Reflections on the S&P at 1000

It's time to revisit and rebalance investment allocations.
August 20, 2009 AT 3:00 AM
Girard Miller
By Girard Miller  |  Finance Columnist
The finance columnist for Governing.

Earlier this month, the stock market bounced 50 percent above its March lows, as measured by several of the common indexes. The S&P 500 stock market index crossed the magic 1000 level, and the technology-heavy NASDAQ passed 2000. At these levels, the stock market is still at least one-third below its 2007 peak, so there is no champagne flowing just yet, but these milestones deserve a little more attention than they received.

Retirement investors have a lot to think about, now that the market has recouped a third of its losses in the previous bear market. Both individuals as well as institutional professionals need to think twice about their current portfolios and make intelligent choices for the future.

First, some economics. We are probably approaching the end of the Great Recession. The National Bureau of Economic Research won't make a declaration about this for some time. Over the past 25 years, they took 15 months after each recession ended to announce it, so don't hold your breath for that information to guide you in your investments. But the economic indicators are starting to line up as they have previously at this turning point in the business cycle.

That said, things really are different this time. As the Great Recession ends, we will not enter the Great Recovery. We will more likely enter the Great Grind for the first year. It will be a long slog forward, with tepid growth and high unemployment working down gradually, as we whittle away at the massive real estate and mortgage problems that continue to act as a drag on this economy. Consumers have been burnt severely, and their newly discovered savings habits will impede consumption, so the economy will come out of this downturn more slowly than any recent recession.

Yes, we will see spurts of growth in sectors where demand is pent-up, including technology. Yes, stocks could front-run the recovery even more than they have already. Yes, the global economy looks better than the U.S. because of China's growth. And yes, the federal stimulus money will start to hit the streets in force soon and carry on into 2010. But the traditional cyclical surge in housing construction will be absent in this recovery, regardless of interest rates -- and the Obama infrastructure package offsets only one-third of the 2008-09 collapse in housing construction and employment.

Foreclosures hang over the housing market and the economy in general. With 30 percent of America's homes underwater in 2010, according to's latest estimates, there won't be any home equity loans to fuel spending for other goodies. The American house is no longer an ATM and an investment asset; it's now a source of deep economic anxiety for a quarter of U.S. households. Likewise, many banks are still sitting on piles of toxic mortgages and will be wary of lending too freely in 2010. They too need to rebuild their capital base. There won't be any irrational exuberance from homeowners and bankers for years.

If we're lucky, the slow start of the next up-leg of economic expansion will eventually result in durable economic growth that takes the market back to its former peaks over the next five years. That would be terrific. But what most investors forget is that from today's levels, an historically normal 10 percent annual rate of return on stocks would just get us to a Dow Jones Industrials Average above 14,000 in five years, so that's just a normal trendline. And if the economy then enters another normal cyclical recession, the historical average is 30 percent down on the next downturn, which would put us back at something like Dow 10,000 in the next recession. Nothing there to cheer about. And nothing there to pay retirement benefits -- whether in pension funds or in individual savings accounts.

So why is that important?

Retirement savers. For starters, a lot of Baby Boomers in the private sector will come to realize that they can't afford to retire until they weather the next bear market. They have learned that their 401(k) can become a 201(k) in a single year, and they will keep working until they know they have a base that looks solid enough for the next cycle. Many will be compelled to buy fixed annuities with meager non-inflationary payouts in order to manage their market risks. Those taxpayers are not going to be terribly supportive of public pension plans that let workers quit ten years before them, and then collect cost-of-living increases.

Pension funds. Next we have the public pension plans, which were funded at roughly 85 percent of their actuarial liabilities at the peak of the last cycle. They are now running closer to 70 percent funded as a result of the 2007-09 market roller-coaster. To get back to their prior funding levels, it will take a lot more than 10 percent annual stock appreciation in the coming decade, as I'll explain below. So their only realistic ways to move toward proper funding are to amortize their unfunded liabilities and raise employer contributions (and taxes), invoke higher employee contribution rates or cut benefits. And cutting benefits for new hires does nothing to erase unfunded liabilities for current workers and retirees.

There is a little fib spreading around the public pension community that investment returns of 10 percent can work us out of the hole we're in. Sorry, but the math doesn't work that way. Achieving 10 percent annual stock returns through to the bottom of the next recession simply enables us to make our actuarial assumptions, nothing more. At that rate, plans would be about 78 percent funded on average. We all need to re-set our expectations and our financing plans to the "new normal" and accept that we've lived through two supercycle bubbles in this century. It will take another decade or two to fully recover.

