Trying to time when financial markets will go up or down is about as useful as betting your retirement money on a pair of dice. I’ve been a critic of this pseudo-science all of my life. However, there is one type of market timing that I agree with. It’s call secular market timing.
The word secular is derived from the Latin word saecularis meaning of a generation, belonging to an age. A secular market includes many bull and bear markets within in one large generational move, in which valuations move from one extreme valuation to the other. These peaks and troughs occur over the long term, 25- to 35-year periods on average.
Figure 1 highlights the secular nature of U.S. equities. It illustrates the peak price-to-earnings ratio (Peak PE) of US equities since 1871. Peak cyclical earnings are used in this Peak PE analysis.
Figure 1: U.S. Equities Peak PE since 1871
Source: US equity price and earnings from Robert Shiller, Yale University
Valuations were lower overall prior to 1950 because companies paid out a significant amount of their earnings as cash dividends. That changed as company boards began to retain cash for reinvestment and share buybacks. Nonetheless, a secular pattern still occurred in valuation.
There are many reasons why long-term valuation shifts occurred. They include − but are not limited to − war, inflation, overleverage, excessive speculation and taxation. It’s not possible to predict what will cause the next secular expansion or contraction, but it is highly probable that valuation volatility will continue.
Each generation will likely experience two secular markets in their investing lifetime. One secular market will likely occur sometime during the accumulation phase and another will occur sometime in retirement.
Can secular markets be used to help you make long-term investment decisions? It can at times, but only if you’re considering an asset allocation change in the next 10 years. The timing of secular moves, coupled with an investor’s individual financial life-cycle, can be an important element when deciding on a long-term investment strategy.
Suppose your goal is to accumulate $2,000,000 in a retirement account before age 62. You’ve been saving and investing diligently, and by age 55 you have accumulated $1,200,000. Mathematically, you’re on track for $2,000,000 if you continue to invest new money and the return of your portfolio is 7 percent annually.
Unexpectedly, the stock market begins to soar. Valuations jump from 15 times earnings to 22 times earnings over a three year period. Your investment account jumps from $1,200,000 to $1,800,000 including contributions and you’re only 58 years old. You’re not going to retire for another four years, so what should you do?
Here is where market valuation comes in. Are you going to risk your retirement on high market valuation or are you going to stick with the original plan and reduce risk? Let’s say you’re contemplating two options: you can increase your retirement goal to $2,200,000 and maintain the same allocation to stocks, or you can decrease the risk you’re taking in stocks and coast into you original $2,000,000 goal.
When the valuation of stocks is high, I would strongly recommend the second option. Reduce risk down to your retirement allocation to stocks and coast into $2,000,000. This is the most prudent strategy. Many pre-retirees didn’t make this choice in 2000 and they suffered dearly for it.
In contrast, when market valuations are low, you have a more difficult choice. You could maintain your accumulation allocation to stocks and hope for a higher amount in retirement. This may enhance your standard of living in the years ahead, but it also means taking unnecessary risk. Perhaps a compromise could be a solution where you reduce down to your retirement allocation with half the assets and retain the higher allocation with the other half.
In summary, stock valuations do matter, but only during a time in your life when you looking at an asset allocation change in the next 10 years anyway. A high valuation means taking the most prudent course of action, while low valuations give you some flexibility.