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Softpanorama |
May the source be with you, but remember the KISS principle ;-)
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The wisdom of holding stocks and bonds in a 401K portfolio became suspect in the 1990s. Who needed bonds? Stocks were the investment of choice. In 1999, the S&P 500's return topped 20% for an unprecedented fifth consecutive year. Jeremy Siegel, the intellectual godfather of the 1990s dot-com bubble, published his first edition of the book "Stocks for the long run" in 1994 and the second in 1998. It was a very good timing for a Wharton Business School Professor Siegel. While in no way the creator of this idea, he mined gold in the atmosphere of dot-com bubble. Anyway, book is probably the most well known advocacy of this approach. We cannot repossess earning from his book, despite the damage made, but at least we can use the term "Siegelism" for naive "all-stock" advocacy.
Now let's discuss why it is naive. First of all, if returns of stocks "in a long run" higher then average returns "in a short run" this should affect bond market -- especially long bonds. This topic was well covered in the paper by Zvi Bodi On The Risk of Stocks in the Long Run Professor Bodi came to the following conclusions:
This paper examines the proposition that investing in common stocks is less risky the longer an investor plans to hold them. If the proposition were true, then the cost of insuring against earning less than the risk-free rate of interest should decline as the length of the investment horizon increases. The paper shows that the opposite is true even if stock returns are "mean-reverting" in the long run. The case for young people investing more heavily in stocks than old people cannot, therefore, rest solely on the long-run properties of stock returns. For guarantors of money-fixed annuities, the proposition that stocks in their portfolio are a better hedge the longer the maturity of their obligations is unambiguously wrong.
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A critical determinant of optimal asset allocation for individuals is the time and risk profile of their human capital. A person faces an expected stream of labor income over the working years, and human capital is the present value of that stream. One's human capital, is a large proportion of total wealth (human capital + other assets) when one is young, and eventually decreases as one ages. From this perspective, it may be optimal to start out in the early years with a higher proportion of one's investment portfolio in stocks and decrease it over time as suggested by the conventional wisdom.
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It is often pointed out that investing in bonds exposes the investor to inflation risk — the risk of depreciation in the purchasing power of the currency in which the bond payments are denominated. One straightforward way to address this problem is to denominate the bonds in terms of a unit of constant purchasing power. Indeed, the governments of the United Kingdom and more recently Australia and Canada have issued long-term bonds linked to an index of consumer prices with precisely this purpose in mind, i.e., to offer investors a safe way to eliminate both interest rate risk and inflation risk over a long horizon.
One sometimes gets the impression from reading popular articles on stocks as an inflation hedge, that their authors view stocks as if they were long-term real bonds. But there is a very big difference between stocks and long-term real bonds. With real bonds, the investor knows that regardless of what happens to the price of the bond prior to its maturity date, at maturity it will pay its holder a known number of units of purchasing power. With stocks there is no certainty of value — real or nominal — at any date in the future.
In the academic finance literature, researchers investigating whether stocks are an inflation hedge in the long run usually hypothesize that real stock returns are unaffected by inflation in the long run. By this they mean that the real return on stocks is uncorrelated with inflation. They do not mean that stocks offer a risk-free real rate of return, even in the long run.
The key dogma of naive siegelism is that you just need to contribute enough money using cost averaging into well diversified index (for example S&P 500 or, better, Total Market Index) and self-regulating market will take care about the rest. You just do not need bonds except may be TIPS. But there are risks that he failed to mention. One is connected with the S&P500 composition.
It is interesting to note that in 2007 financials comprised more than 20% of the S&P 500 and investors in S&P500 suffered "oversized" for diversified index losses simply due to size this sector and the magnitude of the subprime problem. Paraphrasing a popular quote: "we are all subprime now."
And this is not a single case. If you look back at 2000, technology was over 20% of S&P 500, and whenever you get a sector that comprises so much of the market in a capitalization weighted index, it's usually a concern. That means there might be some inherent defects in S&P500 construction which amplify returns during the inflation of the bubbles and corresponding losses when the bubble burst (probably usage of capitalization weights is one such factor). I would not be too surprised to see 30% haircut of S&P500 from the top 2007 value (around 1570 I think) at one point in 2008 or 2009.
If available ion 401K plan, more broad based passive indexes based funds, for example, Vanguard Extended Market Index Instl (VIEIX) might be a better bet:
The investment seeks to track the performance of a benchmark index that measures the investment return of small- and mid-capitalization stocks. The fund employs a passive management strategy designed to track the performance of the Standard & Poor's Completion index, a broadly diversified index of stocks of small and medium-size U.S. companies, which consists of all the U.S. common stocks traded regularly on the NYSE, AMEX, or OTC markets. It typically invests substantially all of assets in the 1,200 largest stocks in its target index, thus covering nearly 80% of the Index's total market capitalization.
The key assumption of naive Siegelism is that the risk of investing in "well diversified portfolio of stocks" generally diminishes with the time you hold them. There are three problems with this assumption:
The danger of secular trend reversal
The notion of "long run" is extremely suspicious and smells data mining
Demographics related issues.
An additional trap due to possible modification of the positions of cheerleaders
Valuation problems.
Corruption of 401K industry: mutual funds exists not to provide investors outsized return, they exist to provide a good life for managers
Is the same trend is in place then for the periods over 10 years diversified index usually (but not always) outperform money market fund and provides the return close to or superior to junk bonds portfolio. But I would like to stress that the key assumption is "the same secular trend" and "in average" For example in my imitation models I see that there were many exactly ten years periods for which where this is not true (like June 1992 - June 2002). But the main problem occurs with the main trend reversal when 401K investors which invest is an index like S&P500 are caught without pants like happed in July 2008.
