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02/12/2005

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Martin Bento

To reiterate a point I made before which no one, including Becker, has addressed: putting vast new infusions of capital into the stock market provides a structural advantage to large firms at the expense of small and medium ones. It is the small ones that provide most of the jobs, and the medium ones that provide most of the innovation. Peter Drucker has studied corporate innovation and done real-world consultancy related to it at probably greater depth than anyone else, and that is the conclusion he comes to. Big firms are too locked in to current markets and techniques; yes, they can afford a lot of R & D, but they cannot sacrifice their current markets to change direction. The new direction comes from the middle firms (the small can't afford much R&D, save in fields like software which are mostly R&D). The structural advantage this proposal gives big firms promises to stifle innovation, which is really America's only hope to remain competitive. And it's not a "natural" result of the "free market"; it will be an artifact of the beast we are creating now.

Becker continues to insist that a political plummet of retirement ages is inevitable, based on a broad survey of paygo schemes. However, the most relevant case is clearly the one we are discussing: the SS system of the US, which has already consented to *increasing* retirement ages. Becker is attempting to ignore a plain fact by trotting out analogies to other situation. Analogies are frequently useful but do not trump facts: you cannot argue that SS never permits increase of the retirement age, because it has, in fact, already permitted this.

As for those who like to argue from first principles, let me ask this: under what definition of freedom is freedom maximized by requiring people to give money to others, so that the latter may realize profit, only partially to be redistributed, on it? The current social security system sacrifices freedom for security and redistribution, and this is a generally-acknowledged tradeoff. But this proposal trades my freedom for several other things, one of which is the profit of someone else, said profit being expressly not based on "need" in the charitable sense. Suppose I object to corporate profits per se, as many people do. What is the moral basis for the government to require me to fund such entities?

Jay Cline

Martin, I am not by no means addressing all your points, nor am I dismissing them, but my first reaction to your last point, Suppose I object to corporate profits per se, as many people do. What is the moral basis for the government to require me to fund such entities? is that under current proposals you would not be required to and I agree that you should not be required.The 4% (not the 15% that has been generally touted here) of SS withholding that has been proposed to be allowed to go into private investments is first, voluntary, and second, it doesn't have to go to an indexed stock fund. You can fund government borrowing by placing that 4% in a US bond mutual fund. Or you can fund the General tax fund and opt out.

Jay Cline

mb, I am honestly stupid. I don't get the math of If you want to get a 5% return on Social Security money, then the total value of companies available to invest in, assuming they average a 5% return, can be no larger than the GNP of America. Do the math. No sarcasm from me this time; I really don't understand it.Where does GNP come into the equation of worth?

Corey

"To reiterate a point I made before which no one, including Becker, has addressed: putting vast new infusions of capital into the stock market provides a structural advantage to large firms at the expense of small and medium ones. It is the small ones that provide most of the jobs, and the medium ones that provide most of the innovation."

I also made this point in the original thread but no one addressed it there either. This argument goes directly to the core assumption that privatization is justifiable because of trickle-down "well paying jobs" that magically are supposed to appear when you give millions to capitalists.

No one will address this because it is not in the talking points, the correct response to attacks on basic assumtions is hand-wringing about contractarian free will and the evil of "redistribution".

Jason Ligon

Corey and Martin:

Wilshire 5000 Index Fund as an investment option. Would that help you out? The beauty of the index option is that it does not pick winners. As companies move in and out of a given index, the fund will buy or sell it. The structural advantage is fairly evenly distributed, unless you are talking about the structural advantage given to those who issue stock at all vs. those who remain privately held. This does not get at 'mid sized companies' per se.

Note also that what you are also implying is that, on the whole, investment creates a net disadvantage to the economy unless cash goes predominately to the most risky (read young) investments. Innovation is, in theory, rewarded with price performance.

"This argument goes directly to the core assumption that privatization is justifiable because of trickle-down "well paying jobs" that magically are supposed to appear when you give millions to capitalists."

The argument is a little more sophisticated than that. Most who make it view jobs as an artifact of growth. A counter argument must be either that growth does not translate to jobs or that there is a better way to get jobs than to grow. The big lie is that there is an alternative. George Bush can't create jobs from the Oval Office, but neither could John Kerry. All you can do is grow or not grow. I hope it isn't too terribly disappointing for me to note that a direct handout to lower income Americans is the same as a cash subsidy paid directly to Wal Mart. There is an argument often made that this is how growth should be driven (as opposed to increasing investment), but even that is different from the argument that Wal Mart should not be able to turn a profit.

