Tuesday, January 26, 2010

Thought of the Day

                                                                                                                                    Sydney M. Williams

                                                                                   Thought of the Day
                                                                                                                                    January 26, 2010

A five percent decline (in the S&P 500) in the last three days of last week spooked stock market participants. Ten years of negative returns have converted individual investors into speculators at best and stock-deniers at worse. Since the end of World War II, the S&P 500 has compounded at 6.6%. If one excludes the last two decades – the 1990s because they compounded at the extraordinary rate of 15% and the aughts because their negative 2.3% compounded return was equally extraordinary – the annualized returns were 6.9%, essentially the same.

Long term historical returns may provide little comfort to those who have seen their funds dwindle over the last few years, but I believe there is value in knowing where we lie along the grid. And those numbers suggest we are close to fair value – and that the next ten years are likely to provide better returns than the previous ten. But they also say nothing about rallies or relapses we are bound to experience in the months and years ahead.

There has been a significant change in the composition of the market, in the sense that forty years ago perhaps 10% of the population owned stock versus 50% today, but the individuals who were invested in stocks forty years ago did so with taxable money, while today they increasingly do so with tax exempt money. While I do not have the statistics, I would suspect that 90% of the money individuals invest in equities today is tax exempt money – pension, 401K and/or IRA accounts; that money is generally managed by professional investors, placing the investor at a distance from his money, a frustration as he has seen it evaporate.

Forty-odd years ago, when I started in this business, public companies were largely owned by individual investors. Beginning in the late 1960s, institutional investors began to dominate shareholder rolls; so by the 1980s the individual had become noticeably less important to corporate managers. A third major shift I have observed is the increase (and now dominance, at least in mutual funds) of tax exempt funds.

As tax consequences have receded in importance, it has been accompanied by a concomitant increase in turnover. Mutual funds, which once had 20%-30% annual turnover (suggesting three to five year holding periods), now turn over their holdings more than 100%. In many cases, hedge funds, the scourge of politicians and corporate managers, tend to be longer term investors than their mutual fund cousins. Corporate managements now, rightly in many cases, view shareholders as renters of stock, not as partners in an enterprise. And, while it should not, short term investing influences corporate decisions. Managing “Street” expectations has become an important function for CEOs and CFOs and deflects them from focusing on longer term projects. As options became more important to overall compensation, the timing of those grants has become more critical, often pitting management against shareholders.

It would be good to see Congress and corporations focus on this subject. With markets down over the past ten years, with baby boomers reaching retirement age and with Social Security close to bankruptcy, Congress should do what they could to encourage savings (and discourage consumption) by reducing taxes even further on long term capital gains and dividend and interest income. Such tax cuts would not only be gifts to the rich (the very rich already know how to handle their tax liabilities); they are imperative to the future of millions of middle class citizens. Despite the performance of the last decade (or perhaps because of it), individuals should be encouraged to own stock or funds, not discouraged. Fund managers should encourage and welcome taxable investors and should manage their funds accordingly. Corporate management should recognize that the assets they use and the cash they consume belong to shareholders, and are not for the purpose of pocket-lining regardless of performance.

The future is unknowable. The halcyon days that marked the 1990s crashed into a wall of carefree (and careless) investing. Very few people saw the end coming. (One who did was George Soros who in April 2000 was quoted as saying: “The music has stopped, but people are still dancing.”) Today, deleveraging by the consumer, worries about enormous federal deficits and concerns about the potential inflationary actions of the Federal Reserve (on this subject one should read Richard Fisher’s – President of the Federal Reserve Bank of Dallas – op-ed piece in today’s Wall Street Journal) present risk to the investor.

But, I have found that the market is frequently ahead of us – a lot of today’s concerns are baked into prices; so that the goal of investors should be to take a longer view and try to get a sense of change yet to come. With the market looking neither cheap nor dear, one should be able to concentrate on stocks and fundamentals and worry less about short term gyrations.

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