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Inefficient markets, like elections, have consequences.
In the article, The Inefficient Market Hypothesis, I surmise that the US financial markets have become increasingly inefficient, and that the trend towards ever greater inefficiency has been going on for at least a generation.
Inefficient markets have consequences that may be prickly for incautious investors.
By definition — at least by the definition in the referenced article — prices in efficient markets tend to be based on facts and to reflect, to some degree, reasoned evaluations of intrinsic value by market participants.
Prices in inefficient markets, on the other hand, tend to deviate and wander far from intrinsic value.
But, what are the consequences of a market in which prices fail to reflect intrinsic value?
Perceived intrinsic value
Anyone who was born in the 1960s or later has lived in an environment in which equity prices have risen constantly, except for the Crashes of 1987, 2000, and 2008.
The expectation has been that holding a diversified portfolio of stocks for the long run will produce long-term returns on the order of 8%.
See: GAO favors over-optimistic projections.
The market recovered after the Crashes of 1987 and 2000, reinforcing popular belief that stock prices possessed some built-in upward bias and that, in the long run, everything would work out. Many millions of people, perhaps most people, believe this, even after the Crash of 2008.
This massive piece of obsolete machinery was once the proud source of profit for some long gone factory owner.
A cold look at equities
However, a cold look at the benefits that one gets from holding stocks, reveals a much different picture:
- Low Dividends: On May 18th, 2010, the average dividend yield on Dow Jones stocks was only 2.62%. Yield on the Nasdaq Composite Index was 0.71%. The S&P 500 yield was 1.98%. That means that if you had one million dollars of your retirement funds invested in the Dow Jones Index, you could expect annual income of $26,200; or $710 for Nasdaq stocks, or $19,800 for S&P stocks. That would be before taxes. This is considerably less that the 8% expectation of the US Government Accountability Office.
- Low Growth: Despite spectacular growth of some fortunate stocks, like Google, corporations, on average, over-the-long run, cannot grow faster than the Gross Domestic Product (unless they serve a worldwide market). Over the period 1946-2003, the geometric average annual growth rate of before-tax profits of nonfarm nonfinancial corporations has been 5.3% — which, adjusted for inflation and taxes, would be considerably less. With an aging population and falling birth rates, there is little reason to expect the long-term growth will be any higher over the next fifty years. See: Equity Values: Discounted Cash Flow.
- Diversion of Profits: Since 1982, the US Securities and Exchange Commission has allowed corporations to divert profits into stock buybacks that in turn go to give value to executive stock options. From 1982 to 2008, companies diverted $5.7 trillion (in 2008 dollars) into stock buybacks, essentially robbing long-term, buy-and-hold stockholders of this income. See: The Stock Buyback Era Evaluated.
- Non-perpetuity of Income: No matter how glamorous and powerful a corporation seems today, and despite the fact that as a legal technicality they may be immortal, all companies, sooner or later, come to an end. Eventually, good leaders and replaced by dolts. An ‘essential product’ becomes superfluous. Most companies in the original Dow Jones Average have disappeared from the scene, forgotten except to financial historians. Politics, unions, war, and incompetence all take their due. The great leaders that built America in the 19th century: Carnegie, Westinghouse, Eastman, Rockefeller, JP Morgan, and many more, are all dust, their memories soiled and tarnished by socialist muckrakers and non-entrepreneurial academics. In the end, great companies are worth nothing and pay no dividends.
This building was expropriated by the Nazis from its owners in 1933. Property rights are only as good as the rule of law.
- Non-Persistence of legal protection: When you buy a stock, you’re acquiring nothing more than a property right that is relevant to a particular legal jurisdiction at a certain time in history. Governments constantly change, abridging legal rights, increasing taxes, devaluating currency, expropriating property. Bond holders in General Motors learned this the hard way when Barack Obama took away their rights and gave them to the labor unions that brought him to power. Franklin Roosevelt increased income taxes to extreme levels. Stalin expropriated holdings of pre-revolutionary capitalists. Hitler took away the property of the Jews. Leftist judges on the US Supreme Court are already sanctioning the taking of private property in eminent domain, transferring ownership from one private holder to another ‘in the public interest’.
