The Float

Fidelity 401(k) Research Update

Yesterday we passed along a few interesting findings from recent research on the 401(k) universe. One item left unclear by media reports was Fidelity's definition of a "single, non-diversified investment option." When we inquired about the meaning of that term with Fidelity, a spokeswoman informed us that the category--which includes no less than 19% of plan participants--includes three types of investments:

1. Company stock
2. A money market fund
3. A mutual fund whose investment mandate covers only one asset class (e.g., a stock-only fund)*

As we noted yesterday, this means that one in five plan participants has assumed either too much risk (in type 1 and 3) or too little (in type 2). There may be a small number of participants for whom a money market vehicle is the most sensible option, but even those on the verge of retirement should be participating in stocks and bonds. After all, their investment time horizons don't stop when retirement begins.

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*Naturally, balanced funds, lifecycle funds, and target retirement date funds are not included in this definition.

Buybacks Count Only Once

In Monday's Wall Street Journal, Russell Gold and Karen Richardson took a look at the energy industry, with emphasis on the big, diversified oil outfits. It's an interesting piece, but one line in particular reminded us of an important point John Hussman made in one of his recent commentaries. First, here's the key passage from the Journal:

"The earnings of big producers like Exxon are plateauing, and they're really growing their earnings through share repurchases," says Chris MacDonald, a portfolio manager in Dallas at WHG Funds. [Emphasis added]

Many market observers--including the ones who type right here at The Float--have noted that share buybacks have helped drive equities higher. But here's Hussman with an important bit of perspective on the buyback story:

In recent weeks, investors have been enthralled with the idea that stocks are being supported not only by earnings surprises, but also by heavy repurchases, as if these are two separate effects.

As I've noted before, repurchases are already reflected in the calculation of the S&P 500 index and index fundamentals such as earnings and dividend figures. To assume that repurchases are a separate source of "return to investors" is double counting.

Notice that the calculation of the S&P 500 already fully reflects the impact of the repurchase on both the level and the growth of per-share earnings and dividends. Investors are emphatically mistaken if they double-count repurchases as a separate or additional "distribution" to shareholders.

Unfortunately, investors are currently engaged in wild-eyed double counting, imagining that higher per-share earnings figures and higher repurchases are separate effects, when they are one in the same. The truth is that a significant portion of the higher per-share figures is the result of repurchases, and the higher repurchases are the result of a paucity of alternative uses for the cash.

To put some numbers on this, Bill Hester notes that according to Bloomberg, among S&P 500 companies reporting to-date, the average surprise on operating earnings (cough) per-share has been 9.66%, while the average surprise on operating earnings on a total dollar basis has been 5.85%. Of course, the average is skewed by a few extreme outliers (for example, Hasbro reported operating EPS of 19 cents, versus an estimate of just 1 cent). The median surprise, which is a more robust measure, has been 2.94% in operating earnings per share, and just 1.93% in operating earnings themselves.

It is wrong to hail an increase in per-share earnings as if it is an "earnings surprise"--as if it reflects an improvement in corporate operating conditions, when it is in fact an expenditure of existing earnings on shares instead of on business investments. When such repurchases are done at rich valuations, they are a signal that the company lacks other productive business opportunities and is instead propping up per-share earnings by disposing of what it does earn.

Why haven't investors figured this out? The story constantly repeated on CNBC is that companies low-balled their earnings guidance in order to surprise investors with better than expected earnings (with the implication that the market will rise forever because companies can continue to do this indefinitely). A good part of the true story is that analysts made their forecasts of per-share earnings based on old, higher share counts, so the juiced per-share figures resulting from repurchases are now showing up as "earnings surprises."

We've noted the disconnect between investors' enthusiasm for buybacks and corporate managers' apparent lack of better things to do with their money. The persistently, even historically low cost of capital has spurred much of this latest repurchase wave, so the point isn't that recent buybacks have been irrational. It's that, on the margin at least, they don't strike us as necessarily the best possible use of all the low-cost capital we've seen sloshing around for so long.

Sources

Russell Gold and Karen Richardson, "Energy, Once Hot, Now Not," Wall Street Journal, July 30, 2007 (subscription required)

John P. Hussman, Ph.D., "Double Counting," Hussman Funds Weekly Market Comment, April 30, 2007

Friday Reading

As we approach the end of another wild week, a few items...

• Jeff Saut of Raymond James reminds us that liquidity is one thing and risk appetites are quite another.
• Bloomberg's John Wasik weighs in on the significant, badly underappreciated impact of mutual funds' hidden costs. (We expect to have more on this topic next week.)
• The Journal's Dennis Berman trots out an artifact of the private equity boom.
• Not for the faint of heart: Jim Kunstler pays attention to the man behind the curtain (via Barry Ritholtz).
• Bloomberg's David Wilson notes that when it comes to research and investment banking, the Street's old habits are hard to break.
• We hadn't seen this when we wrote yesterday's 401(k) item, but here's another bit of research on the challenges of achieving a secure retirement in the era of defined-contribution plans.

401(k) Research: Some Good News, Some Bad

In the midst of all this short-term angst and volatility, let's take a step back to assess the status of the 401(k) world. Two recent research efforts--one by the Employee Benefit Research Institute, the other by Fidelity Investments--shed light on how we're doing in the brave new world of defined-contribution plans.