As secular trends can last for a quarter century and then abruptly reversed to foresee those changes is next to impossible and for sure such task in beyond capabilities for typical market analysts or book writers. For example 1982-2007 period is generally considered to be a financial sector boom with the overlapping dot-com boom-bust. The boom that lasted 25 years was fueled by financial speculation in increasing leverage.
There are tremendous dangers for 401K investors in rising of stocks far beyond their reasonable valuations typical for bubbles as they typically use cost averaging and thus buy larger part of the portfolio closer to the temporary top:
Only 21 percent of families owned stocks outright in 2004, the most recent year for which the Federal Reserve has released data. Almost 50 percent of families owned a retirement account, by contrast. The typical retirement account (median value of $35,200) was also a lot bigger than the typical stock holding ($15,000).
These long-term, buy-and-hold investors, as Mr. Coy pointed out, are actually hurt by a market that rises too quickly. When stocks get so expensive, returns over the next few decades are usually mediocre. And only a small chunk of a typical person's investments will have been made before the run-up.
If the financial boom was unprecedented then the bust can be also unprecedented. The implicit assumption that recessions are such a rare event that expansions periods will compensate handsomely for any recession-imposed drop might no longer hold true in 2008 due to limitations of commodities. Planet is just too small for unlimited growth. If economy is growing fast then using all stock strategy one can get a "cushion" for subsequent drop during the recession before the recession started and the size of the cushion can be such that even 30% drop still keep you ahead of all-bond crowd. But after secular trend reversal there can be a lost decade when losses during bust are amplified by raging inflation.
All in all the hypothesis of smooth growth does not withstand scrutiny: there are long term trends but when they are reversed the huge losses need to be absorbed by all-stock 401K investors. Stocks can fail you in a long run.
The whole notion of "long run" is extremely suspicious and smells data mining. 401K investors does not have the luxury of the "long run" as their period of most active contribution is actually limited to one or two decades (say, 45-55 or 50-60). Before 45 few have money beyond matching company contribution in 401K plans (3-5%) as you need to pay for the mortgage and collect money for kids education. As Keyes noted in Tract on Monetary Reform:
Now "in the long run" this is probably true. If, after the American Civil War, the American dollar had been stabilized... ten per cent below its present value... [the American money stock today] and [the American price level today] would now be just ten per cent greater than they actually are [with no effect on production and empo....
But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.
According to Vanguard study, “How America Saves 2005,” approximately 21% of 401K plan participants held all-equity portfolios. [Life cycle fund investors Doing it wrong - Personal Finance - MSNBC.com]. Such portfolios are mostly close to large diversified index or, often, contain such an index (typically S&P 500) as a large or dominant component. This "S&P500 forever" strategy is just bet on above average speed of growth of the economy and manipulation of stock prices by executives via stock buyback programs. For the last 10 years ending Dec 2007 and assuming cost averaging from zero, S&P500 produced approximately 6% per year return -- slightly better then bonds but not my much.
Assuming $500 by-weekly contribution and a zero starting sum for the period from Jan 2, 2006 to Dec 31 2007 the results would be 232,349 for S&P500 vs. 204,370 for 4.5% stable value fund (something like 12% difference for the period). Please note that due to cost averaging the difference per year (approximately 1%) is almost twice less that the difference in implied annualized yields (6.5% vs. 4.5%). This situation reversed in June 2007 and look quite an apposite with S&P underperforming stable value fund.
At the same time during certain periods "S&P500 forever" strategy used to work extremely well (for example 1990-2000 is one such ten years period). The question is whether those periods are normal or abnormal. Nobody knows the answer until a couple of decades later. BTW since 2000 401K investors are witnessing the biggest stock buyback binge in the history of the stock market and might benefit from starting to ask themselves some questions. As Forbes noted about buyback binge in May 21 2007 issue:
A cheap credit extravaganza and low-returning corporate cash fueled a record $432 billion worth of stock repurchases at S&P 500 companies last year, more than triple the amount in 2003--and more than the gross domestic product of Ireland, Sri Lanka and Singapore combined. The sums spent on stock buybacks last year would have covered the Pentagon's discretionary budget in 2006 and, separately, Medicare's 2006 budget.
The danger of all stock portfolio has another important dimension: stocks values are connected with demographics more then people usually admit. We have 35 million baby-boomers about to retire. They use to put $5,000-$10,000 a year into the stock market which has caused people to believe that there is only a bull market. Now many of them start losing jobs sue to downsizing and outsourcing and soon they will be retiring and taking $50,000 a year, partially out of the stock market. As one MSN reader noted in his feedback on the column by Jow Markman Are we headed for an epic bear market:
When I was a young man, I believed that all those folks in high positions, living in fancy houses (we called them castles in the "old country") and driving expensive cars were smarter and wiser than I. Nope!!
Then came a period of "somebody must know". Then I went through Viet Nam, learned that nobody knows and people in high places will lie, cheat and steal just like us "lowly folks".
So if you think there's some Daddy, God or whatever out there that is going to save you or us from our stupid, greedy scams, better think again. You're on your own and always have been.
While it strikes me as somewhat risky and simulations proves that, in some historic periods is can be the best possible strategy at times economy growth fast (or is hugely stimulated by monetary policy or both). For example it handsomely paid for those who retired in 1999-2000 (better in March 2000 ;-) and immediately moved everything into bonds. It proved to be a reasonably good strategy for those who contributed money into the index from 1996 till 2007 and took money off the table before stock prices collapsed.
