I recently came across an excellent article by Todd Tresidder discussing the many imperfections of the 4% withdrawal “rule” for retirement planning. In the article, one of the suggestions Todd makes is to incorporate market valuation levels (as measured by PE10) into retirement planning decisions.
Because using market valuation (most commonly measured as PE10) as an input in investing decisions is a topic that comes up fairly often, I thought it might be helpful to share my thoughts here on the blog.
What is PE10?
PE10 is calculated as the current market price of the S&P 500, divided by the average of the last ten years of inflation-adjusted earnings for the S&P 500.
Like regular P/E ratios, the idea is that it can be used as an indicator of whether the current price (of the S&P 500, in this case) is high or low relative to earnings. The purpose of using ten years of earnings rather than just one year is to eliminate the impact of meaningless short-term fluctuations in earnings.
Uses of PE10: Asset Allocation and Withdrawal Rates
The most common suggested use of PE10 is to use it to make asset allocation decisions. For example, researcher Wade Pfau wrote a fascinating paper showing that from 1871-2009, a market timing strategy using PE10 (i.e., moving to stocks when the market is at a low PE10 and moving to Treasury bonds when the market is at a high PE10) would have significantly outperformed a simple portfolio with a fixed 50/50 stock/bond allocation.
A second, related use of PE10 is to use it as an input when deciding how much you can safely spend from your portfolio per year in retirement. Again, Wade’s research on the topic is excellent. He shows that, historically, the higher the market’s value (relative to earnings) when you retire, the less you can safely spend from your portfolio per year.
Why I Don’t Use PE10
Despite the data showing the historical usefulness of PE10, I’m not comfortable using it for my own portfolio decisions.
As a general rule, the market does not like to be predictable. For the most part, once market inefficiencies (i.e., patterns that can be used to reliably outperform the market) become well known and easy to exploit, they tend to disappear.
It seems entirely likely to me that PE10’s predictive value is a market inefficiency like any other and that the primary reason it has existed for so long is that there was no way to exploit it. That is:
- Prior to computers, it would have been an enormous task to even calculate PE10, and
- Prior to the existence of no-load index funds (i.e., prior to 1977), there was no cheap, easy way to invest in the market as a whole. Moving in and out of stocks to capitalize on PE10’s predictive value would have meant buying or selling a large portfolio of individual stocks and paying transaction costs that are far higher than they are today. (Higher commissions, higher bid/ask spreads, and usually higher taxes.)
So rather than a data set of 140 years, we’re left with just 34 years (1977-2010). For an indicator that is only supposed to have useful predictive value over periods of 10+ years, 34 years isn’t a heck of a lot to go on.
Is Using PE10 a Terrible Idea?
Despite my personal lack of confidence in PE10 as a useful predictor, I think I’d place PE10-based decisions in the group of investment approaches that are at least reasonable — far better than, say, day-trading individual stocks.
For instance, if PE10 was at a historical high at a time when TIPS yields were also very high, I wouldn’t fault somebody for moving more of their portfolio to TIPS. Similarly, I think it would be reasonable to use a lower withdrawal rate if you retire at a time with unusually low TIPS yields and an unusually high PE10.
On the other hand, I’d be extremely reluctant to suggest either moving more of a portfolio to stocks or using a higher withdrawal rate from a retirement portfolio just because PE10 is low by historical standards.