These are turbulent days in the financial markets. Investors are looking for answers about what they should do. The answers, however, depend upon just who is asking the questions. If the questioner is a speculator, buying and selling stocks with the focus on their momentary prices, I’m not sure that I have the credentials to provide advice. If, on the other hand, the questioner is an investor, holding a highly diversified portfolio of both U.S. and global stocks, I’d say: “Don’t do something. Just stand there.” Investors should stay the course, because successful market timing is near impossible. More importantly, ten years from now, earnings in the S&P 500 will be much higher than they are today.
In 1949, I stumbled upon the December issue of Fortune magazine and learned for the first time that a “mutual fund industry” existed. When I saw the industry described as “tiny but contentious,” I knew immediately that I had found my niche.
In 1974, I founded Vanguard as a truly mutual mutual fund group—operated on an “at cost” basis, for the benefit of its owners rather than its managers. In establishing Vanguard, I had the opportunity to apply a number of important lessons I had learned during my many years in the mutual fund industry, the most important of which was that funds “can make no claim to superiority over the market averages” (a quote from my 1951 Princeton University thesis). Indeed, this fueled my decision to create the world’s first index mutual fund. Originally referred to as “Bogle’s Folly,” Vanguard Index 500, with some $180 billion of assets, is now the largest mutual fund in the world.
I continue to believe that a portfolio holding all of the corporations that comprise the U.S. stock market, albeit with a global flavor, is the only strategy that guarantees an investor will capture his or her fair share of whatever returns the stock market is generous enough to deliver. The reasoning is straightforward. Since I read that 1949 issue of Fortune, America has experienced at least three major bear markets. Each was followed by a rousing bull market that ultimately erased the pain of those short-lived losses.
Investment vs. Speculation
Celebrated economist John Maynard Keynes in his remarkable book The General Theory of Employment, Interest, and Money, published in 1936, defined enterprise as “forecasting the prospective yield of assets over their entire life,” acknowledging that it could not be based on an exact calculation of benefits to come. Enterprise can only flourish if accompanied by “spontaneous optimism,” which he famously described as “animal spirits.” Still, he worried about the dominance of investor psychology in the markets.
Over the very long run, it is the economics of investing – enterprise – that determines the return on stocks. The fleeting emotions that surround investing – speculation, which so worried Keynes – ultimately prove to be virtually meaningless. Too often, the financial community – investors or traders – focus too heavily on the short-term disparities between investment returns and speculative returns, and far too lightly on the necessary long-term coincidence between these two very different components of the stock market’s total return. In fact, their long-term returns have been almost identical. The 10.0 percent average annual return on U.S. stocks during the past 100 years is almost identical to the 9.9 percentage points of the market’s investment return (corporate earnings and dividends). Of course, significant disparities occurred along the way – periods when stock prices eclipsed business fundamentals, and periods when they fell behind.
Nonetheless, most mutual fund managers focus on speculation rather than investment. Indeed, fund managers trade their portfolios with vigor, with turnover rates averaging nearly 100 percent annually. Of course, it is not mutual funds alone that engage in this counterproductive trading behavior. A trend toward speculation has been growing since the mid-1960s. Total turnover on the New York Stock Exchange was less than 20 percent through the mid-1960s. Even by the mid-1990s, it rarely exceeded 50 percent. But in 2007, stock turnover exceeded 200 percent per year. We are in a new era, one with the highest speculation component in history.
When the market focuses on the underlying power of our corporations to earn a solid return on the capital invested, volatility is low. But when our markets are driven, as they are today, by speculation (characterized by hope, greed, and fear), the resultant volatility is almost certain to lead to the kind of turbulence we are now witnessing.
Every era has its times of turbulence and its times of stability and growth. But so far, the 21st century has experienced unprecedented turbulence. Indeed, no sooner had the year 2000 begun than the stock market began to tumble from a (highly inflated) level of 1,520 on the S&P 500 Index to 770 in 2002. At the bottom, a full 50 percent of the value had evaporated.
Five years later, in October 2007, the S&P 500 had more than recouped the lost ground, up 103 percent to 1,565 (down 50 percent and up 100 percent nets a return of not plus 50 percent but zero). Since then, however, stocks have tumbled to 1,300, a 17 percent retreat, but still short of the 20 percent dip that Wall Street defines as a “correction.”
Even these broad market swings mask the underlying volatility of today’s markets. During the 1950s and 1960s, the daily changes in the level of stock prices typically exceeded two percent only three or four times per year. But since last July alone, we’ve witnessed 19 such moves – 12 downward and 7 upward. This volatility reflects the moves of speculators, not the returns of business sought by investors, which change at a glacial pace.
Whither the Storm?
This market volatility is a product of many forces. Surprisingly, one is the institutionalization of the stock market. Over the past half-century, ownership of stocks by individual investors has dropped from 92 to 26 percent. Meanwhile, institutional ownership (mutual funds and pension funds) has soared from 8 to 74 percent. These giant institutions, striving to build profitability, have not only failed to honor the interest of their shareholders/beneficiary principals, but they have also abandoned the time-honored investment principles that focused on the wisdom of prudent long-term investment, and turned instead to an excessive focus on short-term speculation.