Actually while Siegel remains stocks cheerleader, he modified his position after the dot-com debacle and in 2005-2006 carefully avoided wild overgeneralizations typical for his previous books (he prefers now an index consisting strictly of high dividends paying stocks). Unfortunately for him such stocks are concentrated in financials which took a huge hit during sub-prime mess. Like was the case with S&P500 (or other broad indexes), Siegel was not the first proponent of this approach, but he was one of the most vocal proponents. But this approach has its own risks. For example in his July 27, 2002 Economist column How far is down Robert Shiller noted:
Versions of this argument were advanced before 2000 to justify the markets' extraordinary rise. Equities had traditionally been seen as paying a risk premium over the return on safe assets. In fact, optimists pointed out, so long as equities are held for the long term, they can be safer investments than supposedly riskless assets such as government bonds, whose value can be wiped out by inflation. The markets were soaring, it was therefore argued, partly because investors were coming to realize this. The risk premium was falling, and rightly so. As the risk premium fell, the required return on equities fell too--and the warranted p/e ratio was much higher than before.
This was not the only "new era" explanation for the great run-up in share prices. Optimists also emphasized the prospect for faster long-term growth in the economy. This would boost the growth of corporate earnings. With earnings on a higher growth path, current yields were understating the attractiveness of equities. Other things equal, the rate of return on equities would rise. Equity prices therefore had to go up in order to keep the expected return at the appropriate level relative to the return on other assets. (P/e ratios would soar for the time being, but then fall back as reported earnings caught up.)
Arguments about the risk premium, earnings prospects and other new factors (demographic shifts, the spreading share-owning culture, and others besides) were accepted far too uncritically in the late 1990s. They are now in danger of being entirely discarded, which would be almost as unwise. It was absurd (as is now obvious) to argue that equities were, in effect, a riskless asset -- but it was true that equities have been a better bet over the past century than the normal risk premium seemed to imply. In the same way, hopes for higher earnings growth in the "new economy" were ridiculously inflated in the late 1990s--yet the evidence suggests that productivity growth in America really has improved, and some of this should be captured in faster-growing corporate earnings.
Over the next several decades, therefore, the smoothed p/e for the S&P 500 stands a good chance of beating the average of 16 it managed in the 20th century. Admittedly, this is not much help to investors right now. But to be any more precise would violate this column's fairly strict prohibition on calling the market.
While a gifted writer and a good speaker, Siegel remains primitive and naive empiricist devoid of any mathematical sophistication both in the ability (and desire) to test his recommendations on wide range of historic data (that actually makes him very close ally of "financial alchemists", see below). Of course, testing on historical data does into predict future performance but still it helps to avoid self-defeating strategies. And of course his attempts to predict the future ended like most such attempts ends -- one fiasco after another.
For example in 2000 he failed to understand the size of stock bubble and when the recession already started continue to eradiate exuberant optimism. In 2004 Money magazine published an interesting interview It's still stocks for the long run where he corrected his previous approach and suggested to be more selective: to use stocks that are paying high dividends. Later he organized based on this approach consultancy practice and mutual fund family that took a big hit in subprime mess.
While high dividends stocks approach might have intrinsic value higher then the recommendation to use index fund like S&P 500 he got into a very interesting trap: in 2004-2007 the best dividend paying stocks were stocks of financial companies and they became as inflated (or more inflated) then Internet stocks during dot com bubble.
Siegel completely missed this danger of financial superbubble. And when subprime bubble burst they depreciated 30 or sometimes 50% much like Internet stocks during dot-com bust. But financial stocks debacle aside it is interesting to note that most of the period of stocks existence they were bought due to higher dividends that they pay in comparison with bonds, this situation changed in the second half of XX century. During the Internet boom days, dividend sank to the lowest level since the early 1940s. Corporate America thought dividends were irrelevant. Investors didn't lose any sleep when companies canceled or slashed payouts because they were making profits of 20% or more each year on their stocks. But in 2002 dividend were back in fashion and Siegel joined bandwagon. He also adopted more reasonable approach to buying stocks -- "You almost never want to pay over 30 times earnings. " (it's unclear why 30 is the threshold, why not 20 or even 16? )
NEW YORK (Money Magazine) - Jeremy Siegel was the intellectual godfather of the 1990s bull market. His 1994 book "Stocks for the Long Run" sealed the conventional wisdom that most of us should be in the stock market.Even if you don't recognize the academic economist's name, you've certainly heard brokers and financial journalists recite his factoids: that over the long term, stocks have nearly always outperformed bonds.
That stocks are actually less likely to lose money over time, after inflation, than bonds are. And that even if you bought some of the most expensive stocks at the worst possible time -- Siegel cited the notorious "Nifty Fifty" growth stocks of the early 1970s -- you could still make money as long as you just hung on.
After the crashes, the scandals and the just plain lousy stock returns of the past five years, you might think that Siegel, 59, would be chastened.
If he is, it doesn't show. He remains adamant that stocks in general are the way to go for buy-and-hold investors, and he thinks we're about to see the greatest era of growth and innovation the world has ever known.
