How Shiller's CAPE Ratio Is Important In Managing My Grandchildren's Section 529 Accounts.

When my two grandchildren were born, I established a Section 529 College Plan for each.  As you probably know, these are attractive because the capital appreciation in the account is tax-free, as are the distributions out of the account if they go toward financing the beneficiary's college education.

To illustrate how I use Shiller's CAPE ratio to help me manage these accounts, let's consider the account for my grandson.  It was just dumb luck that he was born in November, 2008--right after most stocks bottomed in October that year.  I began investing right away, and ultimately put in a total of $154,000.

The New York State 529 College Plan is managed by Vanguard, which allows the money to be invested in a number of their no-load mutual funds.  Unfortunately, Vanguard's Standard and Poor's 500 Index Fund wasn't one of the choices. I asked Vanguard to determine a mix of available funds that would correlate highly with the performance of that Index.  I invested in those funds.  As of last Friday, the account now totals $396,000.

I called my alma mater to find out what tuition, room, and board costs a freshman this year, which is
$70,000. And one could expect that number to compound at an annual rate of between 3% and 7%, he said. (At my fiftieth reunion, the compound annual growth during that half a century was 6.3%.)
So for planning purposes, I assume the worst--that college costs compound at 7% a year.

Now you might think that I would relax since my grandson's account already  has almost $100,000 a year in it, and there are almost ten years left before he enters college.  Wrong!

As you know, I have adjusted Shiller's mean CAPE ratio to take into account only his last fifty years of data.  My adjusted mean P/E ratio is 19.8, well above his 16.8.  As of Friday,  Shiller's CAPE ratio was 34.8, which means the Index is 75% overvalued using my adjusted mean P/E.  So, if mean reversion were to  occur immediately, the Index could fall 42%.  In that case, rather than $100,000 a year available, my grandson would only now have $58,000 a year--well below the actual cost of $70,000.  So rather than being well ahead, the account is really "behind the eight ball!"

Furthermore, the compound annual total return for the Index (inclusive of dividends reinvested) during  the next 10 years until he enters college is likely to be, at best, little more than 3%.  Meanwhile, annual tuition, room, and board could be $140,000  ten years from now.

So what's a grandfather to do?  I could take my chances and keep the account fully invested in equities.  Or I could reduce the equity exposure and bet that I can buy back at significantly lower prices.  Last Friday, I reduced the equity exposure to 50%.

This outlook is daunting for other long-duration accounts as well.  Most notable are the government pension funds who can't meet their future obligations without assuming an annual return of 7% over the next ten years.  They will be lucky to achieve 3%.  The difference must be made up by a combination of increasing taxes, borrowing more, or cutting entitlements.  Not a pretty picture!