Money & Banking August 13, 1979, 12:01AM EST
The Death of Equities
How inflation is destroying the stock market
On July 23 institutions that manage pension fund money began operating under a new and far more liberal interpretation from the Labor Dept. of what is a prudent investment under the Employee Retirement Income Security Act of 1974 (ERISA). Pension fund money can now go not only into listed stocks and high-grade bonds but also into shares of small companies, real estate, commodity futures, and even into gold and diamonds. “The decision throws the door wide open to hard assets for institutional investors,” says a jubilant Jack B. Backer, a New York diamond dealer.
To millions of people, that ruling could mean a higher return on their pension fund assets after years in which inflation has nibbled away at the return from more traditional investments. On another level, the Labor Dept. ruling is just one more in a nearly endless string of unhealthy things that have happened to the stock market over the past decade.
Only the elderly remain
At least 7 million shareholders have defected from the stock market since 1970, leaving equities more than ever the province of giant institutional investors. And now the institutions have been given the go-ahead to shift more of their money from stocks—and bonds—into other investments. If the institutions, who control the bulk of the nation’s wealth, now withdraw billions from both the stock and bond markets, the implications for the U.S. economy could not be worse. Says Robert S. Salomon Jr., a general partner in Salomon Bros.: “We are running the risk of immobilizing a substantial portion of the world’s wealth in someone’s stamp collection.”
Until now, the flight of institutional money from the financial markets has been merely a trickle. But if could turn into a torrent if this year’s 60% increase in oil prices touches off a deep recession while pushing inflation sky-high. As it is, the nation’s financial markets and its capital flows have been grossly distorted by 13 years of inflation. Before inflation took hold in the late 1960s, the total return on stocks had averaged 9% a year for more than 40 years, while AAA bonds—infinitely safer—rarely paid more than 4%. Today the situation has reversed, with bonds yielding up to 11% and stocks averaging a return of less than 3% throughout the decade.
As a result, even institutions that have so far remained in the financial markets are pouring money into short term investments and such “alternate equity” investments as mortgage-backed paper, foreign securities, venture capital, leases, guaranteed insurance contracts, indexed bonds, stock options, and futures. At the same time, individuals who are not gobbling up hard assets are flocking into money market funds to nail down high rates, or into municipal bonds to escape heavy taxes on inflated incomes. Few corporations can find buyers for their stocks, forcing them to add debt to a point where balance sheets seem permanently out of whack. On Wall Street, the flight from stocks has forced firms to push alternative investments hard—thereby drawing still more money from the stock market.
Further, this “death of equity” can no longer be seen as something a stock market rally—however strong—will check. It has persisted for more than 10 years through market rallies, business cycles, recession, recoveries, and booms. The public was first drawn to equities in big numbers in the 1950s by a massive promotion campaign by Wall Street that worked because the economic climate was right: fairly steady growth with little inflation. To bring equities back to life now, secular inflation would have to be wrung out of the economy, and then accounting policies would have to be made more realistic and tax laws rewritten. But these steps may not be enough. “It will take two or three years of confidence building, of testing, before the market can seriously act like it did in the 1950s and early ’60s,” says William J. Fellner, a professor of Economics Advisers.
The problem is not merely that there are 7 million fewer shareholders than there were in 1970. Younger investors, in particular, are avoiding stocks. Between 1970 and 1975, the number of investors declined in every age group but one: individuals 65 and older. While the number of investors under 65 dropped by about 25%, the number of investors over 65 jumped by more than 30%. Only the elderly who have not understood the changes in the nation’s financial markets, or who are unable to adjust to them, are sticking with stocks.
Even if the economic climate could be made right again for equity investment, it would take another massive promotional campaign to bring people back into the market. Yet the range of investment opportunities is so much wider now than in the 1950s that it is unlikely that the experience of two decades ago, when the number of equity investors increased by 250% in 15 years, could be repeated. Nor is it likely that Wall Street would ever again launch such a promotional campaign. The end of fixed stock market commissions has thinned the ranks of firms that sell stocks and reduced the profit from selling stocks for virtually all firms. Wall Street has learned that there are more profitable things besides stocks to sell, among them options, futures, and real state, that it did not have in the 1950s. For better or for worse, then, the U.S. economy probably has to regard the death of equities as near-permanent condition—reversible some day, but not soon.
Says Alan B. Coleman, dean of Southern Methodist University’s business school: “We have entered a new financial age. The old rules no longer apply.”
The one rule whose demise did the stock market in could be summed up thus: By buying stocks, investors could beat inflation. Stocks were a reasonable hedge when inflation was low. But they proved helpless against the awesome inflation of the past decade. “People no longer think of stocks as an inflation hedge, and based on experience, that’s a reasonable conclusion for them to have reached,” says Richard Cohn, an associate professor of finance at the University of Illinois. Indeed, since 1968, according to a study by Salomon of Salomon Bros., stocks have appreciated by a disappointing compound annual rate of 3.1%, while the consumer price index has surged by 6.5%. By contrast, gold grew by an incredible 19.4%, diamonds by 11.8%, and single-family housing by 9.6%.
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