“A Future for Stocks?”

Sydney M. Williams

Thought of the Day

“A Future for Stocks?”

August 8, 2012

When the government cannot keep its own house in fiscal order, what sort of a message does that send to struggling households? When political cronyism allows a small group of investors to walk away whole from investments that cost taxpayers hundreds of millions of dollars – I am thinking of Solyndra – is it a surprise that cynicism about cronyism between finance and politics is on the rise? When criminal behavior in markets – I am thinking of Jon Corzine and MF Global – go unpunished, is it surprising that people perceive markets to be rigged? When individual investors read that Knight Capital, a firm that most have never heard, loses $450 million in a matter of minutes what does that do to investor’s confidence? With stocks lower than they were a dozen years ago, what message does that send regarding future returns?

There are certain truisms in markets. Extrapolation of the recent past generally governs behavior. Markets are not static. Greatly overvalued markets become grossly undervalued and vice versa. Because markets reflect behavior and expectations, they are impossible to quantify with any precision, despite protestations to the contrary by analysts, technicians and strategists.

The economy and politics are joined like Siamese twins. However, the more closely the two are linked, the less predictable becomes the behavior of the market. Empirical evidence suggests that government cannot make intelligent investments, as we all know too well. On the other hand, commentators like George Friedman, who wrote in an August 7th piece “Financial Markets, Politics and the New Reality,” find that, in terms of allocating capital, the recent performance of the financial community “has been equally unacceptable.” The statement, as it stands is true, but much (but not all) of the bad performance of financial institutions was forced on them by complying with regulations laid down by agencies such as the Community Reinvestment Act, and with an unnecessary assist provided by the Federal Reserve with artificially low interest rates that encouraged reckless behavior on the part of banks and individuals. Would leverage have become so universally employed had money not been so cheap?

In a recent “Investment Outlook”, Bill Gross wrote, “The cult of equity is dying.” That was news to me, because I thought it already was dead. As Vince Farrell wrote yesterday, “Money has been flowing out of equity funds like water into the Titanic. Fifteen years ago today the S&P 500 closed at 933.54. Yesterday it closed at 1401.35. That provided investors, before dividends, an annual compounded return of 2.8%. Over that same decade and a half, inflation compounded at 2.4%, leaving very little in terms of a real return. Twelve years ago, the S&P 500 closed at 1482.80, 5.5% above where it closed yesterday. Inflation only worsened returns. Andrew Ross Sorkin is right when he wrote in yesterday’s New York Times: “Let me offer a more straightforward explanation of why investors have left the stock market: it has been a losing proposition. An entire generation hasn’t made a buck.”

Trading on the consolidated exchanges has been in decline for the past three or four years. Aggravating that trend has been a concomitant increase in high frequency trading, programs in which algorithmically programmed computers trade for fractions of pennies. Such trading strategies now account for an estimated 70% of all trading. What purpose do they serve, apart from enriching a few while providing potential chaos for the many? While they purport to add liquidity, anecdotal evidence suggests the opposite. Index funds and ETFs have permitted investors to purchase baskets of stocks, ignoring individual stock selection in favor of a commodity-like approach, in which all companies within one category are treated the same. Increasingly professional portfolio managers have been able to disregard the tax effect of trading, because more and more of the portfolios they manage are comprised of tax-exempt retirement funds. This has led to shorter holding periods; technicals have subsumed fundamentals in importance. Average holding periods for stocks, which in 1975 were around seven years, have fallen to six months.

More than anything, and no matter the cause, it is a lack of confidence that is spooking investors. In large part this is simply the natural reaction of markets to compensate from previous excesses. The length of the hangover must roughly equate to the length of the party – the party which came to an end twelve years ago this past March. Market returns since have been abysmal. Technology has changed markets drastically, in terms of portfolio structure and trading; allowing high frequency traders to distort markets and front-run traditional orders. Criminal behavior has too often gone unpunished, especially in those cases where the market participants have political ties. Cronyism is a blemish difficult to erase. But most important, in my opinion, is the lack of investor confidence, which is a function of what John Taylor, the Stanford economist and author of First Principles, calls the failure of government to adhere to a “predictable policy framework.”

Businesses are sitting on about $2 trillion in cash, hesitant to invest, as they wait to see what will happen at the end of the year. Temporary fixes do not work. (One exception would be the temporary lifting on restrictions on repatriating corporate overseas cash.) The Republican plan to extend all the Bush tax cuts for a year, while better than the do-nothings in the White House and Senate, will not work. What will revise investor confidence are policies that are permanent in nature: reforming the tax code – lowering overall rates, eliminating myriad deductions and broadening the base – and dropping most of the 4000 federal rules that are sitting in the wings and which are expected, according to Investor’s Business Daily, to “saddle businesses with $500 billion in compliance costs.” Greater predictability would allow businesses to invest the money sitting on their balance sheets, which would then allow corporations to start hiring.

In 1980, Ronald Reagan was elected President. The Dow Jones closed that day at 937.20. Two months later it was up 7.25%. It then declined over the next year and a half until August 1982, as the effect of the sharply higher interest rates, instituted by Paul Volcker and supported by President Reagan, placed the country in a short but steep recession. However, their policies rid the country of inflation that had been destroying asset values, and then set it on a course for a sustained two-decade run. The problems are different today. For years, we have spent what we could not afford. As a consequence, we have too much debt. But today’s lack of confidence, in markets and institutions, mirrors the experience of the 1970s.

There are too many people in positions of power who are either ignorant of the consequences of their financial policies, or who choose to ignore them. Private and public pension plans are using too-high discount rates to determine their unfunded liabilities – meaning they are underestimating the magnitude of the problem. Bill Gross points out that the 100-year 6.6% return to stocks may prove too aggressive for a nation that is far more mature than it was a century ago. And returns to bonds, given current rates, may well prove negative over the next decade or so. Thus, using discount rates of 7% to 8% is misleading, and is another example of kicking the can down the road. The bigger question asks: Is this trend of moving away from equities more secular than cyclical in nature? I don’t know, but I suspect we remain in a long-term, secular correction from a greatly inflated market. However, unlike bonds that have seen their bull market persist in this time of economic uncertainty, stocks have been in correction for more than a decade. Valuations may not be dirt cheap, but relative valuations look attractive. There are dozens of S&P 500 companies with dividend yields in excess of the Ten-year U.S. Treasury Bond, stocks with reasonable likelihoods of dividend increases. They would appear more attractive than their bond equivalents.

We are, as I wrote at the top of this piece, prisoners of our most recent experiences. That means we are less likely to experiment with something new. The tendency is to disappear into a cocoon. As George Friedman puts it, “The latest generation of investors wants to control risk, rather than take advantage of new realities.” The bear markets of 2000-2002 cost investors $6 trillion. Much, but not all, of that loss was recovered by 2007. The subsequent market decline and collapse of housing prices cost investors and homeowners twice as much as the earlier loss. Like groggy boxers trying to lift themselves from the canvass, investors are skeptical of stepping back into the ring.

No matter which way the election goes in November, the economy will face headwinds, including an over-indebted Federal government, deleveraging consumers and a disjointed Europe. But attitudes can change quickly. A greater reliance on markets, incentives to work and predictable policies can cause investors to become convinced that tomorrow will be better than today. Renewed confidence will inject new life into the economy and our markets. Such confidence is unlikely to come from our incumbent President. Our best shot is with Mr. Romney.