Six years ago I went to Vegas with a bunch of family and friends to celebrate my 50th birthday. Since one of my nieces was going to East Carolina University at the time, I jokingly proposed that we all get t-shirts emblazoned with the words, “ECU Blackjack Team.”
It’s a good thing we didn’t. No need to embarrass my niece and her school. We sucked at blackjack—especially me. I don’t know what it is. It’s a simple game, providing you can count to 21. But for the life of me, when I’m actually playing, I lose my ability to count. I always have to ask the dealer what my count is. Pretty sad.
Anyway, I bring up my pathetic blackjack skills because I see a parallel between counting cards and the Shiller PE Ratio. And this parallel is especially important, given that Mrs. Groovy and I are in the critical first 5 years of our retirement. Let me explain.
Counting Cards and the Shiller PE Ratio
Counting cards, like the game of blackjack, is pretty straight forward. You assign a +1 to the low-value cards in the shoe (2-6), a zero to the medium-value cards (7-9), and a -1 to the high-value cards (10, Jack, Queen, King, and Ace). Then, as the cards are played, you mentally sum them in your head. If you reach a point where the sum has a high negative value, this means there’s an abundance of low-value cards left in the shoe, and this situation favors the dealer. If you reach a point where the sum has a high positive value, this means there’s an abundance of high-value cards left in the shoe, and this situation favors the player.
Now a question. If you’re counting cards, and the count favors the dealer, should you bet big? Or should you bet the minimum? If you said “bet the minimum,” go straight to the head of the class. If the reverse were true, and the count favors you, your betting strategy should flip. You should be betting more than the minimum on each hand.
In the investment world, the Shiller PE Ratio is the equivalent of counting cards. For those who may not know, the Shiller PE Ratio is the price-earnings ratio of the S&P 500 based on the S&P 500’s average inflation-adjusted earnings from the previous 10 years.
Wow. That’s a lot of gobbledygook, I know. But here’s the important number to keep in mind. The historic median of the Shiller PE Ratio is 16.14. If the current Shiller PE Ratio is much higher than that, the Wall Street “shoe” is rich in low-value cards, so to speak. The investment landscape favors the dealer (i.e., returns in the immediate future have a good chance of being negative), and the player, the retail investor, should minimize his or her bet on stocks and be more defensive (i.e., increase the bonds and cash portions of his or her portfolio).
To see the card-counting quality of the Shiller PE Ratio, consider the year 1999. In December of that year, the Shiller PE Ratio climbed to 44.20. That’s almost three times the historic median—not many high-value cards were left in the shoe. And sure enough, over the next three years, the dealer won big. The S&P 500 had a -38% return.
In contrast to 1999, let’s take a look at 1932. That year, the Shiller PE Ratio sunk to 5.57 in June—almost two-thirds below its historic median. The shoe was chock full of high-value cards. And any investor who realized this and upped his or her bet on stocks was rewarded handsomely. Over the next three years, the S&P 500 was up 117%.
Bad Moon Rising
I hear hurricanes a-blowing
I know the end is coming soon
I fear rivers over flowing
I hear the voice of rage and ruin
Don’t go ’round tonight
It’s bound to take your life
There’s a bad moon on the rise
I’m not going to sugar coat things. I’m nervous about the stock market.
First, Mrs. Groovy and I have only been retired for a year, and the notion of sequence risk looms large. Investopedia describes sequence risk as follows:
Sequence risk, also called sequence-of-returns risk, is the risk of receiving lower or negative returns early in a period when withdrawals are made from an individual’s underlying investments. The order of the sequence of investment returns is a primary concern for retirees who are living off the income and capital of their investments.
Put in layperson terms, if you’re a newbie retiree with a portfolio heavily weighted toward stocks, and the stock market crashes—à la 2008—your portfolio will be seriously compromised and you just might need to un-retire yourself. Ouch. This is bad.
The second thing that makes me nervous about the stock market is this: the current Shiller PE Ratio is 31.38. That’s almost twice the historic median. And although the Wall Street shoe may not be chock full of low-value cards, it has enough of them to make any thoughtful investor wary. The advantage is clearly with the dealer.
So there you have it. I’m nervous because sequence risk and the Shiller PE Ratio are unmistakably crying out: tread lightly on stocks. If Mrs. Groovy and I were in our 30s, we wouldn’t give a rat’s ass about either. We’d be dollar-cost-averaging machines. But we’re in our mid-50s. There are no more paychecks to fortify our Roths and 401(k)s. And most importantly, we love this retirement thing. Waking up each day knowing we don’t have to work is nothing short of glorious. The last thing we want to do at this point is screw things up and find ourselves back in cubicle hell.
When I was younger, I wasn’t very adept at heeding warning signals. No more. Sequence risk and the Shiller PE Ratio say tread lightly on stocks, I’m treading lightly on stocks.
Our portfolio allocation is currently 35% stocks and 65% bonds/cash. And our stock exposure will remain in the 35% range as long as we’re less than five years removed from the day we retired and the Shiller PE Ratio is north of 20.
Will minimizing our bet on stocks sacrifice our portfolio’s returns? In the short run, yes. The S&P 500 is up almost 15% so far this year. Our two Roth accounts, however, which mirror our overall 35/65 allocation the closest, are only up a little over 9% each. And our underperformance may continue for several years.
But the Wall Street dealer has a knack for humbling giddy players (see the years 1929-31, 1937, 1973-74, 2000-02, and 2008). And at this stage of the game—one year into retirement—we can’t afford to be humbled.
Besides, a 9% return ain’t that bad. Moreover, sequence risk will eventually subside, and the Shiller PE Ratio will eventually favor the player. And when that day comes, we’ll have plenty of chips left to be more aggressive with our stock bets (hello 60/40 allocation).
Okay, groovy freedomists, that’s all I got. What say you? Are we being too wimpy with our stock allocation? Or are we playing it right, given that we’re new to retirement and the Shiller PE Ratio is rather high? Let me know what you think when you get a chance. Peace.