By Hilary Martin, MBA, CFP®
This blog post is prompted by a recent article titled Bad News for Boomers, authored by Karen Damato and published in the Wall Street Journal on March 4th. In it, the author quotes Robert D. Arnott, founder and Chairman of Research Affiliates and manager of two PIMCO mutual funds, who explains that as the ratio of retiring Baby Boomersto still working Gen X’ers rises, the presence of federal debts and deficits will keep economic growth and stock market returns low for decades to come. Obviously, a future of low stock returns seems dismal, and the article raised a bit of a stir. My fee-only financial planning team and I have serious concerns about his logic, though, so I’d like to take this opportunity to answer his analysis.
I will preface (perhaps caveat) my response by saying this: I don’t much like doomsayers. My Nana used to tell me, “Keep your chin up” and it’s the attitude I choose to have about life, love and money. Although Arnott is specifically quoted in the article as saying that he isn’t painting a doom-and-gloom scenario, but rather, a challenging scenario, I hardly think an environment of perpetually mediocre returns isn’t doom-and-gloom. It sounds like Depression-ville to me.
I do not like the habit of the media to publish articles that scare investors into doing the wrong thing—I feel protective of my clients and the rest of us investors, who are trying diligently to save for our collective future. I have already published my thoughts and evidence about market predictions, namely that they have never been and will never be more accurate than pure chance.
That said, I’ll get on with my response. Arnott’s primary message to investors is to expect virtually no real after-tax returns from the stock market over the next 10-20 years instead of the mean 10% nominal returns we have seen for the last 200 years. A good argument, like a good table, has strong legs to support it, so let’s lift up the tablecloth and check those legs out.
First—follow the money. How does Arnott get paid? He is a very well-compensated actively traded mutual fund manager who stands to gain handsomely if you buy his argument and his mutual funds. He explains in the article how his mutual funds solve the problems outlined by the challenging scenario he predicts, and even gives you the names of the funds.
Remember this: when it comes to investing, the only professionals whose incentives are aligned precisely with yours are fee-only financial planners. Our relationship to our clients is a fiduciary one, which means we put the client first. Academics and educators are also typically fairly reliable, but I strongly prefer academics who publish in peer-reviewed journals.
Alright, let’s get back to those legs. The crux of Arnott’s demographics analysis is that the ratio of retirees to workers is already beginning to swell, and that as that phenomenon continues, there will be fewer and fewer workers (and therefore investors) to purchase stocks and bonds from retirees as they sell them to support their lifestyle. And obviously low quantity demanded keeps prices meager.
He goes on to say that retired boomers are going to want to buy a lot of goods and services from the few remaining workers, so prices will rise. Low stock returns plus high prices equals challenged boomers.
His demographics analysis is, of course, spot on. We have known this was coming for decades, and it’s a big nail in Social Security’s coffin. The ratio of covered workers to beneficiaries of Social Security payments has gone from 159.4 in 1940 to 2.9 in 2010. That means there are approximately 3 workers supporting 1 retiree now! And it will get worse before it gets better.
But although fewer workers may be a real problem for living standards—this piece depends on productivity growth, and Gen X is the most productive generation ever—the market is already creating solutions for investors who want to sell. Markets are becoming more global, giving increasingly affluent investors in international and emerging markets access to U.S. stocks. What else are these folks going to do with the dollars they receive when we buy their products?
Also, companies are well-positioned to buy back massive amounts of stock from boomers. As of February, 2012, the top 20 cash-rich firms in America had amassed $1.4 trillion, and Apple alone has cash stores of $100 billion. In the end, boomers will get their cash and the next generation, Gen X, will end up owning the market (until we sell it to Gen Y).
This is a very slow-moving trend that has already begun and is already being addressed. Also, as for demand putting upward pressure on prices, boomers won’t suddenly increase their demand when they retire—their demand will stay about the same, and it’s already being met in the present economy.
Arnott’s next point is murky and riddled with errors. First, he says that the last 100 years of dividend and earnings growth is 1.25% per year. He never actually says it, but later the reader is left to intuit that he is asserting that this number represents real principle growth in the stock market. We all know, however, that real stock market returns over the last 100 years are closer to 6% than 1.25% (see the below chart).
Next, he asserts that his 1.25% number will represent real principle growth in the stock market in the future, which requires an unsupported leap of faith. To this, he adds the current 1.75% dividend yield to get what he says will be a 3.5% real rate of return from the stock market of the future.
The problem is that if he’s going to use a 100 year average in part of his analysis, he should then at a minimum use a 100 year average of dividend yields in his calculation.
The dividend yield for the first half of the century was about 6%, and as recently as the early 80’s dividend yields were again that high. A few key numbers of difference, and Arnott concludes a supposed zero real after-tax return. But, in this case, the devil is in the details. I hope you didn’t buy his mutual fund shares yet.
Then, to strengthen the argument that we can’t expect equity growth from U.S. stocks, he asserts that they’re currently over-valued. Seriously?
After the 46% downturn we went through in 2008? Yes, in fact, he is serious.
As evidence, he uses the Shiller P/E Ratio, which calculates price relative to 10-year smoothed earnings and currently calculates that U.S. stocks are on the high side of 20 times earnings.
However, Jeremy Siegel, a Professor of Finance at the Wharton School, and a frequent guest on CNN, CNBC, and NPR (and not an actively traded mutual fund manager), in a speech at the TD Ameritrade Conference in Orlando this month, said that U.S. stocks are cheap right now. Siegel says those who use the Shiller P/E Ratio should be cautious about using it during anomalous time periods, especially periods that include calendar year 2008.
“In 2008, reported S&P earnings collapsed to $14.88,” Siegle told the audience. “That was more than 80% below the previous year.” Siegel found that most of this drop was due to a $450 billion write-off at three companies: Bank of America, Citibank and AIG.
Not only did these three firms sink the financial industry, they also sank the Shiller P/E. Siegel recalculated the Shiller P/E using more accurate cap-weighted earnings and determined that the overvaluation Arnott points to disappears.
My point here isn’t to argue that stocks are cheap or expensive, you know how I feel about predictions. I merely mean to point out to you that someone with more credibility about investments than Arnott has qualms about Arnott’s evidence and conclusions.
Arnott indicates that the emerging markets seem to represent a great investment opportunity now, and I couldn’t agree more. Emerging equity markets should be represented in your portfolio in relative proportion to their market capitalization, and our firm’s globally diversified portfolios hold 13% of their equities in this asset class.
Arnott likes emerging markets bonds, however, and here he and we diverge. Bonds, unlike equities, don’t often reward investors for taking excess risk with excess expected return.
The job of bonds in the portfolio is to cushion the volatility of the market, and you cannot afford the risk of default here. Investing in lower credit bonds puts you in a position where you might make a few extra percentage points of return, but you risk losing the majority of your principal. Just ask the folks holding Greek bonds today.
Lastly, Arnott the Benevolent makes a sweeping statement that sensible boomers who follow his advice (and, of course, buy his mutual funds) can still retire when they planned, or maybe a year or two later.
Conventional investing, however (not his mutual funds) will keep you working for only three or four more years, somehow, despite earning near zero real returns. Thanks, Arnott, but I’m questioning your arithmetic. How about you leave the planning to the planners?
Contributions to this article were made by Robert Hendershott, Ph.D, Professor of Finance at the Santa Clara University Leavey School of Business.