Jay Cline

putting vast new infusions of capital into the stock market provides a structural advantage to large firms at the expense of small and medium ones.I tried to find some reference where Drucker actually says this or the context that it was said, but can't. Can someone give me a big neon sign?In the absence of any reference material, it does seem funny that someone would use Drucker to oppose investing in the stock market, given that Dr. Drucker enunciated the virtues of “worker capitalism” (The Unseen Revolution : How Pension Fund Socialism Came to America.)From what little I have read (I am not an expert on Drucker), it is rather surprising that someone opposed to the current SS reform proposals would even mention his name, particularly given that Drucker, in the above reference, advocated the ESOP or employee ownership view that has now been made famous by Enron, MCI, etc.Drucker is the guru of performance; he most definitely does not equate that with government. Some short quotes from Drucker in an earlier article, Sickness of Government:
Of all social institutions, business is the only one created for the express purpose of making and managing change. Government is a poor manager.government is big rather than strong; that it is fat and flabby rather than powerful; that it costs a great deal but does not achieve much. . . . The best we get from government in the welfare state is competent mediocrity. More often we do not even get that; we get incompetence such as we would not tolerate in an insurance company.there is no performance (in government) whatever—only costs. This is true not only of the mess of the big cities, which no government—United States, British, Japanese or Russian—has been able to handle. It is true in education. It is true in transportation. And the more we expand the welfare state, the less capable of routine mediocrity does it seem to become. . . .Every government is, by definition, a "government of paper forms." This means inevitably high cost. For "control" of the last 10 per cent of any phenomenon always costs more than control of the first 90 per cent. If control tries to account for everything, it becomes prohibitively expensive.The system which protects government employees from political pressures, Peter F. Drucker notes, "also protects the incumbents in the agencies from the demands of performance".To fear corruption in government is not irrational.Me again. I guess that says it all.PS monkeyboy, fyi, this is called doing your homework, in case you need a refresher.

monkyboy

Jay, one measure of determining a companies' worth is its Price/Earnings ratio. A P/E of around twenty is consider a fair valuation.

This means a company is worth 20 times its earning. If a company earns a 5% profit on sales...it is worth 20 x 5% = its annual sales.

Even though the average company is only earning about 4% right now, and the average company is trading at a P/E of well over 20...saying a company is worth about its annual sales isn't a bad estimate.

Given this...ignoring our current $600 billion trade defecit...the annual sales of all US companies is a fair estimate of the total worth of all possible investments.

Taking a GDP of around $11 trillion and subtracting government spending, private companies sales and transactions like college tutition and payments to landlords, etc. leaves you with about $6 trillion in revenue generated by publicly traded (ie, the ones you can buy stock in) companies.

Jason Ligon

monkeyboy:

You are using specific terms very loosely. A P/E ratio is not a way to value a company as a whole. It is a proxy measure for the actual value of a company vs. its current stock price. P/E must be put into context of growth, because the market looks forward. So, a company with a large initial investment that is not expected to pay off for a few years may have a very high P/E ratio, and justifiably so. Your analysis above fixates on a certain point in history and therefore on the wrong variable.

What you are getting at is that, over the long run, the rate of growth of corporate profits can't exceed the rate of growth of the economy as a whole. Also, you are getting at the notion that P/E is already above historical norm on average. The questions to sort out are:

"What do we expect to happen in the way of growth and earnings?" and

"How will P/E ratios be brought into alignment with historical trends so as to justify historical growth rates?"

The historical answer to the second question is that there will be a correction. Note that this is not the same as saying that the market is doomed to low growth forever, which is the implicit assumption of the criticism you raise. If the market tanks in one year sufficiently to bring P/E to historical levels, we can expect historical growth, on average, thereafter if we hold to the notion that historical P/E is sacrosanct. Another possiblity is that higher than historical rates of innovation would justify higher P/E with higher growth than one would historically expect. Still another is that globalization helps us out quite a bit.

monkyboy

Jason, P/E isn't a bad estimate of a companies' value. Sure, start-ups can have a high P/E, but these companies aren't good investments for long-term stability. Nor are walking corpses like United Airlines and General Motors.

If you are going to invest for steady growth, you need to avoid high P/E, high risk stocks and you have to avoid the obvious dogs. I have yet to see a reliable figure on which companies fit this description and how much they are worth. There is also the question of whether Social Security money should be put into companies like Phillip Morris.

Even if private accounts get approved by congress, we may be trying to get an elephant to mate with a mouse. Social Security currently takes in about $600 billion a year. Most plans I've seen call for one third of that, or about $200 billion a year to be invested.

