Let Them Eat Indexes!

by Gary North
by Gary North

History buffs will recognize the roots of this phrase. Marie Antoinette, wife of King Louis XVI, is supposed to have said "Let them eat cake" when informed in 1789 that the Parisian masses had run out of bread. There is no reliable evidence that the ill-fated queen ever said this, but it has made good propaganda since 1789. The sign of the insensitivity of the successful to the suffering masses is some version of "Let them eat cake."

In our day, the public no longer worries about bread, except as a source of unwanted carbohydrates. The free market had made us all so rich that our concern is with too much bread and too much cake. Twinkies celebrated its 75^th birthday recently – cost-conscious Americans’ favorite substitute for cake. Our waistlines reveal that ours is a world very different from Marie Antoinette’s.

But every society has its worries. Our worries center around official statistics. This includes stock market indexes. Newspapers run reports on how the Dow Jones did yesterday. Websites monitor this statistic constantly. TV anchormen do not let a broadcast get by without a reference to the Dow, usually with a line chart behind them. Up 6 points, down 9 points; it doesn’t matter how minuscule the change is from the day before. It will make it onto prime-time news.

The Dow is regarded as monitoring the pulse of the American economy. It is seen as the mark of America’s success or failure. "As goes the Dow, so goes America." Individually, we would not admit in private that we believe this, but the evening news indicates that millions of us do. We say we don’t believe in astrology, either, but what newspaper would dare to drop its astrology column?

Yes, yes: that’s for all those other people. Well, I hope so, but the reality is this: all those other people are eligible to vote. Upset them, and the incumbent political party is in trouble. "It’s the economy, stupid," 1992’s formula for national electoral success, still resonates with the voters.

POLITICAL NUMBERS

Official indexes tend to calm down the electorate. They are designed to calm down voters. This is why governments have the statisticians jiggle and juggle the official statistics. For example, we feel better when the Bureau of Labor Statistics announces that job growth increased in the previous month. On May 6, the BLS announced that job growth was up 274,000 jobs in April.

Sometimes, this sort of statistical optimism leads to verbal speculation that the economy is stronger, so inflation will rise, so the Federal Reserve will raise interest rates, which will strengthen the dollar, which will make exports more difficult, which will slow the economy. The Dow drops. Or doesn’t.

How does the BLS know that there were 274,000 new jobs? Not by counting them. It has a statistical formula which includes the likely creation of new businesses and the likely demise of old businesses. This is called the birth-death ratio.

Let me assure you, the journalists who report the employment figures do not report the following. That’s because hardly anyone knows about it, and of those who do, hardly anyone understands it, and of those who do understand it, hardly anyone knows what the BLS formula is or how the samples are made. The Bureau of Labor Statistics does publish a page about the birth-death ratio.

I have never met anyone who can explain it. Here, we read:

To account for this net birth/death portion of total employment, BLS is implementing an estimation procedure with two components: the first component uses business deaths to impute employment for business births. This is incorporated into the sample-based link relative estimate procedure by simply not reflecting sample units going out of business, but imputing to them the same trend as the other firms in the sample.

Got that? Good. Now it gets complicated.

The second component is an ARIMA time series model designed to estimate the residual net birth/death employment not accounted for by the imputation. The historical time series used to create and test the ARIMA model was derived from the UI universe micro level database, and reflects the actual residual net of births and deaths over the past five years. The ARIMA model component is updated and reviewed on a quarterly basis.

We assume that the same formula is maintained from month to month, so that we can compare apples and apples, or whatever the statistical fruit is. We assume lots of things in trying to make sense of the economy. We should also assume that three months later, there will be a revision of this month’s statistics. There probably will be. These revisions tend to be downward. They also tend to be ignored by the press.

The good news regarding jobs may be better-than-expected (by whom?) good news or less-than-expected (by whom?) good news. It depends on how the reporters want to pitch the statistic.

When people feel secure in their jobs, they tend to save less. They spend more. They assume that whoever is managing their retirement funds knows what he is doing. They don’t worry about the future.

Recessions rarely last long. During recessions, Americans worry about their jobs. They worry a little about their pension funds. But, as we saw in 2001, they don’t worry much. They buy. They especially buy nicer homes. They borrow. They especially borrow mortgage money.

THE WEALTH EFFECT

Economists speak of the wealth effect. When people think they are doing well – jobs, investments – they tend to save less. They assume that good times will take care of retirement portfolio growth. A rising market will let them retire in comfort. The self-discipline of thrift today can be deferred. Besides, thrift is so uncomfortable.

