Efficient Frontier 

William J. Bernstein

Of Viruses, Distressed Sales, and Stocks' "Rightful Owners"

Benjamin Roth's marvelous The Great Depression: A Diary contains this entry from December 11, 1931, just several months short of the bottom of the worst bear market in United States history:

A very conservative young married man with a large family to support tells me that during the past 10 years he succeeded in paying off the mortgage on his house. A few weeks ago, he placed a new mortgage on it for $5,000 and invested the proceeds in good stocks for long-term investment. I think in two or three years he will show a handsome profit. It is generally believed that good stocks and bonds can now be bought at very attractive prices. The difficulty is that no one has the cash to buy.

Or, as put by Benjamin Graham, "Those with enterprise haven't the money, and those with money haven't the enterprise, to buy stocks when they are cheap." In other words, those with the enterprise—the plungers—had long since run out of cash, and those who kept themselves in cash hadn't the courage.

The forlorn equities markets of the early 1930s were not, however, entirely illiquid; securities still traded among buyers and sellers. Someone was always there to take equities off the hands of the distressed and the panicked, and it's a good bet that Roth's "conservative young man" did well.

Most of those who bought stocks in the early 1930s fire sale were far wealthier and older than Roth's mortgager. As supposedly put by J.P. Morgan, "In bear markets, stocks return to their rightful owners." (This quote, like most ascribed to Morgan, as well as to Einstein, Twain, and Keynes, is apocryphal.)

Economic historian Richard Sylla recently pointed out a better documented summation of this process from Matthew Josephson's The Robber Barons:

[During a market panic] there are many casualties, cruel transfers of individual fortunes. Yet he who possesses even a modicum of unimpaired capital is as one who watches the sand run down in an hourglass, while fully aware that he may, at the given moment, turn the glass over and begin the process anew.

Just who turns over Josephson's metaphorical hourglass to purchase equity from the distressed and the panicked during bear markets? Benjamin Roth's assertion that no one had the cash to do so was incorrect, as his "conservative young man" demonstrated. Morgan and Josephson had a far better idea of just who stocks' "rightful owners" were: society's wealthiest, the possessors of "unimpaired capital" with which to accumulate shares at low prices.

Today, as then, unimpaired capital usually means Treasury securities. One does not need to be a Buffett scholar to know that the Sage of Omaha is fond of them. No matter how low the yield, almost every Berkshire annual report contains some variant of "We shall continue to hold our liquid reserves in T-bills." If investors have learned anything from the dark days of 2008 and now 2020, it's that when things go to hell, those wishing to deploy fixed-income securities of lesser quality—municipals, corporates, and mortgage-backed securities—for stock purchases are going to take a haircut at the approximate level of the clavicle. Buffett's apparent equanimity at the worst of times in no small part derives from sitting on a comfortable pile of such "unimpaired capital."

Today, the top quintile of the population owns 92% of stock wealth, and the bottom four quintiles own 8%. This discrepancy is likely to grow in the coming decades as the upward distribution of equities towards their "rightful owners" plays out, most of the time gradually, but sometimes in paroxysms.

Over the past generation, as ever fewer American workers participate in defined benefit schemes that provide a reliable stream of retirement income, ever more have become their own portfolio managers via defined contribution plans such as 401(k) plans.

This burgeoning mass of defined-contribution assets will be ground zero for the upward redistribution of equity assets. It will occur for three reasons. The most obvious mechanism, but likely the least important, is poor trading habits. During the the financial crisis of 2008–2009, defined-contribution investors, at least at Vanguard, did not in fact panic. An exhaustive study of its 401(k) participants showed that during the crisis, only 11% of them sold significant amounts of equity; for the other 89%, inertia seemed to overwhelm panic.  (Nonetheless, while it's true that Vanguard does a better job of instilling good investment hygiene among participants than other investment companies, it's not clear how well "Vanguard discipline" applies to its defined-contribution-plan clients, who likely did not themselves choose to work with Vanguard, but were placed there by their presumably enlightened employers.  Moreover, receipt of an investment statement did seem to trigger selling, and it's not clear how Great Depression-level market falls would further erode investment discipline.)

The second reason for the upward redistribution of stock assets will be the fall in defined-contribution assets as one moves from older to younger cohorts of retirees. A recent study from the Center for Retirement Research (CRR) shows that the balances of pre-retirement (ages 51–56) "late boomers" (those born 1955–1960) are an astounding 46% less than those of the "early-boomers" (those born 1946–1953) and of the "war babies" (born before 1946) at the same age. The authors postulate that this alarming fall in retirement assets is due to work loss and deteriorating employment quality in the wake of the global financial crisis. Since every share of stock must be owned by someone, it goes without saying that falling 401(k) balances among younger pre-retirees through decreased real wages implies an upward redistribution of stocks to the wealthy.

There is a third and even more alarming mechanism of the upward redistribution of stock assets: "cashout leakages" from workers withdrawing plan balances consequent to job changes, non-repaid loans and, critically, emergencies such as job loss and medical expenses. A 2015 paper from the CRR estimated this leakage at around 1.5% per annum, or about 25% over the span of total employee participation.

The cashout leakage is about to get much worse. As I write this piece, uncounted millions of Americans, newly out of work as a result of the response to the Covid-19 pandemic, have come face to face with the cruel mistress of financial destitution. The luckier among them will stave off ruin by liquidating what little assets they have, mainly in the form of their 401(k) and IRA accounts, and even at this early date, one does not have to venture very closely into the social media sphere to see evidence of this . Other small investors, both inside and outside retirement plans, while not immediately threatened by penury, will sell their equities in panic.

It should be obvious who will be buying up these equity assets at distressed prices: J. P. Morgan's "rightful owners," who sit on large piles of Josephson's unimpaired capital. Eventually, the bull market will resume, amnesia for the carnage will set in, and stocks' wealthy "rightful owners" will sell some of their shares back to plan participants at higher prices. This chasm between the amount of that unimpaired capital available to the rich and to the average 401(k) participant will continue to cycle equity-derived wealth ever upward.  

This, by itself, is bad enough. But it is unconscionable that we allow such a process to be accelerated by a retirement system that forces the vast majority of the population to compete against the few armed with massive amounts of unimpaired capital. The current system doesn't need a few tweaks and nudges; it needs dynamite and replacement with a system that actually protects workers, their families, and their retirements. 

 

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