The total value of companies available to invest in is much smaller than most people seem to realize. Five years of SS funds equals over a trillion dollars. Is there room in the market for it. If so, for how long? If this is to be a long term fix, the other great source of wealth in the U.S., real estate will have to be looked at too...

Corey

"Still another is that globalization helps us out quite a bit."

Globalization only helps you out in the sense that you can use it to bring as-yet-unexploited resources (labor, oil, bananas) into the economy at discounted rates (vs. what it would cost to exploit equivalent resources locally). Of course, like all wells, this one will also eventually run dry.

In the last decade, our ability to globalize has increasingly run into the rest of the world's resistance to being globalized. It is harder and harder to hide the sweatshops given the internet and cheap global air travel. We can attach the terrorism label to the resistance, but we still aren't making any net profits in the middle east.

Last time we had crazy market growth, it started and ended in the tech sector, with a rush to bring startups public and admittedly silly valuations all around. Trillions went into the market, and things looked rosy. Wages went up across the board, jobs were everywhere. Of course, it crashed, but NOT all the way.

Now Bush and Becker (and by association Posner) want to drive trillions into the market again, with the unmandated conversion of social insurance trusts. They are correct in predictng that the short term effect of their plan will be to drive up the valuations of companies that are selected for participation in the index.

Of course, there is a difference that should be glaring between growth driven by innovation and growth driven by index fund investment. It is the mystery behind the "jobless recovery." (and no, I refuse to count part-time jobs now held by people who used to work full time as progress) You CAN grow the economy without changing the poverty rate simply by making sure the new money made goes exclusively to wealthy white male property owners. After all, its in the constitution eh?

So, the trillions are going into the index funds, and that brings me full circle to my original point that this is nothing but corporate welfare.

Large companies do NOT innovate, they regulate established markets. They purchase new technology only when the market for the old is saturated. They hire someone new when someone dies.

If Bush was serious about stimulating growth, he would foster a startup/IPO climate and make it easier to create 80 new jobs for every good idea. He would leave Social Security alone, as a safety net for the wild ride, and would open up stem cell research.

But Bush is only serious about rewarding "his base", the "haves, and the have mores." Bush said it, not me, not Michael Moore.

Steve J.

BECKER:"It is inconsistent to complain about the low savings in U.S. and object to a system that is likely to increase savings, much of which would be invested in equities. Higher savings would reduce dependence on foreign investments in the country, and would make more domestic capital available to be invested. Is that bad?"

It won't make more capital available. Every dollar diverted from SS will have to be borrowed by the Feds on the private market.

Steve J.

BECKER:"To be sure, people make mistakes, "

The Silent Scandal: 401(k)s and the Failure of Responsibility
by Robert Markman
Journal of Financial Planning
http://www.fpanet.org/journal/articles/1998_Issues/jfp1298-art2.cfm

Reality #1

Most investors cannot or will not manage their own portfolios. Adding more choices does nothing to change this and probably only makes things worse. Adding more choices to a 401(k) seems absurd when nearly every quantitative study confirms the fact that many plan participants are woefully ignorant of even basic investment fundamentals.

Reality #2

Calls for "more" and "better" education are the mutual fund industry's version of President Johnson's "War on Poverty." Enormous resources have been and will be expended. The goal is so noble, so self-evidently positive, that we are willing to ignore the fact that there is little evidence that force-fed information translates into substantially better results for most investors.

Reality #3

Survey after survey confirms that the shortage Americans feel most is not information, not education, but time! Barron's recently reported research that says "an astounding 44 percent confessed that, given the choice, they'd rather have more free time than money." (We doubt that they meant more free time to read Barron's.) The "lack of time/unwillingness to take the time" syndrome is the ultimate trump card in the whole equation. All efforts to empower, educate and expand choice ultimately fail when confronted with this reality. The bottom line is that current moves to expand participant choice and educate investors is the financial equivalent of rearranging the deck chairs on the Titanic.

Myth of Bull Market Returns
The answer lies in a common misperception about mutual fund returns. Even sophisticated fund investors frequently miss the fact that the return achieved by a fund is often far different from the return achieved by the investors in that fund.
The Boston market research firm Dalbar found that between 1984 and 1995 the average stock fund posted a yearly return of 12.3 percent, while the average investor in those funds made just 6.3 percent.

Fear of [Social Security] privatization generally centers on concern over what the long-term consequences would be for the inexperienced and uninformed investor. And, as we've seen, that concern is more than justified.

Steve J.

BECKER:"many of you do not have that confidence in people."