This same attitude afflicts corporate America. In a story published in Business Week (August 5, 2002), the authors commented on what they called the pension pinch. Because of the downturn of the market after November, 2000, corporate America was facing a new reality. Its pension funds were not being automatically funded by stock market indexes.

Amid the wreckage of the worst bear market in at least three decades, hemorrhaging corporate pension plans are rapidly becoming Wall Street’s biggest new worry. They have lost hundreds of billions of dollars, and now companies face the end of their long-running holiday from writing checks to the plans. Over the next 18 months or so, companies ranging from General Motors to United Technologies face having to pump billions into their plans to comply with federal laws to protect pensioners.

The authors were correct. This is exactly what large corporations had to do. General Motors, as the authors mentioned, was most at risk. Little did they know!

General Motors Corp., which has the biggest pension plan of all, with $80 billion in obligations, disclosed July 16 that it expects to put $9 billion into its plans by 2007.

Ha! General Motors had to float a $17 billion bond sale in 2003 to meet its pension fund obligations. Then, in 2004, it had to add another $13 billion. Yet it is still $57 billion in the hole.

The company has recently been reduced to junk bond status by Standard & Poor’s. So was Ford. Legally, many investment funds cannot hold junk bonds. Legally, fund managers will have to sell GM and Ford bonds. This should have begun last week. It didn’t. We shall see if the fire sale, or any sale, takes place. We shall see if Federal regulators or fund investors force them to do so.

The 2002 article went on to describe how America’s largest corporations got themselves into this pickle. Basically, the primary cause was the wealth effect. The same mentality that governs American consumers also governed corporate managers.

How did companies paint themselves into such a corner? It was more than bad luck. They made a bold bet during the 1990s that stock prices and interest rates would move in opposite directions, as they have nearly every year since the Great Depression. The relationship is crucial to pension funds because when interest rates go down, government rules require the plans to have bigger pools of investments to meet future obligations. That can only happen if stocks rise or companies put more money into the funds.

For years, the tactic worked like a charm as fund assets went up while their liabilities increased. Companies became confident about putting more of their pension assets into stocks than before. The resulting investment gains during the bull market more than covered most of the payouts they made to current retirees, averaging about 7% of the funds’ total values. Better yet, accounting rules allowed companies, quite legally, to boost their reported earnings by billions with higher projected investment gains because they were holding more stocks. Some, again quite legally, were able to actually tap the surpluses to help pay retiree medical expenses and even merger consolidation costs.

So, the corporations used their statistically overfunded pension funds as a convenient ATM machine. The pension funds became a source of operating expenses, especially medical costs. In other words, the corporations did exactly what the trustees of the Social Security Trust Fund have done ever since 1938.

Lately, however, the bet has turned sour. Stocks – in which a record 60% of fund assets were invested in early 2000 – have gone down in the bear market, as have interest rates. The result: Funds’ assets have plunged at the same time that their liabilities have soared. The pincer movement has wiped out surpluses racked up during the long-running bull market, and then some.

The authors then pointed to a major problem facing investors, including fund managers. The companies generally do not report the status of their pension fund obligations. What they report is governed by them, not by any independent agency.

The fear is that nobody but the companies knows exactly how big the cash calls will be. Companies hardly ever disclose anything in their Securities & Exchange Commission filings about the impact of the government pension rules on them. "The specific calculations are impossible to get right with publicly available data," says Trevor S. Harris, accounting analyst at Morgan Stanley. That is important because it means investors can’t accurately predict corporate cash flows.

Which companies are facing the biggest problems? Old-line companies that are unionized.

Old-line companies or those with large unionized workforces will be particularly hard hit because they have large defined-benefit plans – ones offering guaranteed payouts to pensioners. The biggest obligations are among auto, telephone, airline, steel, chemical, and pharmaceutical companies.

I dredged up this old article for two reasons. First, it was right on target. Second, it was published in mid-2002, close to the bottom of the stock market. The S&P 500 was around 900. It rose, then fell back to 800 the following March. Today, it is around 1200. You can see the swings.

So, despite the bad news regarding the pension funds’ condition, investors in mid-2003 decided to ignore the information. They rushed back into the stock market.

They assumed that GM could solve its pension problem. We now know that this assessment was premature. GM and Ford investors have taken major hits, both in stocks and bonds. But the stock market’s current rebound indicates that these wake-up calls have made no impression on investors and fund managers.

Investors did not wake up in 2002. They have not awakened in 2005. They assume that they can continue to rely on the wealth effect for their retirement portfolios.

JIGGERING WITH THE STOCK INDEXES

Everyone plays the manipulation game. Everyone wants things to look better.

