An earlier blog entry described the background of my recent correspondence with Michael Kitces on safe withdrawal rates (SWRs). Set forth below is the text of an e-mail that I sent Michael’s way in the evening of Thursday, August 21.

Michael:

Thanks again for providing stimulating feedback.

There’s a punctuation mark that you use in your study that I found entirely appropriate in one sense and extremely odd in another sense. It comes at the end of the sentence in which you put forward the following words: “Those extended periods of expanding or contracting P/E ratios (producing long-term real returns above or below historical averages) can often be anticipated in advance — by looking at the valuation of the aggregate market at the beginning of the time-period.” You employed an exclamation point at the end of that sentence.

Your exclamation point expresses your surprise at the claim being made. That’s entirely appropriate because most investors and most investing experts today do not think of stock returns as being predictable. But It’s also extremely odd that a finding that stock returns are largely predictable would come as a shock to anyone in the year 2008. Whether stock returns are predictable or not is a question of fundamental importance. Can it really be that this reality comes as a surprise to many smart people at this late date?

It really does come as a surprise to many. I have interacted with tens of thousands of middle-class investors on internet discussion boards and most are shocked to hear that long-term returns are to a large extent predictable. But the historical data leaves room for virtually no doubt on this question. Why do people not know this? How is it that this critically important reality is not more widely appreciated?

I believe that the reason why the reality is not better appreciated is because Passive Investing is today’s dominant model for understanding how stock investing works. The Efficient Market Theory tells us that returns should NOT be predictable. If the market is efficient, the market price should always be roughly right. If the market price is always roughly right, it should not be possible to predict future returns by taking into account mispricings.

Your correct statement that knowing the P/E10 of the market helps us anticipate future returns is in conflict with what the the dominant model for understanding how stock investing works tells us to expect from stocks.

The root puzzle is — why were the initial SWR studies set up in the way they were? Why did anyone think it would be a good idea to describe the SWR as a stable number? Why was it not understood from the start that the SWR must change with changes in valuations (as do long-term returns)? The explanation is — the early SWR researchers believed in the Efficient Market Theory and in Passive Investing.

If you are right that returns are predictable (I strongly believe that you are), then the Efficient Market Theory is wrong and the Passive Investing model has failed to properly explain how stock investing works in the real world.

Do you see it that way? Do you agree that the stakes here are huge?

Rob

An earlier blog entry described the background of some recent e-mail correspondence between Michael Kitces and I on safe withdrawal rates (SWRs). Set forth below is the text of an e-mail that Michael sent my way on the afternoon of August 21.

Rob,

Thanks so much for the feedback! My deepest sympathies on your computer problems – I feel like I live and breathe by my computer and internet connection these days, so I definitely understand your pain!

Feel free to draw from my email for your blog if you’re so inclined, to advance the conversation.

Regarding the status of retirees who are on a “bad” track because they retired based on a 4% SWR early in the decade – well, from the financial planner’s perspective, this is WHY we work with clients on an ongoing basis and monitor the status of their retirement plans. To avoid those precise disasters. My concern, of course, would be for all those who don’t work with planners, who aren’t as necessarily plugged into “monitoring” their own financial situation, and who may end out too far down a road that has at best some painful choices ahead.

On the other hand, I have to admit that, based on my professional experience, many clients automatically tend to moderate their spending in difficult markets anyway. In other words, I find that many clients moderated their spending somewhat during the last bear market, EVEN IF they “thought” their spending was “safe”, and we are seeing the behavior again from some clients already in this bear market. Unlike almost every other investor behavior that is financially damaging, this tendency to moderate spending in difficult market and economic environments, regardless of whether it’s “necessary”, puts a helpful damper on the bear market drawdowns anyway. Of course, that doesn’t help everyone, and some people also exhibit the “bad” behavior of ratcheting spending up too much in bull markets (and then get caught unprepared in the next bear market), but I hope that the tendency to moderate spending in difficult environments (consciously or subconsciously) will help a little.

In the meantime, I agree with you that the more consumer education, the better! 

With warm regards,

Michael

Michael Kitces recently published a study of safe withdrawal rates (SWRs) that adopts a mix of the Old School and New School approaches. Michael pointed out correctly that the SWR for a high-stock portfolio can go a good bit higher than 4 percent at times of low valuations (Yes! Yes! Yes!) but failed to point out that the SWR for a high-stock portfolio can also go a good bit lower than 4 percent at times of high valuations (Boo, Baby!). I wrote a blog entry on the first Nold School study and sent an e-mail to Michael applauding him for his big advance while pointing out that failing to go totally New School leaves millions of retirees at a big risk of suffering busted retirements in days to come.