Siegel became leading advocate of dividend-weighted indexes in the worst time possible. As I mentioned before dividend weighted indexed suffered from poor financial stocks performance in the second part of 2007; that might continue in 2008):
Fundamental indexation means that each stock in a portfolio is weighted not by its market capitalization, but by some fundamental metric, such as aggregate sales or aggregate dividends. Like capitalization-weighted indexes, fundamental indexes involve no security analysis but must be rebalanced periodically by purchasing more shares of firms whose price has gone down more than a fundamental metric, such as sales, and selling shares in those firms whose price has risen more than the fundamental metric....According to my research, dividend-weighted indexes outperform capitalization-weighted indexes and are particularly valuable at withstanding bear markets. For example, the Russell 3000 Index lost almost 50% of its value between the bull market peak of March 2000 and the October 2002 low. Over this same period, a comparable total market dividend-weighted index was virtually unchanged. A dividend weighted index did have a bear market, but it only corrected by 20%. Moreover, the dividend-weighted index bear market didn't start until March 2002, and it lasted only six months (compared to 24 months for the cap-weighted index). The dividend-weighted index is now about 40% above its March 2000 close, whereas the S&P 500 and Russell 3000 are still not yet back to even. A similar performance occurred in other bear markets.
The historical data make an extremely persuasive case for fundamental indexing. From 1964 through 2005, a total market dividend-weighted index of all U.S. stocks outperformed a capitalization-weighted total market index by 123 basis points a year and did so with lower volatility.
In Pros and Cons of Index Investing Rob Bennett wrote:
The second thing I don’t like about index investing is that the conventional indexing approach does not permit consideration of the effects of changes in valuation levels.
The price you pay for an asset affects the long-term return you will obtain from investing in it. I don’t see any way around that reality. It is something that must always be true. So I never feel comfortable investing without first checking out whether the thing that I am investing in is undervalued, fairly valued, or over-valued.
Indexing purists do not take the valuation levels of the stock indexes they invest in into account when making their investment decisions. I do not see any reason why indexers could not take valuation into account. The point of indexing is to be sure to earn the returns earned by the market as a whole by investing in the market as a whole rather than in individual companies in it. There is no reason why one could not increase one’s investment in the market as a whole at times of low valuation and decrease it at times of high valuation. In theory, index investing is compatible with valuation-informed investing. In practice, however, many indexers are hostile to the idea of adjusting one’s stock allocation in response to increases and declines in stock prices.
The key problem is that most "indexers" does not take into account valuation and that means they subject themselves to increased risk due to buying stock at or close to the top [Banned at Motley Fool!]
Why is this approach so controversial? Because it is rooted in the common sense idea that stocks, like all other assets, offer a better long-term value proposition when purchased at reasonable prices than they do when purchased at extremely high prices. At every place at which I have discussed Valuation-Informed Indexing (which I developed with the help of the hundreds of Financial Freedom Community members who offered constructive input during The Great Safe Withdrawal Rate Debate before further discussions were banned), I have seen two reactions to it.
Ordinary investors see quickly the merit of the idea of taking valuations into account, and are eager to learn more. Big Shots who have written books or published studies or calculators or web sites see this new approach as a threat to their status as Grand Poohbahs and cannot stand the idea of others talking about it and learning about it and further developing the concept by doing so.
That means that avid Siegelists might later become disillusioned with the returns offered by stock indexes purchased at high valuations and suddenly realize that there are times when buy-and-hold investing (and, especially, cost averaging investing) is not nearly so exciting an approach as it has been advertised by gurus.
Being simple and attractive (albeit questionable) approach to 401K investing Siegelism proved to be remarkably resilient in years after dot-com bubble burst. Future is unpredictable by definition but to extent this strategy to provide the best returns for any historic period and for investors of all ages is naive.
Still as one of my friends, who uses all stock portfolio in his 401K noted in September 2007 "I am still up 10% this year and what about you ?" To use the old Upton Sinclair quote, "it is very hard to get someone to understand something when their self-esteem depends on remaining naive."
There were 30 defined bear markets on the Dow. Ten worst have declines over 30% and include one with the decline of over 80%. If my friend will be forced to retire the next year and this year will mark the start of the sharp recession then 30% decline will wipe out 30% of his savings. He is over 50 and that's the risk he takes.
While one day crashes grab the headlines, they are not that dangerous as market recovers pretty soon. But bear markets can bleed an 401K investors by stealth and force them to sell in the most inopportune moment -- at the bottom like happened with many 401K investors who were close to retirement in 2003. But crash of 1929 extended into a bear market lasting almost throughout the 1930s and only ended by World War II. It lasted over 10 years and it took more then 20 years for stock fully recover compensating those who bought exactly at the peak. See BBC NEWS Business Market crashes through the ages for more information.
Also interesting is testimony of Robert Kutter before the Committee on Banking Services. This is not typical yellow financial press alarmist "blah-buster". The author is professional who speaks to professionals and he sees some deep analogies between the current situation and the situation in 1920s.
Testimony of Robert Kuttner
Before the Committee on Financial Services
Rep. Barney Frank, Chairman
U.S. House of Representatives
Washington, D.C.
October 2, 2007
Mr. Chairman and members of the Committee:
Thank you for this opportunity. My name is Robert Kuttner. I am an economics and financial journalist, author of several books about the economy, co-editor of The American Prospect, and former investigator for the Senate Banking Committee. I have a book appearing in a few weeks that addresses the systemic risks of financial innovation coupled with deregulation and the moral hazard of periodic bailouts.
In researching the book, I devoted a lot of effort to reviewing the abuses of the 1920s, the effort in the 1930s to create a financial system that would prevent repetition of those abuses, and the steady dismantling of the safeguards over the last three decades in the name of free markets and financial innovation.
