The Unintended Consequences of 401k

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”.

Like Watching Paint Dry

Earnings release season for Q2 10 has pretty much run its course, and wary optimism has certainly paid off since our last Musings. The Market seems to want to go higher, more in synch with a steadily recovering (from the Panic of 2008 and the nano-panic wrought by the imminently dissolving Euro) global economy than with the like-watching-paint-dry recovery as indicated by U.S. economic data. Its reactions as companies opened up their kimonos and revealed what in the aggregate was a rather fine fettle seemed more indicative of Price Reality dysfunction (i.e., a surfeit of speculative interest running so roughshod as to demoralize all but the hardiest of investors) than anything else. The Q2 results clearly confirmed that “back from the brink” as defining trend remains intact. Yes, there was a pause in there, a prudent tap on the brakes by business decision makers that rippled back up the supply chains, but it was just a tap. The volcanic ash quickly settled, the oil dissolved into vapors and rock, Europe remembered that slow decay is normal course of things in most of its principalities, and that hit to household wealth that is Market correction spent the last, for the time being, of its fury. Then it was all down the memory hole in no time at all.

The wall of worry continues, and the Market continues to climb it. There is always a mix of good news and bad news; it’s just that at any given time one kind tends to get a lot more attention than the other. Europe has for longer than any of us have been around been a bad accident waiting to happen. It took a regime change in one of its creakier entities, along with the wholesale re-set of pension asset values inflicted by 2008, to remind us of this fact, but we soon learned that the powers that be are well practiced in art of kicking it down the road. This has caused the congenitally worried crowd to shift their focus to whatever uncertainty lingers about the U.S. economy. We have been treated to an almost daily litany as to how slowly, fitfully, unevenly the economy is recovering. Earnings were for the most part gangbusters, but what about revenues?, the naysayers lament. Home sales took a post-subsidy dip, but who didn’t expect that? (We are also supposed to be dismayed about lack of progress in reducing the number of homes for sale, as if would be sellers who were prudent enough to take their homes off the market during the Panic would not try again once they saw signs of recovery in their particular markets.) But nowhere are the howls of dismay more plaintive than on the matter of jobs, or the lack thereof.

All this blather about a “jobless recovery” strikes me as simply the most convenient way to keep things “interesting” on behalf of those interests who benefit from a high level of day-to-day volatility. That weak jobs growth is being posited as an indication of a sputtering economic recovery strikes me as farfetched in the way the things go when someone seems to be trying get you to zig when its time to zag. The purportedly weak growth is just about as one should expect, given the hand we have dealt ourselves. In every downturn since about the time “data processing” became IT (who knows, maybe even before then, but none of us were around to take note) some jobs just go away and don’t come back. (Think steel making, c. 1982). Such is the discontinuous nature of creative destruction. This tendency became even more pronounced once that 25 or so year golden era that was the result of WW2 (i.e., what we now call global competition having had time to rebuild from the rubble and start to give us a run for our money) had run its course. Global competition of the sort that has defined the past twenty years imposes a certain discipline that creates at least some drag when improving prospects prompt a need to consider adding more employees. Add to this secular shift a heightened level of uncertainty with respect to taxation, regulation and mandated expenses, and we should not be surprised that companies are not hiring as fast as the politicians and the marginally employable would like.

It also matters that so many of the “talking heads” of the investment world live and work in parts of the country that have the most serious impediments to recovery. Money centers like NYC, Boston and LA have systemic issues generations in the making. They boomed harder and then busted harder. They enacted policies and face topographic constraints which exert upward pressure on how much it costs to live there, which steadily eats away at their erstwhile advantages. While some parts of the country didn’t boom or bust quite so hard, if at all, these place are facing serious, persistent hurt. So while much of the rest of the country is getting on with it, it still feels like acute recession where most of said talking heads live, work and occasionally breed. They draw their oxygen from precisely those places that have fallen the furthest and as of yet have the least sanguine prospects of recovery. Being surrounded by lingering despair, with so many intractable obstacles (though if Governor Christie could balance NJ’s budget without raising taxes, who is to say what is intractable?) cannot help but bleed over into one’s assessment of the world’s future. I would submit that there is a whole lot more country out here that is finding its way forward, not as quickly as some would like, but quickly enough.

The July jobs report did not indicate that the economy was shrinking or even slowing down, though slower y/y growth is certainly what we should expect as the near death experience of 2009 gets anniversaried and then some. Private sector jobs were created, it just wasn’t as many as a consensus of economists had guessed it would be. What I see in the aggregate number, though, was little remarked upon. Yes, a big part of the decline was all those census workers being sent back to their respective couches. Everyone expected as much, and if they were in the estimate business they had no problem cranking that into the equation. What is being missed I would like to call the Chris Christie Effect. Employment is heading south when it should be growing because state and local governments, most remarkably the Garden State, of all places, are owning up to past profligacies and bringing their budgets back closer to earthbound reality. This means cutting expenses, which means hiring freezes and maybe even letting a few “workers” go. It no doubt also means cutting back on some contracts, which in terms of jobs bleeds over into that which is classified as private sector. It is the long overdue actions by the likes of Gov. Christie that is weighing on that statistical indicator of economic recovery we call jobs creation. And this is but one of many reasons that recovery, lived a day at a time by those of us who have money on the line or find ourselves at the margins, employment-wise, find it so much like the proverbial drying paint.

One other item from this slow news week we seem to have been in of late, a “you heard it here first” regarding the 2012 election: The question of who will run on the Democratic ticket is getting more interesting than who the Republicans will run. This latest installment of the White House’s Permanent party/vacation strikes me as bizarre. What can they be thinking, spending the hard pressed taxpayers money on a junket for “forty close friends” at a luxury resort in Europe? This, on top of how many other high dollar excursions? One gets the sense that they get the sense that the “good life” presently available is not going to last much longer, so get it while you can. The trip to Spain, when so many of the rest of us are settling for a downsized vacation or none at all, was so over the top as to make me wonder if she is not, in the lexicon of therapy, “acting out”. If so, we should not be surprised if in the months ahead we get something quite a bit more dramatic, something that will be remembered a generation from now. We should also not be surprised if someone within the Administration not the President moves to the head of the ticket in 2012. We can be sure that she and her husband would like nothing more than to regain that good life that they experienced when they resided at 1600 Pennsylvania, and that they have been laboring assiduously to bring that to pass. Their friends and allies will continue the slow, as yet too subtle to notice, poisoning of the incumbent and everything he touches, ahead of the day when she, festooned with cartoon accomplishments, will step forward and into the breach. (Now wouldn't a fight between her and the grizzly mom be a treat to watch?)

That is an early heads up of potential drama well down the road. For the moment, it's all about global economic recovery. My take on Earnings Season, Q2 10, was that tepid jobs growth notwithstanding, the global goods producing economy is on the mend. Despite this, traditional equity owners are so disheartened by a decade of unacceptable returns, and so frazzled by what has become the 200 pound tail that is Speculation wagging what has withered into a neutered shih tzu of the rest of the Market, that valuations languish as if its never going to get better. With such valuations, the economy does not have to get up and run for investors to do well. A slow, dull as watching paint dry, even halting, recovery, as households and corporations continue to fortify their balance sheets, will be all that is needed for patient, gutsy investors to reap an ample reward over the next couple of years.