Chairman GREENSPAN. Senator, I thought that the initiative that
the Senate produced was very important and very effective.
As I said to the Chairman before the hearing, my original view
was that taking accounting standards and moving them out of the
private sector was really unnecessary because my view was always
that accountants basically knew or had to know that the market
value of their companies rested on the integrity of their operations
and that, indeed, that signature that they put on an order form is
where the net worth of the company comes from.
And that, therefore, their self-interest is so strongly directed at
making certain that their reputation was unimpeachable, that regulation
by Government was utterly unnecessary and, indeed, most
inappropriate. I was wrong.
FEDERAL RESERVE’S SECOND MONETARY POLICY
REPORT FOR 2002, COMMITTEE ON
BANKING, HOUSING, AND URBAN AFFAIRS
UNITED STATES SENATE, JULY 16, 2002

Jay Cline

mb, so if value in your calculations is income multiplyed by P/E and the average P/E is 20, why are you not multiplying GDP times 20, giving $220 trillion in capacity to absorb an influx in funds?Oops, you're multiplying only the profit portion. which completely ignores assests.Sorry, my bad.Ok, let's be straight here. Value is market capitalization, that is stock price times outstanding shares. That is, the total amount of money invested and its current value, which on the Big Board is $20 trillion. Divide that by 4% (not the total 15%) of GNI proposed to be potentially diverted to the market ($10 trillion times .04 = $400 billion) and you get 50 years, not 5 years.So, mb, your homework for the day is to find out how many times Big Board capitalization increased from 1955 to 2005, multiply that by $20 trillion and determine when we can expect the SS fund to overwhelm the market. And don't tell me that is an unreasonable expectation, because it is at least as reasonable to assume that, as it is to assume the market cap will not change at all, which is what you have been braying.

Jay Cline

You CAN grow the economy without changing the poverty rate simply by making sure the new money made goes exclusively to wealthy white male property owners. After all, its in the constitution eh?Corey, you really diminish your credibility with statements like this. Read your Constitution, with Amendments. Specifically the 15thAmendment XVSection 1. The right of citizens of the United States to vote shall not be denied or abridged by the United States or by any state on account of race, color, or previous condition of servitude.Section 2. The Congress shall have power to enforce this article by appropriate legislation. and the 19thAmendment XIXThe right of citizens of the United States to vote shall not be denied or abridged by the United States or by any state on account of sex.Congress shall have power to enforce this article by appropriate legislation.

monkyboy

Jay,

I accept the figure of $20 trillion for the total market value of every publicly traded company in the world. I still don't think SS money should be put into foreign companies, though.

Looking at just U.S. publicly traded companies you get a total market value of around $14 trillion.

If you look at the value of just the Standard & Poor's 500, give or take the 500 most valuable U.S. companies, they have a combined value of around $12 trillion. So about 85% of the total value of U.S. stocks available for purchase are in just 500 companies.

How have they risen in value? As you might imagine, they have actually dropped in value over the last 6 years. I don't think you can go back to 1955, when our major competitors were still clearing away the rubble from their economies left from World War 2.

The value of the S & P 500 is down over the last 6 years and flat over the last 10 years. As the S & P 500 represents the maximum return large investments can earn, it certainly doesn't look promising for the SS private account plan...

joeblow

Of course, the answer to your concern monkeyboy is to not force anyone to invest their money. Let them keep it to do whatever they like with it.

jb

Jay Cline

mb, the 50 years is based on the estimate I gave to address your concern for how long it would take to flood the market with SS funds.Dispute the 50 years or answer the question.

Jason Ligon

"If you are going to invest for steady growth, you need to avoid high P/E, high risk stocks and you have to avoid the obvious dogs. I have yet to see a reliable figure on which companies fit this description and how much they are worth. There is also the question of whether Social Security money should be put into companies like Phillip Morris."

Let me get this straight. If we discard all growth stocks, and restrict ourselves to P/E on the order of the incredibly arbitrary figure of 20 ish, then take out companies that don't sell products you like and companies with foreign ownership (presence?) from that list, you are saying that there aren't many companies left? I think I agree with that.

The other point I think I'm getting from all this is that a future-looking investment on the part of a company that is expected to pay off in the future should result in a high P/E currently. Innovators, therefore, have high P/E. If we exclude innovators from our list of available investments, there are no innovative companies to invest in. I think I agree with that statement, as well.

Anonymous

A P/E of 20 is hardly arbitrary, Jason. Only stocks trading at a P/E of 20 or below are returning the 5% needed to make private accounts viable.

It's hard to see how we are going to invest trillions of SS dollars in the stock market and not put most of it in S & P 500 companies as they account for 85% of the market value of all U.S. stocks.