The Senate Banking Committee, in the celebrated Pecora Hearings of 1933 and 1934, laid the groundwork for the modern edifice of financial regulation. I suspect that they would be appalled at the parallels between the systemic risks of the 1920s and many of the modern practices that have been permitted to seep back in to our financial markets.
Although the particulars are different, my reading of financial history suggests that the abuses and risks are all too similar and enduring. When you strip them down to their essence, they are variations on a few hardy perennials – excessive leveraging, misrepresentation, insider conflicts of interest, non-transparency, and the triumph of engineered euphoria over evidence.
The most basic and alarming parallel is the creation of asset bubbles, in which the purveyors of securities use very high leverage; the securities are sold to the public or to specialized funds with underlying collateral of uncertain value; and financial middlemen extract exorbitant returns at the expense of the real economy. This was the essence of the abuse of public utilities stock pyramids in the 1920s, where multi-layered holding companies allowed securities to be watered down, to the point where the real collateral was worth just a few cents on the dollar, and returns were diverted from operating companies and ratepayers. This only became exposed when the bubble burst. As Warren Buffett famously put it, you never know who is swimming naked until the tide goes out.
There is good evidence — and I will add to the record a paper on this subject by the Federal Reserve staff economists Dean Maki and Michael Palumbo — that even much of the boom of the late 1990s was built substantially on asset bubbles. ["Disentangling the Wealth Effect: a Cohort Analysis of Household Savings in the 1990s" [PDF]]
A second parallel is what today we would call securitization of credit. Some people think this is a recent innovation, but in fact it was the core technique that made possible the dangerous practices of the 1920. Banks would originate and repackage highly speculative loans, market them as securities through their retail networks, using the prestigious brand name of the bank — e.g. Morgan or Chase — as a proxy for the soundness of the security. It was this practice, and the ensuing collapse when so much of the paper went bad, that led Congress to enact the Glass-Steagall Act, requiring bankers to decide either to be commercial banks—part of the monetary system, closely supervised and subject to reserve requirements, given deposit insurance, and access to the Fed's discount window; or investment banks that were not government guaranteed, but that were soon subjected to an extensive disclosure regime under the SEC.
Since repeal of Glass Steagall in 1999, after more than a decade of de facto inroads, super-banks have been able to re-enact the same kinds of structural conflicts of interest that were endemic in the 1920s – lending to speculators, packaging and securitizing credits and then selling them off, wholesale or retail, and extracting fees at every step along the way. And, much of this paper is even more opaque to bank examiners than its counterparts were in the 1920s. Much of it isn’t paper at all, and the whole process is supercharged by computers and automated formulas. An independent source of instability is that while these credit derivatives are said to increase liquidity and serve as shock absorbers, in fact their bets are often in the same direction — assuming perpetually rising asset prices — so in a credit crisis they can act as net de-stabilizers.
A third parallel is the excessive use of leverage. In the 1920s, not only were there pervasive stock-watering schemes, but there was no limit on margin. If you thought the market was just going up forever, you could borrow most of the cost of your investment, via loans conveniently provided by your stockbroker. It worked well on the upside. When it didn’t work so well on the downside, Congress subsequently imposed margin limits. But anybody who knows anything about derivatives or hedge funds knows that margin limits are for little people. High rollers, with credit derivatives, can use leverage at ratios of ten to one, or a hundred to one, limited only by their self confidence and taste for risk. Private equity, which might be better named private debt, gets its astronomically high rate of return on equity capital, through the use of borrowed money. The equity is fairly small. As in the 1920s, the game continues only as long as asset prices continue to inflate; and all the leverage contributes to the asset inflation, conveniently creating higher priced collateral against which to borrow even more money.
The fourth parallel is the corruption of the gatekeepers. In the 1920s, the corrupted insiders were brokers running stock pools and bankers as purveyors of watered stock. 1990s, it was accountants, auditors and stock analysts, who were supposedly agents of investors, but who turned out to be confederates of corporate executives. You can give this an antiseptic academic term and call it a failure of agency, but a better phrase is conflicts of interest. In this decade, it remains to be seen whether the bond rating agencies were corrupted by conflicts of interest, or merely incompetent. The core structural conflict is that the rating agencies are paid by the firms that issue the bonds. Who gets the business – the rating agencies with tough standards or generous ones? Are ratings for sale? And what, really, is the technical basis for their ratings? All of this is opaque, and unregulated, and only now being investigated by Congress and the SEC.
Yet another parallel is the failure of regulation to keep up with financial innovation that is either far too risky to justify the benefit to the real economy, or just plain corrupt, or both. In the 1920s, many of these securities were utterly opaque. Ferdinand Pecora, in his 1939 memoirs describing the pyramid schemes of public utility holding companies, the most notorious of which was controlled by the Insull family, opined that the pyramid structure was not even fully understood by Mr. Insull. The same could be said of many of today's derivatives on which technical traders make their fortunes.
By contrast, in the traditional banking system a bank examiner could look at a bank's loan portfolio, see that loans were backed by collateral and verify that they were performing. If they were not, the bank was made to increase its reserves. Today's examiner is not able to value a lot of the paper held by banks, and must rely on the banks' own models, which clearly failed to predict what happened in the case of sub-prime. The largest banking conglomerates are subjected to consolidated regulation, but the jurisdiction is fragmented, and at best the regulatory agencies can only make educated guesses about whether balance sheets are strong enough to withstand pressures when novel and exotic instruments create market conditions that cannot be anticipated by models.