To be sure, financial institutions have held the majority of all U.S. equities for several decades, and their focus on short-term expectations with the attendant high turnover even longer. So what accounts for the recent surge of market turbulence? In this new environment, the raison d’etre for money managers, and the basis by which they are held accountable, became the maximization of the value of the investments made by their clients, measured over periods as short as years or even quarters. Even as institutional managers turned to speculation (as Keynes predicted), corporate executives became increasingly attuned to short-term profits and the stock-market valuations of their firms.
Another culprit is financial innovation. While innovation is broadly regarded as a blessing in the financial sector, it is hardly uniformly so. There is a sharp dichotomy, between the value of innovation to the financial institution itself and its clients. The providers of financial services are heavily motivated by self-interest to organize securities into packages and “products” that earn profits for themselves. Some of these innovative products are simple and cost-efficient; others are mind-bogglingly complex and expensive.
Unfortunately, our institutions have a large incentive to favor the complex and the costly over the simple and the less expensive. As a result of the subprime crisis, some of the world’s mightiest financial institutions have collectively taken some $90 billion (estimated to total an astonishing $265 billion when all’s said and done) of write-downs from untested and complex financial instruments such as collateralized debt obligations (CDOs)—let alone the hundreds of billions of losses experienced by their clients.
CDOs are but one example of the exploding market for financial derivatives. As recently as 1960, derivatives on the S&P 500 Index – futures and options – did not even exist. Today, an estimated $23 trillion of these futures and options are outstanding, compared to the $13 trillion actual market value of the 500 Index itself. The “expectations market,” then, is almost double the value of the “real market.” These derivatives are a mere drop in the bucket of the global total of some $500 trillion in financial derivatives of all types. As a point of reference, the gross domestic product (GDP) of the entire world is about $50 trillion, a mere one-tenth of the derivative total.
The Age of Turbulence
In 2003, a remarkable debate about derivatives occurred between two of the most respected leaders of the entire financial community. World famous investor Warren Buffett described derivatives as “financial weapons of mass destruction,” while Federal Reserve chairman Alan Greenspan applauded their benefit, noting that “the prudent use of derivatives help banks to reduce risk.” Five years later, it seems that Buffett got it right. While derivatives have enriched the financial sector (and the rating agencies) with enormous fees, they have wreaked havoc on the balance sheets of those who purchased them, including the banks and brokers themselves.
In today’s turbulent markets, it is ironic that Greenspan chose The Age of Turbulence as the title for his recent book. Indeed, he did much to bring about that turbulence. His adamant refusal to set stringent credit standards for bank lending and mortgage issuance has been well documented, and his determination to hold down interest rates far longer than economic conditions seemed to dictate did much to feed speculation in the bond and stock markets.
Today’s turbulence also reflects the failure of our commercial banks and investment banks to consider the extraordinary risks of the securities they were creating and marketing, and earning billions in fees and commissions. In the end, however, they were left with tens of billions of dollars – even hundreds of billions – on their own balance sheets.
With both home and stock prices in retreat, our policy makers are running scared. The Federal Reserve making credit available to banks (a good, and necessary step) and driving short-term interest rates down (great for borrowers but terrible for lenders and savers, and terrible for the dollar). These policies increase the likelihood that inflation will rear its ugly head later on.
While the move might be to not intervene and just let the markets clear, our political leaders seem to have pressed the panic button. The $150 billion fiscal stimulus plan – right out of Keynesianism – may not provide much in the way of stimulating the economy, but only add to an already staggering deficit in the Federal budget. It’s easy for our politicians to give money to “the people.” But Americans will eventually pay for the “gift,” either through higher taxes or through devalued dollars.
In short, the combined blast from our monetary masters and our fiscal authorities will likely not make a positive difference either to our markets or our economy. Not only are our markets driven by the confidence of investors putting their dollars on the line, but our economy is driven by the confidence of consumers spending on their needs and wants, and corporations, spending to enhance the returns on their capital.
The inherent risk in our financial markets – enhanced by truncated time horizons, the dominance of speculation over investment, excessive financial innovation, easy credit, burgeoning credit risk, and a concentration of assets in banking conglomerates – has increased in recent years. These problems may well carry over to the performance of our economy, now approaching – if not already in – recession. If that is the case, we will see the leveling off of corporate earnings growth, perhaps followed by significant earnings declines.
Yet we’ll likely muddle through. Throughout our 230-year history, America has always done exactly that. Our society and our economy will almost certainly continue to reflect the resilience that they have demonstrated in the past.
To do more than muddle through, we must all develop the courage to take up arms against this sea of troubles that I’ve described today. If we do, the stock market will undoubtedly resume an upward course based on the intrinsic economic value of business growth.
Of course, our markets need “financial entrepreneurs,” traders, and short-term speculators, “risk-takers restlessly searching to exploit anomalies and imperfections in the market for profitable advantage.” Equally certain, our markets need “financial conservatives,” long-term investors who “hold in high esteem the traditional values of prudence, stability, safety, and soundness.”
Together, we must work together to restore that balance, and return financial conservatism to its rightful pre-eminence. For as Lord Keynes wrote many years ago, “When investment becomes a mere bubble on a whirlpool of speculation, the job of capitalism will be ill-done.”
John C. Bogle is the founder and former chief executive of the Vanguard Group.