I explained in an earlier article here (“A Better and Less Risky Way to Invest in Stocks”) why you need to take into consideration the price at which stocks are selling when setting your stock allocation. Stocks offer lower returns and greater risk when purchased at high prices. So those who go with higher stock allocations when stocks are cheap and with lower stock allocations when stocks are overpriced can expect to be able to retire five to ten years sooner than those who follow Buy-and-Hold strategies, according to the academic research of the past 30 years.
The purpose of this follow-up article is to offer guidance on how to know when to change your stock allocation and by how much. I suggest a four-step process:
Step One: Identify the P/E10 Level
P/E10 is the current-day price of the S&P 500 index over the average of its last 10 years of earnings. This number tells you whether stocks are worth buying or not. P/E10 is the price tag for stocks.
Say that you buy $100 worth of an index fund at a time when stocks are priced at fair value. U.S. stocks have always generated an average long-term return of a bit over 6 percent real per year. So it is realistic for you to expect a $6 profit each year on your $100 investment.
Now say that stocks are priced at two times fair value. This means that only $50 of your $100 purchase price is going to obtain stocks. The other $50 is buying cotton-candy nothingness. You will likely obtain a $3 profit each year on your $50 investment in stocks (that’s a 6 percent return). But your return on the $50 of cotton-candy nothingness is going to be zero. So your overall return will likely be something near 3 percent ($3 of return on a $100 purchase).
If you pay three times fair value, your return will only be something in the neighborhood of 2 percent. If you pay one-half fair value, your return will be something in the neighborhood of 12 percent (when you pay only half of fair value, you obtain $200 worth of stocks for each $100 you pay).
The current P/E10 value is reported daily at this web site.
Small changes in the P/E10 level are of no consequence. And knowing the P/E10 level tells you nothing about how stocks are likely to perform in the next year or two. So there is no need to check the P/E10 value more than once per year. You should expect to need to make an allocation change once every eight years or so on average.
Step Two: Determine the Likely 10-Year Return for Stocks
The Stock-Return Predictor, a stock valuation calculator at my web site, reveals the likely 10-year return for stocks starting from any possible P/E10 level. A P/E10 level of 7 is amazing. Purchase stocks when the P/E10 level is 7 and you can realistically expect an annualized 10-year return of 17 percent real.
The fair-value P/E10 level is 14. Stocks represent a very strong long-term value proposition when purchased at fair value.
P/E10 levels between 20 and 25 are in the danger zone. Stocks sometimes perform well starting from these P/E10 levels. But stocks become risky when the P/E10 value exceeds 20.
Stocks become insanely risky when the P/E10 level goes above 25. There has never been a time when the PE10 level went above 25 and stock investors did not suffer a wipeout.
Step Three: Compare the Likely Stock Return With the Return Available from a Low-Risk Investment Class
I believe that I should be compensated for being willing to take on the risks associated with stock investing. So I am not willing to buy stocks when I can obtain an equal return from Treasury Inflation-Protected Securities (TIPS) or IBonds or Certificates of Deposit. Stocks start to look attractive to me when they offer a return at least 2 percentage points greater than the return I can obtain from a low-risk asset class.
Step Four: Consider Where We Stand in the Bull/Bear Cycle
Stock valuations do not jump randomly from super-low levels to super-high levels. They change gradually over a 30-year or 35-year time period. They start at super-low levels, move to fair-value levels, continue moving up until they reach insanely high levels, and then crash hard.
We are today at a P/E10 of 21, working our way down from a P/E10 of 44 to a P/E10 level somewhere in the neighborhood of 7. The Return Predictor tells us to expect an annualized 10-year return of 2.7 percent real. We likely will see returns far worse than that in the early years of the 10-year time-period (while stock valuations continue to drop) and much better than that in the later years of the 10-year time-period (after we achieve capitulation and begin on the path to economic recovery).
Please understand that you will not obtain the 2.7 percent return unless you hold any stocks you buy today for a full ten years. Unless you are certain that bone-crushing losses in the early years will not cause you to sell, you would be better off in some other asset class until the price for stocks improves a good bit more.
Rob Bennett believes that safe investing is profitable investing. His bio is here.