New OPEB Strategies
after the Market Meltdown

Sept. 22, 2008 By GIRARD MILLER

Stocks: yes. OPEB bonds: eventually, but not yet.

Girard Miller
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Last week's market meltdown left a bear's clawmark on the charts as the Dow Jones Industrial Average (DJIA) closed at 10,609 on September 17 with a 25 percent-down market selloff. After that, the federal mortgage securities bailout story and a short squeeze in financial stocks rallied the market by 750 points before the weekend.

Although bear markets are defined as 20 percent price declines, a 25 percent market decline is typical in recessions. Over the years, that has been an opportune time to acquire or add to stock-market holdings for the long run. The only problem with this observation today is that the U.S. and world economies are stagnating yet not officially in a recession. The investment opportunities arising from past bear markets and past recessions were notably different for long-term investors depending on whether they invested cash or employed leverage. This leads me to suggest different strategies with respect to the use of cash versus leverage to fund a stock portfolio in an "other post-employment benefits" trust (or a pension fund).

After last week's market meltdown, OPEB plan administrators can prudently invest their initial annual plan contributions to OPEB trusts using higher levels of stock ownership than they might otherwise later (when the economy is expanding again). As explained below, thoughtful plan sponsors should wait until a recession is declared or statistically verified before implementing a leveraged OPEB bond strategy.

Equity-tilt without leverage. The case for investing a start-up OPEB trust's long-term portfolio in an all-equity or equity-tilt portfolio at this time is pretty straightforward. After reserving enough cash in a separate money market fund to pay for ongoing claims, the remaining initial contributions to a start-up OPEB plan are but a trickle compared with future required investments. Most OPEB plans use 30-year actuarial amortization of their large unfunded liabilities, so the first-year contributions to the investment fund are a mere 3-5 percent of the eventual mature size of the fund. Like a 25-year-old employee making his first investments in a 457 deferred-compensation account, a young OPEB plan has the capacity to take greater risks with its early investment dollars because there is ample time for the markets to work through temporary setbacks and there will be 20 to 30 times more principal invested in subsequent years. Add to this the current depressed state of stock prices in this bear market, and a very sensible long-term strategy is to "buy stocks low and hold for the long term.” An all-equity OPEB portfolio (net of liquid assets held aside for bill payments) is therefore a perfectly rational strategy this year.

This equity-tilt strategy clearly flies in the face of statewide OPEB investment pools, which typically invest their assets in a traditionally "balanced” asset allocation — such as mature pension funds that don't have the capacity to absorb such risks because they are much closer to full funding. This is one reason that I believe most OPEB plans should be custom-managed to take into account their unique asset-liability structures and their funding status. There are actuarial reasons to consider this approach right now, also, which I will be happy to forward to readers who e-mail me for more technical details. To implement this strategy, a dollar-cost averaging strategy is wise to consider, given recent market volatility and continued economic uncertainty.

OPEB bonds are not soup yet. Financial professionals should now prepare longer-term strategic plans to use OPEB bonds when the time is right, if they have legal authority and the financial flexibility to do so. But now is probably premature for actual issuance in this down-market cycle — even though the market had declined by 25 percent from its peak before it bounced. Historical analysis is illuminating here.

Both the stock market and the bond market aligned on September 17 to trigger a potential market signal to eventually sell OPEB bonds for 60 percent to 65 percent of the plan's unfunded liabilities and invest in equities. With the "Dow Down 25 Percent” and the "flight to quality" pushing U S. Treasury bond yields down to 4 percent, the quantitative market index conditions I outlined in a previous column on OPEB bonds were satisfied. A 25 percent stock market decline is historically sufficient for initiating cash-basis stock investments, but it is not sufficient for leveraged OPEB bond strategies.

Using OPEB bonds is a leveraged strategy that requires stock market investment returns to outperform the costs of bonds. In the previous column, I quoted historical research going back 60 years showing that once the stock market has declined by 20 percent or more, stocks have subsequently outperformed bonds 100 percent of the time over long-term periods of more than 20 years. The long-term historical case for OPEB bonds has thus been established now. However, there remains an unfulfilled condition for the optimal issuance of OPEB bonds, in my opinion — as explained below. It is not enough to be right in the long run, because an issuer of OPEB bonds must also survive the inevitable intermediate business cycles as well. Thus, public officials should wait until a recession takes hold before using the leverage of OPEB bonds. Otherwise, there is a risk that the next stock-market rally is merely a late-cycle blow-off like 1988-89 and 1998-99, and not a genuine expansionary bull market.