Michael has given me permission to set forth the texts of his e-mails at this blog for the benefit of those interested in learning more about how SWRs work and how valuations affect long-term stock returns in general. This blog entry and a number of future ones will contain the texts of the e-mails that Michael and I sent to each other as we talked over the findings of the Retire Early and Indexing communities during the first six years of The Great Safe Withdrawal Rate Debate. Set forth below are the words of the e-mail that Michael sent my way on Monday, August 18.

Rob,

Thanks so much for getting in touch with me and passing this along! What a
great collection of material you have on your website!

Regarding your comments about the possibility that the SWR could be below
4%… well, I certainly wouldn’t say that I am in any way adamant that the
SWR could never be lower. To the contrary, I am a strong believer in the
long-term impact of valuation on market returns, and am well aware of the
impact that unusually high distorted valuations can have. In point of fact,
I still anticipate that ultimately, we will look back in another 25 years
and see that the time period from 2000-2029 will be the “new” worst case
scenario for SWRs, trumping even the damage of the 1966-1995 period.
Particularly if inflation continues to be as problematic as it has lately
become. However, we don’t yet have data to firmly establish that. At this
point, it’s reasoned speculation (albeit pretty well-reasoned) but not
necessarily a lot more, since we just don’t yet have the data to see how
this will ultimately play out.

That aside, given that today’s P/E10 ratios are more reasonably within the
range of other historical valuation peaks (not including the start of this
decade), I find that continuing to apply the 4% SWR methodology in today’s
environment to be reasonable. If we truly went back to P/E10 peaks earlier
this decade – valuations far beyond any point in the historical range – I
think I would agree with you that, to say the least, we need to HEAVILY
caveat any use of a 4% withdrawal rate. But today’s P/E10 is not in the 30s
or 40s. It’s back in the low 20s – damaging by any historical measure, but
not necessarily a valuation environment that will destroy a 4% SWR. Even
your own Retirement Calculator implies safe withdrawal rates around 4% at
P/E10 ratios around 21-22 (P/E10 22, TIPS 2.0, Stocks 40%, shows 4.00% SWR
on your site).

In point of fact, though, I did mean to make the exact point that you are
articulating more directly in my own newsletter – that ultimately, our 4%
SWRs are predicated on a certain range of valuations, and that to the extent
we have valuations that dramatically exceed that range (a la P/E10 in 2000),
we may find that the 4% SWR is invalidated at those levels. In retrospect, I
don’t think I made it as directly as perhaps I had wished, and I can
appreciate you calling me out on this.

But my focus in the newsletter was simply to put forth what we can at least
see in the existing historical record about the impact of a range of
valuations (and generally integrating valuation with SWRs) – a body of
research that I found to be lacking (although I’ll grant that’s partially
because the planning community seems to be generally unaware of your
passionsaving.com website!). To look at how the valuations earlier in the
decade may theoretically extrapolate in the future is absolutely worthwhile
– I just think it’s a separate (albeit related) extension of this research
path (and I only have so much room in any one issue of my newsletter!).
Nonetheless, this is still something I hope to explore further in the future
though!

In any event, the point here was simply to acknowledge that there ARE
valuation environments where higher SWRs appear to be “safe” (where
valuations themselves are more reasonable), but likewise to make the point
that today’s environment IS NOT ONE OF THEM. However, I also don’t find
today’s environment to be so valuation-stretched to imply that the 4% SWR of
the historical record is invalid – to the contrary, it appears to fall right
into the same category (as even your calculator indicates). Thus, the
conclusions of my research and how I stated it (which I’ll grant wasn’t
quite how BusinessWeek presented it, but you can’t always control how the
media portrays your research!). Could we get back to ultra-high valuations
again? Perhaps, although frankly I find it highly unlikely anytime in the
foreseeable future; the historical record also clearly shows that once
valuations start trending off of a peak, they ultimately dip below the
median and close to a historical low before another secular bull market
starts, so I find that a P/E10 of 12 is more likely sometime in the coming
decade than returning to a P/E10 over 30.

In any event, thanks again for sharing your website, your thoughts, and your
feedback. I will try to blog about your website myself and see if we can
make the planning community more aware of the great work that you’re doing.
And please don’t hesitate to contact me if I can otherwise be of service in
the future!

With much thanks and warm regards,

Michael