A last parallel is ideological — the nearly universal conviction, 80 years ago and today, that markets are so perfectly self-regulating that government's main job is to protect property rights, and otherwise just get out of the way.
We all know the history. The regulatory reforms of the New Deal saved capitalism from its own self-cannibalizing instincts, and a reliable, transparent and regulated financial economy went on to anchor an unprecedented boom in the real economy. Financial markets were restored to their appropriate role as servants of the real economy, rather than masters. Financial regulation was pro-efficiency. I want to repeat that, because it is so utterly unfashionable, but it is well documented by economic history. Financial regulation was pro-efficiency. America's squeaky clean, transparent, reliable financial markets were the envy of the world. They undergirded the entrepreneurship and dynamism in the rest of the economy.
Beginning in the late 1970s, the beneficial effect of financial regulations has either been deliberately weakened by public policy, or has been overwhelmed by innovations not anticipated by the New Deal regulatory schema. New-Deal-era has become a term of abuse. Who needs New Deal protections in an Internet age?
Of course, there are some important differences between the economy of the 1920s, and the one that began in the deregulatory era that dates to the late 1970s. The economy did not crash in 1987 with the stock market, or in 2000-01. Among the reasons are the existence of federal breakwaters such as deposit insurance, and the stabilizing influence of public spending, now nearly one dollar in three counting federal, state, and local public outlay, which limits collapses of private demand.
But I will focus on just one difference — the most important one. In the 1920s and early 1930s, the Federal Reserve had neither the tools, nor the experience, nor the self-confidence to act decisively in a credit crisis. But today, whenever the speculative excesses lead to a crash, the Fed races to the rescue. No, it doesn't bail our every single speculator (though it did a pretty good job in the two Mexican rescues) but it bails out the speculative system, so that the next round of excess can proceed. And somehow, this is scored as trusting free markets, overlooking the plain fact that the Fed is part of the U.S. government.
When big banks lost many tens of billions on third world loans in the 1980s, the Fed and the Treasury collaborated on workouts, and desisted from requiring that the loans be marked to market, lest several money center banks be declared insolvent. When Citibank was under water in 1990, the president of the Federal Reserve Bank of New York personally undertook a secret mission to Riyadh to persuade a Saudi prince to pump in billions in capital and to agree to be a passive investor.
In 1998, the Fed convened a meeting of the big banks and all but ordered a bailout of Long Term Capital Management, an uninsured and unregulated hedge fund whose collapse was nonetheless putting the broad capital markets at risk. And even though Chairman Greenspan had expressed worry two years (and several thousand points) earlier that "irrational exuberance" was creating a stock market bubble, big losses in currency speculation in East Asia and Russia led Greenspan to keep cutting rates, despite his foreboding that cheaper money would just pump up markets and invite still more speculation.
And finally in the dot-com crash of 2000-01, the speculative abuses and insider conflicts of interest that fueled the stock bubble were very reminiscent of 1929. But a general depression was not triggered by the market collapse, because the Fed again came to the rescue with very cheap money.
So when things are booming, the financial engineers can advise government not to spoil the party. But when things go bust, they can count on the Fed to rescue them with emergency infusions of cash and cheaper interest rates. …
In the 1994 legislation, Congress not only gave the Fed the authority, but directed the Fed to clamp down on dangerous and predatory lending practices, including on otherwise unregulated entities such as sub-prime mortgage originators. However, for 13 years the Fed stonewalled and declined to use the authority that Congress gave it to police sub-prime lending. Even as recently as last spring, when you could not pick up a newspaper's financial pages without reading about the worsening sub-prime disaster, the Fed did not act — until this Committee made an issue of it.
Financial markets have responded to the 50 basis-point rate-cut, by bidding up stock prices, as if this crisis were over. Indeed, the financial pages have reported that as the softness in housing markets is expected to worsen, traders on Wall Street have inferred that the Fed will need to cut rates again, which has to be good for stock prices.
Mr. Chairman, we are living on borrowed time. And the vulnerability goes far beyond the spillover effects of the sub-prime debacle. …
One last parallel: I am chilled, as I’m sure you are, every time I hear a high public official or a Wall Street eminence utter the reassuring words, "The economic fundamentals are sound." Those same words were used by President Hoover and the captains of finance, in the deepening chill of the winter of 1929-1930. They didn’t restore confidence, or revive the asset bubbles. …
The most basic and alarming parallel is the creation of asset bubbles, in which the purveyors of securities use very high leverage; the securities are sold to the public or to specialized funds with underlying collateral of uncertain value; and financial middlemen extract exorbitant returns at the expense of the real economy. This was the essence of the abuse of public utilities stock pyramids in the 1920s, where multi-layered holding companies allowed securities to be watered down, to the point where the real collateral was worth just a few cents on the dollar, and returns were diverted from operating companies and ratepayers. This only became exposed when the bubble burst. As Warren Buffett famously put it, you never know who is swimming naked until the tide goes out.
There is good evidence — and I will add to the record a paper on this subject by the Federal Reserve staff economists Dean Maki and Michael Palumbo — that even much of the boom of the late 1990s was built substantially on asset bubbles. ["Disentangling the Wealth Effect: a Cohort Analysis of Household Savings in the 1990s" [PDF]]
A second parallel is what today we would call securitization of credit. Some people think this is a recent innovation, but in fact it was the core technique that made possible the dangerous practices of the 1920. Banks would originate and repackage highly speculative loans, market them as securities through their retail networks, using the prestigious brand name of the bank — e.g. Morgan or Chase — as a proxy for the soundness of the security. It was this practice, and the ensuing collapse when so much of the paper went bad, that led Congress to enact the Glass-Steagall Act, requiring bankers to decide either to be commercial banks—part of the monetary system, closely supervised and subject to reserve requirements, given deposit insurance, and access to the Fed's discount window; or investment banks that were not government guaranteed, but that were soon subjected to an extensive disclosure regime under the SEC.
