The concept of secular bull and bear market cycles are relatively straightforward - high valuation levels tend to lead to extended periods of sub-standard performance, and the reverse is true when initial valuations are low. This has been supported in research ranging from Robert Shiller's Irrational Exuberance and his P/E10 ratios to Ed Easterling of Crestmont Research (and his great book, Unexpected Returns: Understanding Secular Stock Market Cycles), and more. The implication - don't take so much risk in high valuation environments, and load it up when valuations are low (favorable).
Yet the implications of market valuation extend beyond just the portfolio. As I have written in The Kitces Report, they also have a significant impact on determining a safe withdrawal rate when someone retires. Those who retire in favorable valuation environments have safe sustainable spending levels that start 20% higher than those who retire when stocks are overvalued.
And I believe the ramifications extend even further. Overvalued markets - with a high risk for market declines - also increase the risk of a significant market decline. And even if the decline is temporary, the impact on an individual's saving behaviors can be long-lasting. The point being - even young investors with incredibly long time horizons must be cognizant of market valuation, or they risk damaging their long-term financial success, even if the long-term return eventually averages out to what was anticipated!
Market valuation can also be relevant for tax decisions. Investors often trying to hold onto investments for the long-term for tax reasons - whether it is to hold an appreciation position long enough for it to qualify for preferential long-term capital gains rates, or simply an unwillingness to sell a position and take a gain (and some risk) off the table because of the tax impact that will occur. Yet the reality is that it takes a remarkably small decline in an investment to completely wipe out the benefit of years of tax-deferral. The end result - perhaps we should be far more aggressive about taking our gains (and cutting our losses) in high valuation environments, and be more open to letting our winners run and our losers try to recover when favorable valuations support it. Similarly, an acknowledgement of valuation could shift an individual's decisions about when to sell a business, or exercise stock options.
The impact of valuation on long-term market returns is also relevant for most forms of financial planning projections we analyze. Return assumptions for a retirement plan might be adjusted upwards or downwards to account for current valuation levels. Monte Carlo projections may acknowledge a dispersion of potential returns, but the probabilities could be adjusted further to account for a valuation environment that still further underweights or overweights the risk of a bad return sequence or the possibility of a good one.
The bottom line is that a long-term average is a useful piece of information, but it just doesn't tell the whole story. And once you begin to account for how markets are valued, the implications quickly spread beyond just a pure discussion of portfolio composition.
So what do you think? Is market valuation a relevant factor in your financial planning discussions? Should it be?