Consider Standard & Poor’s, the rating company that just downgraded General Motors and Ford. Some market watchers prefer the S&P 500 to the Dow Jones Industrial Average. Far more companies are in the S&P index.

Both the Dow and the S&P 500 are subject to statistical jiggering. Companies that do poorly are removed from both indexes. Both add companies that seem to be doing well.

Again, let us return to 2002, when bad news was visible in the stock indexes, and readers were a little more alert to reality. An article appeared on the Slate site, "The Poor Standard of Standard & Poor’s" (Aug. 1, 2002). The author discussed in detail the way that the S&P 500 is subject to revisions.

The index is one of the more unlikely villains of the bubble. Despite perceptions, the index is not a passive investment vehicle. Instead, S&P is constantly choosing new stocks and booting old ones. And in the past few years, S&P’s modus operandi – which receives surprisingly little scrutiny – led it, essentially, to recommend that investors buy highly speculative companies at or near their tops.

How did this happen? Because any stock index is structured to reflect current realities. The past is sacked when it become too embarrassing.

When a company merges with another index company, or is acquired by a foreign concern, or files for Chapter 11, the S&P committee automatically deletes it. And some companies simply wither away to the point where the committee – which remains anonymous to forestall lobbying – determines them to be too insignificant to merit inclusion.

Between 1990 and 1994, the committee made an average of about 13 changes each year. But with the surge of merger and acquisition activity in the late 1990s, the need for deletions rose. Between 1996 and 2000, the committee changed an average of 40 companies each year. In 2000, a record 58 changes occurred.

The index managers added high-tech companies in 1999, which was close to the top.

AOL was arguably the first New Economy stock granted entree into the S&P 500. It entered at the close of 1998, replacing Venator, the parent company of Foot Locker. Network Appliances entered on June 24, 1999, followed soon after by Qualcomm on July 21, Global Crossing on Sept. 28, and Yahoo! on Dec. 7. The tech-tilted makeover accelerated throughout 2000.

The problem was not that these companies were added – it was clear that they represented an important part of the economy – but when they were added. S&P essentially took many of these speculative companies at or near their tops. When Yahoo! came in, it traded at an astronomical 228 (it’s now at 13); Qualcomm traded at 159.75 when it was initiated into the club, and now it trades at 27.

Index funds that follow the S&P 500, and which are the darlings of the buy-and-hold investment strategy school, bought these stocks at the top. Global Crossing is long gone – bankrupt.

On the day Yahoo! joined the S&P 500, it rose 67 points. And in the week between the announcement and the actual inclusion, Yahoo! rose 136 points, or 64 percent. According to a 2000 study by Salomon Smith Barney, stocks selected for inclusion outperformed the S&P 500 by 7.7 percent in the period between the announcement and the inclusion. The net effect: S&P 500 mutual funds – that is, you – effectively bought these new stocks at artificially inflated prices.

The indexes drop poorly performing stocks after they have shrunk. This is called "sell low." They add stocks after a long period of rising prices. This is called "buy high." This "buy high, sell low" strategy guides the stock index funds. But it does more than guide index funds. It guides the investment community generally.

Because of its breadth and diversification, the S&P 500 is the crucial benchmark for professional investors. Investments by insurance companies, pension funds, college savings funds run by states, and public employee pension funds are either invested in the S&P 500 companies or mimic its makeup closely. "The S&P 500 is used by 97 percent of U.S. money managers and pension plan sponsors," S&P’s Web site proudly notes. "More than $1 trillion is indexed to the S&P 500." (That sum is almost certainly lower now.) About 8 percent of the shares of every S&P 500 stock are held by index funds. As a result, S&P’s eight-person Index Committee, which selects the companies that enter and leave the S&P 500, is a far more influential stock picker than Warren Buffett or Fidelity manager Peter Lynch.

CONCLUSION

Most Americans ignore retirement. They assume that "something will turn up." They trust Social Security and Medicare – the red-ink monsters that are rated as if they were tools of budget-balancing. But even those Americans who dutifully add funds systematically to their retirement fund portfolios according to the recommended buy-and-hold strategy are rarely informed regarding the assumptions of those who take their money: corporate managers, index designers, and index fund managers. If they did understand, they might plan differently.

Or would they? Stories like those that I have cited appear from time to time, but investors take little notice. It seems easier to trust the experts . . . until the bills come due.

When the bills do come due, the experts will say, "We knew it all along." And when index fund investors complain, the experts will say, "Let them eat indexes."

May 11, 2005

Gary North [send him mail] is the author of Mises on Money. Visit http://www.freebooks.com. He is also the author of a free multi-volume series, An Economic Commentary on the Bible.

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