Since repeal of Glass Steagall in 1999, after more than a decade of de facto inroads, super-banks have been able to re-enact the same kinds of structural conflicts of interest that were endemic in the 1920s – lending to speculators, packaging and securitizing credits and then selling them off, wholesale or retail, and extracting fees at every step along the way. And, much of this paper is even more opaque to bank examiners than its counterparts were in the 1920s. Much of it isn’t paper at all, and the whole process is supercharged by computers and automated formulas. An independent source of instability is that while these credit derivatives are said to increase liquidity and serve as shock absorbers, in fact their bets are often in the same direction — assuming perpetually rising asset prices — so in a credit crisis they can act as net de-stabilizers.
A third parallel is the excessive use of leverage. In the 1920s, not only were there pervasive stock-watering schemes, but there was no limit on margin. If you thought the market was just going up forever, you could borrow most of the cost of your investment, via loans conveniently provided by your stockbroker. It worked well on the upside. When it didn’t work so well on the downside, Congress subsequently imposed margin limits. But anybody who knows anything about derivatives or hedge funds knows that margin limits are for little people. High rollers, with credit derivatives, can use leverage at ratios of ten to one, or a hundred to one, limited only by their self confidence and taste for risk. Private equity, which might be better named private debt, gets its astronomically high rate of return on equity capital, through the use of borrowed money. The equity is fairly small. As in the 1920s, the game continues only as long as asset prices continue to inflate; and all the leverage contributes to the asset inflation, conveniently creating higher priced collateral against which to borrow even more money.
The fourth parallel is the corruption of the gatekeepers. In the 1920s, the corrupted insiders were brokers running stock pools and bankers as purveyors of watered stock. 1990s, it was accountants, auditors and stock analysts, who were supposedly agents of investors, but who turned out to be confederates of corporate executives. You can give this an antiseptic academic term and call it a failure of agency, but a better phrase is conflicts of interest. In this decade, it remains to be seen whether the bond rating agencies were corrupted by conflicts of interest, or merely incompetent. The core structural conflict is that the rating agencies are paid by the firms that issue the bonds. Who gets the business – the rating agencies with tough standards or generous ones? Are ratings for sale? And what, really, is the technical basis for their ratings? All of this is opaque, and unregulated, and only now being investigated by Congress and the SEC.
Yet another parallel is the failure of regulation to keep up with financial innovation that is either far too risky to justify the benefit to the real economy, or just plain corrupt, or both. In the 1920s, many of these securities were utterly opaque. Ferdinand Pecora, in his 1939 memoirs describing the pyramid schemes of public utility holding companies, the most notorious of which was controlled by the Insull family, opined that the pyramid structure was not even fully understood by Mr. Insull. The same could be said of many of today's derivatives on which technical traders make their fortunes.
By contrast, in the traditional banking system a bank examiner could look at a bank's loan portfolio, see that loans were backed by collateral and verify that they were performing. If they were not, the bank was made to increase its reserves. Today's examiner is not able to value a lot of the paper held by banks, and must rely on the banks' own models, which clearly failed to predict what happened in the case of sub-prime. The largest banking conglomerates are subjected to consolidated regulation, but the jurisdiction is fragmented, and at best the regulatory agencies can only make educated guesses about whether balance sheets are strong enough to withstand pressures when novel and exotic instruments create market conditions that cannot be anticipated by models.
A last parallel is ideological — the nearly universal conviction, 80 years ago and today, that markets are so perfectly self-regulating that government's main job is to protect property rights, and otherwise just get out of the way.
We all know the history. The regulatory reforms of the New Deal saved capitalism from its own self-cannibalizing instincts, and a reliable, transparent and regulated financial economy went on to anchor an unprecedented boom in the real economy. Financial markets were restored to their appropriate role as servants of the real economy, rather than masters. Financial regulation was pro-efficiency. I want to repeat that, because it is so utterly unfashionable, but it is well documented by economic history. Financial regulation was pro-efficiency. America's squeaky clean, transparent, reliable financial markets were the envy of the world. They undergirded the entrepreneurship and dynamism in the rest of the economy.
Beginning in the late 1970s, the beneficial effect of financial regulations has either been deliberately weakened by public policy, or has been overwhelmed by innovations not anticipated by the New Deal regulatory schema. New-Deal-era has become a term of abuse. Who needs New Deal protections in an Internet age?
Of course, there are some important differences between the economy of the 1920s, and the one that began in the deregulatory era that dates to the late 1970s. The economy did not crash in 1987 with the stock market, or in 2000-01. Among the reasons are the existence of federal breakwaters such as deposit insurance, and the stabilizing influence of public spending, now nearly one dollar in three counting federal, state, and local public outlay, which limits collapses of private demand.
But I will focus on just one difference — the most important one. In the 1920s and early 1930s, the Federal Reserve had neither the tools, nor the experience, nor the self-confidence to act decisively in a credit crisis. But today, whenever the speculative excesses lead to a crash, the Fed races to the rescue. No, it doesn't bail our every single speculator (though it did a pretty good job in the two Mexican rescues) but it bails out the speculative system, so that the next round of excess can proceed. And somehow, this is scored as trusting free markets, overlooking the plain fact that the Fed is part of the U.S. government.