Look at the internet bubble to see the fate of most stocks trading at high P/E ratios, Jason. A few were 'innovators', the rest were junk.

Jay, it looks to me like 25 years will buy every single share available. Don't forget, the SS is supposed to grow at 5% compounded each year.

Jay Cline

Ok, let me blow the lid off of this notion of flooding the market and 'consuming' all available stocks.Can't happen (despite my willingness to cater to mb's arguments). Why? More money comes into market, increases demand for stock, stock price goes up, company doesn't like the high price of stock and offers split (say 2 for 1). Now, there are twice as many stocks available at old price and company has twice as many non-distributed shares available at old price. Company sells some of that stock, pays off debts, reduces operating costs related to debt servicing, has more economic muscle to intiate projects and programs that it shelved because it didn't have the financing and didn't want to incur additional debt to finance. Down the road, company benefits from investments from sale of stock and bottom line improves. Market Cap increases with increased profits. If we are going to measure the true capacity of a market to take in an influx of investments, in the short term, one component (and there are others) would have to be the amount of non-distributed stocks, not outstanding stock. In the long term, increased productivity, return on investment, yadda yadda yadda, expands total value and yes Virginia, for the small amounts of influx we are talking, it is insignificant.Sorry for the games, but I really thought someone would see the error a whole lot sooner (yeah, I am laughing all the way to the bank)

monkyboy

Hehe Jay, someone should make you president. Unfortunately, stock splits don't double earnings. You would simply be doubling the P/E of the stock. The whole argument for private accounts is that they would have a higher rate of return than the current policy of buying government bonds.

A more likely scenario is SS money, after causing a brief spike in stock prices so Bush supporters get a nice bonus, is that it will crowd out foreign investment and regular investers from the stock market...

In the end, I don't think politics or theory enters into this debate. Are there enough shares to absorb SS money. Hard to say, but it doesn't look like it.

Jim S

"Company sells some of that stock, pays off debts, reduces operating costs related to debt servicing, has more economic muscle to intiate projects and programs that it shelved because it didn't have the financing and didn't want to incur additional debt to finance."

A perfect example of why that model doesn't wash is the current activities of the oil companies. They are awash in cash. Oil is hovering at just under $50 an hour. No serious analyst thinks that (pending some amazing technological miracle) oil prices will be dipping below $30 a barrel ever again, much less any time soon. What do the oil companies do? They base all of their spending on exploration on prices of $20 a barrel or lower. There is some financial activity in the nature of dividend payouts. While that benefits shareholders it doesn't necessarily do wonders for overall economic activity. Several articles I've read said that there is a ton of VC going begging for someplace to invest it. What does that say about your claim that the existence of investment money will always lead to economic growth and jobs?

Jason Ligon

Wilshire 5000 Total Market Index

Check volatility vs. S&P 500. Check total number of investable shares. Check historical performance. Check whatever you want, it seems to solve a great deal of the problems you think are out there with only going with S&P 500. It is probably the most broadly diversified index in the world. I think, despite its name, it has over 6,000 US based companies.

Anon glosses over long histories of performance of small and mid cap stocks, telling us that volatility makes them not pay off. Corey complains that invested assets would only go to The Big Boys, even though real innovation comes from the smaller players. MB tells us that the largest 500 companies in America do not have enough shares to support social security invested over a period of time (because, you know, no one will be selling shares to spend their money), but then tells us that no other companies can be invested in.

Given all of these assumptions, I have to agree that the problem would be unfixable. I happen to disagree with all of them, so I don't know where that leaves us.

Smaller, growth oriented companies innovate more, that is true. They take risks. They borrow and make big investments. These investments quite often pay off. Innovation IS rewarded on the market by share price movement. Diversification across capitalization categories is smart, not foolish. Some of this money will go into bonds because diversification across asset classes is smart, not dumb as well. As people approach retirement, more and more of their money will go into debt instruments as they begin to seek stabilization, income, and ultimately liquidity. I am not at all convinced that even if we only invest in the S&P 500, we will run out of shares.

monkyboy

I am not convinced, either, Jason. Just trying to get the facts. I think the debate about Social Security has raised everyone's knowledge of how that program works. Private accounts have made me dig deeper into corporate America.

One thing I find strange is that both the DJIA and the S&P 500 regulary dump underperforming companies and replace them with up and comers. In the year 2000 alone, the S&P 500 removed 147 companies from its index and replced them with better performing ones...

Those who claim that the stock markets always rise in the long term frequently point to these two indexes as proof. Constantly dumping losers and replacing them with winners doesn't seem like it would give an honest picture.

I welcome suggestions on where to look to get a clearer picture :)

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