If the next recession brings a normal 30 percent decline in stock prices, then this business cycle has to grow equity prices at 10 percent annually for another eight or nine years simply to keep us above the prior market peak of DJIA 14,100. Back in 2007, funding ratios were 85 percent but liabilities will grow at least 30 percent greater by 2016. So, a DJIA 14,100 by then leaves us still at the 75 percent funding level. If this cycle follows normal historical patterns, stocks would have to rise by 16 percent annually over four years to offset the effects of an average recession and an average business cycle. That seems like a tall order in a tepid economy.

Yet both of these scenarios fall short of the actuaries' current projections for pension fund returns. To make headway against today's actuarial deficits through investments alone, we need more than 18 percent compounded stock market growth for almost a decade before a recession of average size.

So, with that somber view to set our perspective, what's a poor soul to do with his or her retirement nest egg now? And what should pension funds be doing?

Let's start with individuals first, since we're all individuals and we all plan to retire. The irony of 2009's stock market rally is that the investors who followed the rules and maintained their target asset allocations were able to buy a bunch of stock (funds) in the March bottom, and they are now probably over-invested in stocks! That's right, a 50 percent bull market rally from the last bottom now leaves some investors with portfolios that are 10 percent too heavy in the stock market. Although there will be a temptation to "ride the winners" now, in hopes of making back the losses of 2008, history says that's a gamble.

Historically, stocks typically increase in value another 25 percent in the 15 months following the end of a recession, taking them to levels that were approximately the same point as the next-cycle bottom. This phase in the market cycle is what I call the "Green Zone" of lower risk and higher returns for equities. For those able to bear the outlier risk of a double-dip recession, I suppose that might be an opportunistic strategy to consider. However, the problem with such thinking is that this cycle is closer in nature to the depressed 1930s than to any other postwar business cycle.

So the prudent investor should stick with her knitting and maintain an age-appropriate asset allocation. To maintain proper portfolio balance, that means moving some recent stock-market profits into bonds (or short-term, foreign-bond or stable-value funds, if you agree with me that interest rates are likely to rise and the dollar eventually to decline). If stocks actually do rally another 25 percent by the end of 2010, then your current holdings will look lots better anyway and you don't need to be greedy. You'll again clip some profits in stocks and move them to bonds. This is called a "trim discipline." You buy a little insurance against downside risk.

For pension funds sitting on big losses from 2008, the temptation will be to ride your winners. After all, that would help restore the funding ratios to 2007 levels, right? Again, there is a chance that stock market history is on your side, but the risk now is that the economy underperforms the animal spirits in the stock market during the next recovery. If you've made big profits in the past three months, or at least recovered some losses, this may be a good time to revisit your asset allocation and make sure you haven't accidentally slipped into a too-risky profile. I'm not unduly worried about returning to the March bottom at this point, but a practical person would have to believe that somewhere in the next six to eight months, we will receive some lackluster economic reports that disappoint the bulls on Wall Street enough to cause a correction that jars investor confidence on Main Street.

Pension funds in the coming decade will need to think harder about their approach to asset allocation. In the past, they took a "buy and hold" approach, which has failed miserably in the past two business cycles. With Baby Boomers aging, and liabilities cemented with constitutional protections, pension funds need to start thinking about risk-management strategies for the next business cycle. If we see stock returns of more than 10 percent annually in the next four to five years, mature pension funds will need to think about locking up profits by more than just rebalancing. They may need to shift to a higher bond allocation for good -- or at least until the next recession bottom. This would be a game-changer in the pension industry.

Finally, if you failed to rebalance during the bear market, and your stock portfolio is still so far underwater that it represents far less than your long-term investment goals and risk profile would suggest, there is good news: The next business cycle has just begun, and although you should not expect to recover your losses any time soon, you can afford to maintain your equity exposure at this point in the cycle. If you're lucky, you'll get back to a normal weighting when the economy fully recovers and then reaches its expansion phase.

If all this sounds too complicated for you, remember that those asset allocation or target-date funds in your 457 or 403(b) plan actually do all this rebalancing for you automatically. They have their flaws, but they did acquire stocks at the March bottom and are now trimming back to maintain their long-term asset allocations. They buy low and sell high, at least on the margins.

Girard Miller's general market observations and institutional investment strategies are his own and not those of affiliated organizations, and should not be construed as investment advice or recommendations concerning specific securities.

Girard Miller
Girard Miller | Finance Columnist |