When big banks lost many tens of billions on third world loans in the 1980s, the Fed and the Treasury collaborated on workouts, and desisted from requiring that the loans be marked to market, lest several money center banks be declared insolvent. When Citibank was under water in 1990, the president of the Federal Reserve Bank of New York personally undertook a secret mission to Riyadh to persuade a Saudi prince to pump in billions in capital and to agree to be a passive investor.
In 1998, the Fed convened a meeting of the big banks and all but ordered a bailout of Long Term Capital Management, an uninsured and unregulated hedge fund whose collapse was nonetheless putting the broad capital markets at risk. And even though Chairman Greenspan had expressed worry two years (and several thousand points) earlier that "irrational exuberance" was creating a stock market bubble, big losses in currency speculation in East Asia and Russia led Greenspan to keep cutting rates, despite his foreboding that cheaper money would just pump up markets and invite still more speculation.
And finally in the dot-com crash of 2000-01, the speculative abuses and insider conflicts of interest that fueled the stock bubble were very reminiscent of 1929. But a general depression was not triggered by the market collapse, because the Fed again came to the rescue with very cheap money.
So when things are booming, the financial engineers can advise government not to spoil the party. But when things go bust, they can count on the Fed to rescue them with emergency infusions of cash and cheaper interest rates. …
In the 1994 legislation, Congress not only gave the Fed the authority, but directed the Fed to clamp down on dangerous and predatory lending practices, including on otherwise unregulated entities such as sub-prime mortgage originators. However, for 13 years the Fed stonewalled and declined to use the authority that Congress gave it to police sub-prime lending. Even as recently as last spring, when you could not pick up a newspaper's financial pages without reading about the worsening sub-prime disaster, the Fed did not act — until this Committee made an issue of it.
Financial markets have responded to the 50 basis-point rate-cut, by bidding up stock prices, as if this crisis were over. Indeed, the financial pages have reported that as the softness in housing markets is expected to worsen, traders on Wall Street have inferred that the Fed will need to cut rates again, which has to be good for stock prices.
Mr. Chairman, we are living on borrowed time. And the vulnerability goes far beyond the spillover effects of the sub-prime debacle. …
One last parallel: I am chilled, as I’m sure you are, every time I hear a high public official or a Wall Street eminence utter the reassuring words, "The economic fundamentals are sound." Those same words were used by President Hoover and the captains of finance, in the deepening chill of the winter of 1929-1930. They didn’t restore confidence, or revive the asset bubbles. …
One can view stocks as fiat currencies of particular firms. Or, if you wish, options of the earning of the firm. And that means that they are by and large confidence game.
Rampant self interest, both individual and institutional, can keep Ponzi schemes going far longer that skeptics in the virtue of 100% stock 401K portfolios would think possible. As long as you can keep the stocks moving up, and the faithful invested, participants not only stay in despite the gradually increasing risks, but are actually leery of pulling out, lest they lose out to peers who remained in the game and gained a bit more. That's what experience of tech stock bubble 2001-2003 teaches us and it might repeat in a new yet unpredictable form with subprime bubble.
In 2007 market participants have lost all memory of what risk is and are behaving as if the so-called wall of liquidity (namely LBO cash) that was the main drive of stock rise (so called Paulson rally) will last indefinitely and that volatility is a thing of the past.
The problem is actually more dangerous because 401K plan usually have eclectic selection of stocks often reflecting which financial firm managed to bribe company brass first. some fonds in 401K protfolios can have fees that make investing in them losing proposition no matter what you do.
Recently John Waggoner is a personal finance columnist for USA TODAY published an interesting column essentially stating that many stock mutual funds exist not to provide investors outsized return, they exist to provide a good life for managers. (see Some stock funds can't even outperform lowly T-bills - USATODAY.com):
Investors spend a lot of time trying to figure out how to build a winning stock portfolio. Surprisingly, however, some stock mutual funds have spent a decade building portfolios that have lagged the returns from the lowly three-month Treasury bill. You'd be amazed at how much work it can take to make a stock portfolio give T-bill returns — and how many funds have managed to make the leap from the merely mediocre to the truly dreadful.A basic tenet of investing is that, over the long term, stocks tend to return more than bonds or T-bills. The past 10 years have borne this out.
T-bills have gained an average 3.7% a year from November 1997 through November 2007, assuming you reinvested your interest.
The Lehman Bros. U.S. Aggregate Bond index, a broad measure of the bond market, has returned an average 6.1% a year the same period.
The Dow Jones Wilshire 5000 index, which measures the returns from virtually the entire stock market, has risen an average 6.6%.
Lagging T-bills for so long takes work.
There is no scientific reason to believe in the "stocks for long run" hypothesis. There is no statistical confirmation that even for random 10 years "investment period" all stock portfolio will outperform 50% stocks 50% bonds portfolio or 100-your age stocks/bond portfolio.
Using broadly diversified index you probably can expect to do equal or better then 100% of stable value fund but that does not exclude period when you will be 7-10% behind and it is during those periods 401K investors often dispose their stock holding (panic at or close to the bottom). that happed with a lot of stock investors during dot-com bubble and it is happening right now as deflation of a new bubble unfolds.
One must realize that holding 100% of anything means putting all eggs into one basket and such position dies not withstand close scrutiny.