You’ve seen a few downturns in your time. Based on your experience, what’s next?
This is the toughest cycle I’ve ever seen. Recovery time is going to be long, and an enormous amount of de-leveraging still has to be done. When we read that the savings rate is going to 6 percent, that doesn’t mean people are putting 6 percent of their income in the bank, it means they’re “un-dis-saving” 6 percent — paying off credit cards and this sort of thing. If they were saving 6 percent, it would be available to spend in the future. All that de-leveraging will not hasten recovery. Keynes calls this the paradox of thrift — we have to save money individually in this country, but while that’s good for us, it’s bad for the economy.
How would you grade the administration’s response to the crisis?
We’re in such a mess, to be honest, that I think the government is doing about the right things. I’m of the school that says that they’ve got to do something big and fast; they can’t stand back. I even reluctantly support the bailout of GM. Capitalism is a mean, competitive thing, and under normal circumstances I would say, sad as it may be, we’ll just let General Motors go. But under these circumstances, I would not. That said, now we’re into GM for $100 billion. A hundred billion! Where does this end? One place we know that it ends — if you’ve got $5 trillion in extra debt, that’s $200 billion of interest every year, year after year.
So what should investors do?
Two things. First of all, you have to decide whether you are an investor or a speculator. And most of us are speculators. Not me. What most people do is try to find a good mutual fund manager and go with him until he does badly. Or they try to find a good stock, and then when that doesn’t do well, they find another good stock. Turnover in the stock market is 320 percent — twice as high as it was in 1929, the previous high — and it’s 10 times what it was when I came into this business in the early ’50s. Mutual funds turn over portfolios on average 100 percent a year. That’s speculation. So why are we speculating with our shareholders’ money?
I’m going to guess you’d recommend index funds, which have very low turnover.
You betcha’.
And investors’ second step should be?
Check to make sure you’ve got your asset allocation right, which should have something to do with your age. If you’re 65, 65 percent bonds is a good starting point. But it’s also more complex that than, because Social Security for a typical family has a capitalized value of $250,000 to $300,000. So if you’re 100 percent in stocks in your $100,000 retirement account, you’re really only 25 percent in stocks overall. There’s also a big difference in two people 10 years from the end of their career if one person is a tenured college professor and the other is an automobile worker. So human capital comes into this — specifically how risky that capital is.
What returns do you foresee for stocks over the next 10 years?
Past returns are not a guide to the future. Start with that. Here’s what is a guide to the future (and I’ve written about this going back to my senior thesis at Princeton): Investment return is the dividend yield when you buy in plus earnings growth. But dividend yields can be cut, and they were cut by 22 percent this year, which is alarming. So that takes your dividend yield down to about 3.5 percent. And then you try to puzzle out what earnings growth will be. From these levels, I think it could pretty easily be 5 percent a year over the next 10 years. If we have a slower economy, it could be 4 or 3, but let’s say 5 percent. So let’s call the investment return 8.5 percent on stocks, compared to 6 percent on corporate bonds, and only 4 percent on treasury bonds. That would make stocks more attractive than bonds over the next decade.
And that investment return can either climb or fall depending on what you call the speculative return, or the direction in the price-earnings ratio, right?
Yes. But what is the price-earnings ratio right now? Nobody knows, because we don’t really know what the earnings are. We know that when PEs are under 10, they are much more likely to go up than down, and when they are over 25 they are much more likely to go down.
Do you agree with those who have suggested recently that overseas markets will outpace U.S. markets?
I think the whole international argument is overdone. We know in the U.S. that we have a consumer economy that’s going to change — that’s negative. But on the plus side, we have a remarkably creative economy, remarkable protections of ownership, a great legal system, and free movement of capital. Is that going to be true in Brazil in two or three years? Finally you come down to valuations, and this is where it gets really murky. Will investors be paying more for securities in Brazil or India or China? With China, there’s now a feeling that growth rates have been greatly overstated.
What should you do to increase your return?
Think about costs: The average equity fund probably has an expense ratio of 100 to 150 basis points (Ed: Or, 1 to 1.5 percentage points). Those portfolios, the big ones, are turning over on average probably 75 percent a year, which creates another 50 basis points in transaction costs. Many of them are sold with a sales charge, so for people that hold their funds for five years, that’s a 5 percent sales charge amortized over five years, which is another 1 percent. You’re up to 2.5 percent. When you come to the end of the trail, if the market gives an 8 percent return, you get 5.5 after those costs. Do it in a compound interest table over 50 years and you find that the investor, who put up 100 percent of the money and takes 100 percent of the risk, gets about 30 percent of the return. And the financial system, which puts up zero percent of the capital and takes zero percent of the risk, gets 70 percent of the return. That is the tyranny of compounding.
What surprised you the most about the economic meltdown?
My biggest surprise was how out of control the financial system had grown. How AIG could have that huge amount of insurance on credit defaults without any protection is unbelievable. Of course, bankers made a lot of money for quite a while. And that’s part of the issue, this shadow banking system — the huge role it has come to play in the American economy.
What changes would you make to protect retirement savings?
You need to firm up Social Security — which wouldn’t take a lot. And the 401(k) system has to be fixed. The 401(k) is the retirement plan of the future. But you simply can’t do some things we’ve been doing, like letting the investor take his money out every time he changes his job. Think of what Social Security would look like if we did it that way.
Will any good come of this crisis?
The crisis in our stock market and in our economy has presented us with the opportunity to do a really big thing — to reform our financial system. Our old ownership society, in which stocks were owned largely by individuals, is long gone and will not return. Its successor, the agency society, now prevails, with institutional money managers holding and trading the lion’s share of U.S. stocks and operating in their own financial interests. The present crisis is a reflection of that change, and it gives us the opportunity to build, out of the ashes of our failed agency society, a new fiduciary society in which the interests of the investors come first.