Think about this scenario: What if stocks were to rally 40 percent from last week's low, and then decline 25 percent from that level? You'd break even at today's market levels. But if you had borrowed money to make those investments, you would be underwater because of your interest costs. Historically, that is the experience of pension obligation bonds sold after the financial panics of the past two decades. That's why OPEB bonds are still premature, in my opinion. To put it another way, the finance officer who relies on 20-year periods may already be retired by the time the leveraged strategy pays off ultimately, but during her career she may see the strategy go underwater and lose her credibility if not worse. Not much upside there.

Historically, stocks decline by an average of 25 percent in recessions. The decline in the DJIA from 14,100 in October 2007 to 10,609 last week satisfied that test. However, an official recession has not been declared by the economists who make that determination, even though it already feels like one to many people. Some sectors of the economy have continued to expand this year. That leaves open one of the formal conditions for optimal issuance of OPEB bonds. Otherwise, there is a risk that this bear market in stocks is simply a financial market washout and not a nationwide economic malaise as well. The cyclical success of a 2008-09 OPEB bond issue in coming years will likely hinge on whether this market meltdown is a recessionary bear market.

Historically, there have been numerous bear markets with stock prices declining more than 20 percent. Of these, a majority occurred during recessions. Stated inversely, however, not all bear markets occur in recessions. The stock market crash of 1987 was one, and the 1998 financial panic was another.

One study comparing "standalone” bear markets and "recessionary” bear markets shows that the length and depth of the latter sets a stronger foundation for enduring recoveries. That is because recessions eliminate excesses in all sectors of the economy, not just the financial markets, and set the stage for stronger growth thereafter. Standalone bear markets last only 200 days on average and recessionary bear markets average 500 days. Standalone bear markets have occurred in the middle of a business expansion seven times in 68 years — roughly once a decade.

This is important because the standalone 1987 and 1998 financial market washouts were followed by 40 percent stock-market recoveries in the eighth and ninth innings of those decades' extended business cycles. Then the markets suffered recessionary declines which wiped out most of those 40 percent gains. Borrowing money to buy and hold stocks in the aftermath of a standalone financial crisis was therefore a losing strategy. Although stock market patterns seldom repeat themselves, there is a lesson here worth remembering with respect to OPEB investing.

To see the difference, look at the 10-year chart of the Dow Jones Industrials below. The chart begins with the panic bottom in 1998, followed by a late-cycle rally into 1999, followed by the recessionary decline of 2001-2003, and then the cyclical expansion from 2003-2007 and the ensuing financial market malaise of this past year. Investors who bought stocks with cash in 1998 made money in this period. However, they would have fared terribly if they had borrowed money to fund their investments. The interest costs would have wiped out all their gains to date, and they would have been seriously underwater in 2002-03. On the other hand, if they had instead sold OPEB/POB bonds in 2003, even after the recovery began, their use of leverage would have been successful. This distinction is not hypothetical: Those are the dramatic differences between the pension obligation bonds sold by New Jersey in 1998 and the Wisconsin POBs of 2003.

Stock market choice
Chart Source: MSN Money

Unlike the stock market crash of 1987 and the collapse of Long Term Capital Management following the Asian contagion in 1998, this year's financial meltdown was rooted in the housing and mortgage industry — on Main Street, not just Wall Street. Thus, it feels much more like a broad cyclical economic downturn. The recovery from these levels may ultimately be regarded as the beginning of a new business cycle rather than a rebound from a primarily financial-sector panic. The longer this malaise runs, the more likely that will be the case. Duration is a key differentiator between panics and recessions.

For OPEB bonds to succeed, the ideal conditions would likely be a declared national recession or at least a six-month measured decline in broad economic indicators like GDP. Currently the leading economic indicators suggest that we are heading into recession, but the data for the second half of 2008 will not be known until early next year. Every bone in my body says a recession is already underway, but my analysis and professionally disciplined strategies require objective data, not subjective instincts. That is why patience is necessary for those formulating or considering OPEB bond strategies.

Start planning now. That said, the "Dow Down 25 Percent” signal is clear: It's now time to get ready. Formulate and refine an OPEB bond plan, especially if you sense the economy slipping further. It could be a once-in-a-decade opportunity if the economy trends lower in coming months. As the chart above shows, stock markets typically move upward swiftly once it becomes evident that the storm has passed. There probably will not be a long window to issue OPEB bonds once the coast is clear. Those who procrastinate in their planning usually miss the boat.

Girard Miller, an analyst of benefits and investments with 30 years of experience in the public, private and nonprofit sectors, can be reached at Girardinmalibu@charter.net. His general market observations and institutional investment strategies are his own and should not be construed as investment advice or recommendations concerning specific securities.
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