What the Romans called the Dog Days of Summer took an inordinate toll on investors psyches this time around. The traditional, pre-Labor Day miasma just might be ending on a promising note (witness the Market’s response on Friday 9/27 to objectively negative news re BA, INTC and Q2 GDP), but August certainly turned out to be a good month for investors to have their attention diverted elsewhere. We find ourselves trying to understand a seeming disconnect between what sure looks like “good enough” global economic growth and apparent equity valuations. Investors have been given a steady stream of reminders that based on what corporate acquirers are willing to pay, (the 3Par auction being quite the outlier from what looks like an “up 35%+” norm). Nonetheless, equities are undervalued and discouragement continues to rule the day. It’s beginning to remind me of the last time the world gave up on equities. This has me thinking about a very important change that has taken place over the intervening era, which is presently complicating what I still believe is inevitable recovery.
The “last time” I have in mind was in 1981, when I started in the business. There was palpable discouragement about the stock market back then. Most of the old hands (i.e., had lasted more than two years) at the brokerage firm would tell you it had been a very long time since they had enjoyed the business. This was because like today, equities had not delivered for upwards of ten years. Unlike today, investors could earn very high nominal rates on money markets, but otherwise it seemed like real estate and perhaps oil & gas partnerships were the only games in town. Commodities were in the late days of finding favor as well. These sentiments could not have been more wrong over the ensuing five, ten or twenty years. Yet here we are, thirty years later, with going on eleven years of disappointing returns having inflicted a quite similar funk.
I believe that this despond will pass, that at some point in the next few years money will begin to flow in earnest out of sterile assets like commodities or fully priced bonds and back into equities. It will happen as inexplicably as it did (sans the hindsight we now enjoy) through most of the 1980s. In a way, it simply has to, for a reason that is presently complicating our slow motion recovery. This complication revolves around a very important change that was implemented in 1980. That was when changes to the IRS Code, most notably Section 401k, took effect and began to shift the risks and uncertainties of retirement planning away from corporations and toward households. It had been correctly observed that a host of factors, most notably medical technology, were increasing life expectancies and so turning post-retirement obligations into open ended liabilities. A better way had to be found, and indeed it was. Over the ensuing decades, 401k and similar qualified plans would supplant defined benefits plans in most of the private sector. I can remember hearing Sir John Templeton, just a few years into it, predicting a sort of “people’s capitalism” coming to pass as a result. I can also remember wondering at that time what the unintended consequences of such a development might be. We are now very much in the throes of one such consequence.
What I have in mind is the mirror image, if you will, of another consequence as it played out a dozen or so years ago. It rests on the premise that these assets loom large in the psyche of a large and, in terms of consumption, very important segment of the economy. To the degree that defined contribution plans have grown to be something of a cornerstone of perceived financial well being in millions of households, “how the accounts are doing” will affect behavior, especially when it comes to discretionary consumer spending. This was readily observable during the Tech Boom. 40lks and other such plans burgeoned (along with home equity and, for a few, stock options). I would submit, though, that it is not just the value of the account but what the investor assumes to be a realistic return out into the future that affects behavior. When, in 1999, the retirement account was bigger than expected, it made households feel richer than they really were. Perhaps more importantly, the notion that said balance could realistic grow at 20% had a profound effect as well. If such growth was indeed possible, it meant that one really didn’t have to contribute to savings any more. What was the point if we were all going to be so fabulously rich anyway? Indeed, it was in many instances quite rational that one could spend 100%+ of one’s income from labor, as the expected asset value growth would more than make up the difference.
So here we are today living through an opposite sort of development. That 401ks and the like are not in 2010 as capacious as millions of households now with ten fewer years to work with thought they would be in 2000 is well advertised. Perhaps less well thought out is what has happened to the assumed return portion of the householders thought process. It has been a very long time since anyone who was not either extremely gifted or extremely delusional could muster much confidence at earning a return that was even close to double digits. This takes a toll on discretionary spending both subjectively (i.e., feeling less flush and so less inclined to feel like spending) and objectively, insofar as acting on the felt need to save more for retirement leaves less cash available. This brings us to the problem at hand. The confidence to spend on anything but necessities, to outsource all manner of household chores and all kind of decisions that make for a vibrant economy, has come to be very dependent on what households expect their retirement plans to earn “for the duration”. When this expectation, a fragile thing to begin with given the experience of the past decade, takes a hit as has since late April, this willingness to spend takes an even bigger hit. Not in every household, but in enough of them to effect the data in ways that scare the bejeebers out of those who seemingly live and die by economic data. That such fluctuations in expected returns (a highly subjective thing for most us, no?) would dampen spending and so economic activity and so create a bit of a destructive feedback loop has turned out to be something of an unintended consequence of the people’s capitalism that was set in motion in 1980.
I do not believe that this is any kind of definitive factor, that some kind of death spiral around retirement account values and consumer spending is going to drag us into an interminable recession. More likely, it is just one more thing that makes recovery what we all expected a year and a half ago: numbingly slow, but enough to keep the global economy expanding. But on the matter of qualified plans, I would note one other very important development that thirty years of evolution have brought us to. The changes wrought by Congress in 1979 fundamentally altered and improved Corporate America. The capital to fund so much of what was accomplished over the balance of the century would have been much more costly if a path away from such open-ended liabilities had not been created. But it only transformed part of the economy. While defined benefits and post retirement health care obligations by corporations have been eliminated or largely tamed (with a few notable exceptions, but even the auto industry reached something of an end game on this), the public sector is another matter entirely. The retirement obligations of state and local governments has been a very smelly elephant in a very crowded room for a very long time. (I can remember it posited as a looming crisis when living in New Jersey in the late 1980s.) Nonetheless, when times are good and asset values seem to trend inexorably higher, our ability to disregard smelly elephants knows no bounds. This is one of the things that ended when asset values crashed. Among other things, the Crash made stark the disconnect between those who, per the 1980 change in the rules, were rendered personally accountable for their retirement security (over and above SSI) and those who continue to enjoy a lifelong financial security on the taxpayers’ dime. Once reality was reimposed, egregious contractual obligations entered into by conflicted politicians could no longer be ignored. Life long health with no contributions, the opportunity to retire at 50 and then double dip, and all being paid for by increasingly insecure feeling taxpayers, this simply will not stand. There is no place for what the Governor of CA recently called a “protected class”. I see this issue, which by being about comfort and security in one’s old age, as well as basic fairness, is as viscerally as they get, as being at the very fault line that defines political struggle du jour. It is energizing what has turned into a class based conflict, and the “not-so-protected” class is a lot bigger and a lot more worked up.
How this sorts out over the next decade or so will get a few degrees clearer in November, as blessedly, we seem to be able to work these class struggle thingys out with ballots as opposed to bullets. In the meantime, the Market will continue to exasperate us if we watch it too closely. But as time goes by, as households reliquify and most importantly, as the last bit of juice gets wrung out of a fixed income market that has feasted on that clamor for specious certitude, money will start to flow back into equities. Either that or the savers and investors are ready to settle for next-to-nil returns “for the duration”.
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