- Risk of Loss of Principal: The issuer of common stock offers to pay you nothing if something goes wrong. The only chance of recovering your investment is to sell your shares to someone else. However, when in this unfortunate position, you may find that the amount you can recover on the market is only a fraction of what you initially paid.
What we may conclude from this is that 75% of the income most expect to receive from common stocks depends upon the purely speculative consideration of capital gains obtained by selling part of one’s portfolio to someone else at some distant future date.
Inefficient markets have consequences. Here are pensioners protesting in England.
This may seem like an unlikely, shaky income stream on which to base your health and welfare in your old age, but nevertheless, millions upon millions of people make precisely this risky bet. (Many, dependent upon pension plans, don’t realize that these plans make exactly the same risky bet — or worse.)
In the article “How much are equities over-valued“, written in 2007, I concluded that equities, at that time, were about 40% over-valued. The Crash of 2008 corrected this discrepancy, to some extent, but prices started up again in 2009 and 2010.
Now, there may be a few people, in academia and in the markets, that believe that markets are substantially over-valued, but all the arguments and logic in the world will not change general perceptions, as long as prices continue to rise.
The false hope of capital gains
The consensus annual return on equities, used by millions in retirement planning in the United States, is about 8%. This is the number often built into popular retirement planning software. It is the number sometimes used by the US Government Accountability Office. Major public pension fund administrators, responsible for the retirement of millions of workers, often use this or a similar number in evaluating the degree to which their retirement obligations are properly funded.
However, the average return on common stock dividends is 2%, or less. This means that the average investor who retired in 2009 with $1 million in an IRA, expecting an income of $80,000, would only receive $20,000 of this from dividends.
To reach an expected retirement income of $80,000, the retiree would have to sell $60,000 in stock.
Inefficient Markets: The world is full of false hopes and unfulfilled promises.
If the investor’s portfolio doesn’t increase $60,000 during the year, there will be less income producing assets in the next year.
Even if the price of the portfolio increases by $60,000 every year, the dividend yield will have to stay at the expected 2% for the retirement goal to be met.
The problem here is clear.
The retiree is dependent upon a steady increase in equity prices of about 6% a year, as well as continuity of a dividend yield of 2%. However, market price may increase or decrease, dependent upon what other investors are doing and general economic conditions.
Secular market forces
Since 1983, stock prices have increased faster than intrinsic value because corporations have been using profits to buy back stocks, forcing prices upwards.
However, it takes more and more money to continue this manipulation as prices rise. After 2000, companies found that profits were insufficient to cover buyback programs and began to raid depreciation reserves and borrow from banks — very imprudent behavior.
The Crash of 2008 may have marked the end of an era for Wall Street.
When sub-prime mortgage lending finally set off a credit squeeze, money for buybacks began to dry up, contributing eventually to the Crash of 2008.
What this means it that for retirees to receive 8% income on equities, prices would have to be much, much lower.
If investor expectations have been a return of 8%, the facts suggest that market prices have been well above the amount that investors have been paying for stocks.
However, it is unlikely that most people will believe this — until it is too late and they are looking in a rear view mirror.
In fact, I have a hard time believing this, so powerful and unanswerable is the persuasive force of a long-held common belief and of persistent economic behavior.
The spell of inefficient markets
As I mentioned in the article on the Inefficient Market Hypothesis, I believe that it is human nature to interpret increased market value as reflecting an increase of intrinsic value of investment assets. Even when the market crashes, most people want to believe that the fall is only temporary.
When interpreting markets, most of us suffer from a persistence of backward vision and terminal optimism.
No matter how influential a person may be, it is virtually impossible to turn an inefficient market or convince the investing masses based on reason or argument.
Irving Fisher of Yale, one of the world's greatest economists, may have been right about intrinsic value, but the market didn't agree.
In 1929, Irving Fisher, one of America’s foremost economists, declared that stocks were undervalued and put his money where his mouth was. He lost his fortune and had to depend upon the charity of Yale University in retirement.
