the Same Pattern Over and Over Again.”

Set forth below is the text of a comment that I recently posted to an article on safe withdrawal rates posted by Michael Kitces at his blog: 

Michael:

This is an A+++ article. You make some amazingly important points that have been generally overlooked by most in this field for years now. I write a weekly column at he Value Walk site on Valuation-Informed Indexing. I will be exploring this article in depth in one of my future columns there.

The point you make re how high valuations predict low returns 10 years out but higher returns down the road is of HUGE significance. This is very troubling for the millions of retirees who relied on the infamous “4 percent rule” in planning their retirements. Almost all retirement failures come about because of poor returns suffered in the first 10 years of the retirement. What we are seeing is that the 4 percent rule put MILLIONS on the path to suffering failed retirements because they suffered or will soon suffer big losses in the first 10 years of their retirements. The data shows that the odds of a high-stock retirement portfolio used in a retirement beginning in 2000 and employing the 4 percent rule surviving for 30 years was only 30 percent at the time that retirement began. Not safe! Not close!

The other big issue here is WHY do things go as you properly state they do — Why do high valuations predict different things in 10 years and in 30 years? This is just what we should expect to see if Shiller is right that it is investor emotions that serve as the primary determinant of stock prices rather than economic developments. Investor emotions follow the same pattern over and over again. Valuations go up and up and up for about 20 years as investors come to appreciate the fun in voting themselves free money. Then valuations get so high that investors become fearful and pull prices down to levels as insanely low as they once were insanely high.

Stocks will perform poorly for the next 10 years or so. But once we reach a P/E10 level of 8 or perhaps a bit lower, the psychology will change again and we will begin a 20-year secular bull market. This is why it is so important that investors lower their stock allocations at times when prices are insanely high. The capital that is protected by going with a low stock allocation can be invested in stocks paying amazing returns on a going forward basis once prices have gone to insanely low levels. The result is that those investors who used the peer-reviewed research of the past 34 years as their guide can retire many years sooner than those who followed Buy-and-Hold strategies.

When the compounding returns factor is incorporated into the analysis, the difference can be in the many hundreds of thousands of dollars. The impact of taking valuations into consideration when setting one’s stock allocation is counter-intuitively big.

Thanks much for the great work you have done in this area.

Rob