Charles Merrill, the founder of Merrill Lynch, in the same year, was convinced that stocks were over-priced, sold his holdings, told his clients to do likewise, and closed his business (temporarily), and virtually no one listened.
In my own business, I tried to persuade clients to get out of equities before the Crash of the Brazilian market in 1971 and failed entirely. (See: The Bubble in Brazilian Equities: 1971).
It doesn’t matter if you’re right or wrong, smart or dumb, connected or alone, the persuasive force of millions of ‘voters’ in the great election of asset values — the financial markets — and past trends, will carry the day.
Even if people believe you, there is a tendency to hang on just a little longer, waiting to see if ‘the market’ confirms what you are saying. But when ‘confirmation’ comes, it is usually like a heart attack, sudden, painful, and debilitating to rational action. We become frozen with fear, like deer looking into the headlights of an oncoming car.
Even you yourself, having examined carefully and believing your own arguments, will find it hard to turn against a market trend and put your theories to the test of action.
The problem is that markets can be inefficient for a long, long time. We can marry, raise a family, and see our children off to college, while the same, inefficient market trends grind on and on.
Some market turning points
Markets can be inefficient for different reasons and persist for long periods. The transition between one type of inefficient market to the next is usually a period of strife and uncertainty which may last five to fifteen years.
World War I was a transition point in world capital markets.
- World War I: The First World War was one of those transition periods between inefficient markets. The extreme costs of war marked the beginning of the end for the British Empire and the transfer of world financial power from London to New York.
- The decade prior to 1929: In the roaring twenties, Wall Street was characterized by a general lack of reliable information, rampant market manipulation, lack of regulation, wild speculation, and bucket shops. In other words, there were substantial ‘informational barriers’ and the market was inefficient. However, compared to today, price-earnings ratios were low and dividend yields were generally higher than yields on bonds.
- The Great Depression: This was another transition period. During these years, the United States when through a period of deflation, high unemployment, and radical reform of the rules of markets. Investors were ‘on hold’, awaiting for ‘that man in the White House’ (FDR) to go away. For investors and capitalists, the future was murky, not unlike the US today under Barack Obama.
- World War II: This was another transition period that ended with the death of Roosevelt and victory for the allied powers, led by the United States. The US emerged as the most powerful nation on earth and the free world moved into times of economic optimism, while much of the rest of the world embarked on a long, failed experiment in socialism.
- The Post War Period: A different type of inefficient market emerged in the years 1945-1963. American companies became international, subject to laws of many countries. There was the movement of ‘democratization of capital’ and the growth of mutual funds which were sold door-to-door to unsophisticated investors. As mutual funds grew in importance, dividend yields relative to bond yields fell, eventually breaking the traditional commonsense relationship that called for stock yields higher than bond yields. Fancy mathematics began to enter investments and the groundwork for Modern Portfolio Theory was laid. It seemed to many that the market was becoming more efficient, but this was not the case.
The War in Vietnam was another turning point in US capital market history.
- Vietnam, Nixon and Carter: An expensive war that the United States did not win, race riots, blood in the streets, radical big government reforms, inflation, unemployment, and the delinking of the dollar from gold are some of the highlights of this turbulent transition period. It marked the coming of age of the Baby Boomers and the beginning of a new social period.
- Reagan and beyond: The election of Ronald Reagan put an end to the ineffective government of Jimmy Carter and led to lower taxes and somewhat smaller government. However a new and more virulent virus of inefficiency was introduced with SEC Rule 10b-18 which granted corporations ’safe harbor’ to buy back their own stock, opening the era of stock buyback manipulation and obscene executive remuneration. As a result of delinking the dollar from gold in the Nixon administration, trade deficits began to grow, creating an excess of foreign dollars in the fixed income market and driving down interest rates. This was also the era of the Efficient Market Hypothesis, which led to non-managed index funds and other informational inefficiencies. Finally, an explosion of financial derivative products created overly complex markets that engendered further inefficiencies.
- The Crash of 2008 and Obama: We are now in what I consider to be another period of transition, like the Great Depression, or the Vietnam, Nixon, Carter Era. Although touched off by poor regulation and mis-management of Wall Street, the dominant feature of this period, I believe, will be the impact of the radical Obama political agenda. This period will last at least as long as Obama is in power, perhaps much longer if sufficient damage is done to the economy by profligate policies that have no equivalent in American history. It is possible, perhaps likely, that the United States will emerge from the Obama era much weakened, with economic leadership passing from Wall Street to the Far East. So far, the ‘blood in the streets’ aspect of prior transitions has been avoided, but it is still early days. The effects of the Obama transition may be felt for five to fifteen years, only time will tell.
Awaiting Blood in the Streets
Looking back at how the economy emerged from previous transitions, I note that in each new period, equity prices started at reasonable levels. This was true at the beginning of the Roaring Twenties, the Post WW II Period, and the Reagan Era. It is as if markets, recognizing prior inefficiencies ‘reset’ and start over.
All it takes for blood in the streets is a pretext to riot.
However, for the current market to ‘reset’, it will be necessary for equity prices to fall considerably, which will have dire consequences. I think it highly unlikely that corporate profits and dividend payouts will rise to a point that makes current price levels ‘reasonable’.
Now, I don’t know what might trigger a sharp downward adjustment in equity prices, although there certainly are many reasons for serious concern with regard to the political and economic outlook.
But if (or perhaps when) this market downward adjustment occurs, here is what to expect:
- Civil Unrest and Riots: The primary result of a sharp drop in equity prices will be a vast underfunding of retirement plans. Millions who now look forward to a nice comfortable retirement, with overseas cruises, days of leisure at the golf course, and a second home in Florida, may suddenly be faced with the prospect of having to move in with their children. Spoiled Baby Boomers and pampered unionized employees will be irate. We might look to the recent riots in Greece as an example of what might happen when people have been deprived of the goodies they have been promised.
- Radical Changes in Lifestyle: If the value-based assets needed to pay fat pension plans are simply not there, the short fall can’t be created except by the government printing money. This will help debtors and wipe out creditors. Even so, people will need to make substantial changes in lifestyle to survive.
- Internal Migrations: The old, liberal stronghold cities, with untenable public pension plans and unfunded social promises, will go bankrupt. At first, they will attempt to raise taxes, but people will simply move away. California, New York, and the rust belt will be hard hit.
Now, it is too early to write off the United States as a world power. The elections of 2010 and 2012 may set things straight and new leadership may emerge, as it did in the time of Reagan and Eisenhower, and put the country back on an upward path. But, maybe not. World history is all about the rise and fall of empires and the United States certainly had its time in the sun in the 20th century.
In any event, the inefficiencies of the capital markets over the last thirty years are likely to have serious consequences and it is best to be prepared.
How to be ready for a new era
The critical decision to make in preparing for the world after Obama is to decide whether or not you think equity markets are over-priced, or whether you still believe in the Common Stock Legend of “stocks for the long run”.
James de Rothschild is attributed with saying, "Buy when there is blood in the streets".
The one question that I would suggest that you consider is simply this:
What investment assets would you hold if you knew that you wouldn’t be able to sell the assets to someone else in the future. In other words, what would you hold if all you were to get in return is what the issuer gives you?
If you can’t find anything in today’s market that satisfies this criteria, it may be better to wait, in cash, until a suitable investment appears. After all, if equities are really 40% over-valued, wouldn’t it be better to be buying after the crash, than before.
But what if the crash never comes? What if the future is just like the past? What if the millions that believe in ’stocks for the long run’ are right?
Well, that is why I won’t waste my time trying to persuade you what you should do. First of all, I don’t know. Second, even if I did, you wouldn’t believe me.
If you are brave enough to give some advice to my readers, please do.
But then, one can always fall back upon that old piece of market advice, attributed to James de Rothschild, “Buy when there is blood in the streets”, and, if the value of pensions of millions does disappear, that may actually occur.
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