Here's the good news:

• Bigger Balances. Thanks to ongoing contributions and asset appreciation, EBRI estimates that those who participated in the same 401(k) from 1999 to 2006 enjoyed an average annual increase of 8.7% in their account balances. Given the two-and-a-half-year bear market in the middle of that period, that's decent growth, though when one considers the impact of contributions--especially those made at and near the bear market lows of 2001 and 2002, the numbers don't seem quite as impressive. Another cautionary note: This group of 3 million plan participants, though important, is hardly inclusive or fully representative. And the unrepresentativeness cuts in one direction only. After all, this subset includes the best-positioned workers: Consistently employed, participating throughout, and, on balance, enjoying rising incomes through this period.
• Automatic Enrollment and Increase. Fidelity found that auto enrollment policies increased participation rates from 53% to 81% and that auto increase programs raised deferral rates by 1.2% from 2005 to 2006. The comparable change in plans without auto increase provisions: 0.3%. Automatic enrollment and deferral ratchets are clearly helpful and should be included in many more plans.

And the not-so-good news:

• Flawed Asset Allocation. We don't know exactly how Fidelity defines "inappropriately allocated," but its analysts concluded that "74% of participants appear to have had their savings inappropriately allocated, with 22% holding all equities and 13% holding no equity." Without unpacking the internal numbers, it's difficult to reach clear conclusions about these findings. Some participants should hold all equities, though we think the number who should hold no equities is vanishingly small. Here's EBRI Fellow Jack VanDerhei, quoted in a MarketWatch piece:

"When they're younger, they're probably investing much more aggressively," he said. "It's when they're getting closer and closer to retirement and starting to become more risk-averse that you start to see those rates phasing down." Instead of savers focusing on the many years they're likely to need income in retirement, "in many cases their perceived investment horizon shrinks down to 'until the day I retire,'" he said.

This point is so important we've made it here ourselves. When time horizons are long--and for most people their time horizons at retirement will stretch out to 20, 30, even 40 years--prudent exposure to equities and equity-like assets is simply imperative.

• Excessive Concentration. Here's a devastating fact from Fidelity: Fully 19% of participants were invested in "a single, non-diversified investment option." As with "inappropriately diversified," we don't fully grasp Fidelity's terminology, but from here that sounds like company stock. (We have a call in to Fidelity and will post an update with the definition as soon as we have it.) Regardless, this isn't a pretty picture, and it suggests that literally millions of Americans are exposed to wildly inappropriate levels of risk (either too much or too little). This is a major problem with the current defined-contribution regime. By forcing rank-and-file employees to serve as their own money managers, the system extracts massive long-term costs and impairs future standards of living. All of which, to our way of thinking, is grossly inconsistent with the intent of ERISA.

We've written repeatedly on various problems in the 401(k) universe (here, here, and here, for example) and we'll continue to do so as plan sponsors, participants, regulators, and service providers look for better ways to provide the best possible retirement security for the largest possible number of Americans.

Sources

"401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2006," Employee Benefits Research Institute, August, 2007

"Building Futures VII: Highlights of Findings," Fidelity Investments, July 25, 2007

Andrea Coombes, "Devilish details: Even as 401(k) balances march higher, overall retirement picture is mixed," MarketWatch, July 31, 2007

Anyone Get the Bends?

Now that's intraday volatility.

 

Wednesday Reading

Prudent risk management! And some informative reading to help guide us all...

• In today's New York Times, David Leonhardt takes a look at the mortgage landscape and doesn't much like what he sees:

The peak month for the resetting of mortgages will come this October, according to Credit Suisse, when more than $50 billion in mortgages will switch to a new rate for the first time. The level will remain above $30 billion a month through September 2008. In all, the interest rates on about $1 trillion worth of mortgages, or 12 percent of the nation's total, will reset for the first time this year or next. A couple of years ago, by comparison, only a marginal amount of mortgage debt---a few billion dollars--was resetting each month. 

• How 'bout Beazer today? You reckon investors are a little edgy at the moment? Looking at an intraday chart, it appears that several million shares traded hands during the mid-morning swoon in BZH, including a few hundred thousand in the neighborhood of $8.50 per share. Ouch.
• Bloomberg's Matthew Lynn ponders the fate of the "Greenspan Put" at the Bernanke Fed and central banks around the world.
• CNNMoney's Grace Wong trots out the new contrarianism: It ain't as bad as you think.
• MarketBeat notes another potential implication of a credit stoppage: Unfinished share buybacks.
• Over at MarketWatch, Mark Hulbert weighs in on the contrarian value of magazine covers (noted previously in this space here and here).

Santelli Sums It Up

Here's CNBC's Rick Santelli a moment ago...

I think the big, easy story that nobody wants to talk about is we have a collision going on between global growth and global credit. And everybody's focusing on this firecracker going through the air that was subprime, ignoring the fact it's landing in a fireworks factory which is highly leveraged easy credit for years, and anybody who thinks that all the good underpinnings in organic growth and all those good metrics, which really haven't changed, won't be affected by that collision is ignoring the reality in front of them.

Interesting times, no?

Demystifying Credit Cycles

As Wall Street's roller coaster rolls on this morning, we'd like to recommend a recent item from NYU's Nouriel Roubini.

Roubini has been sounding the alarm on housing and credit market concerns for several months. Even if his recession call has been wrong (or, as they say in the business, not wrong, just early!), his caution has provided a useful counterweight to prevailing notions of subprime and housing "containment."

So here's the item, which we recommend you read in full*: "Are We at the Peak of a Minsky Credit Cycle?" Roubini describes the late Hyman Minsky's taxonomy of borrowers and the typical dynamics of a credit cycle in which risk aversion erodes and leverage builds to excess. This is useful stuff.

Remember: As we wrote late yesterday, the name of the game is prudent risk management.

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*The last part of the commentary is behind a subscription wall, but the free portion is both extensive and informative.

Neither a Borrower Nor a Lender Be

So much for that morning reprieve! The level of credit-related anxiety spiked again this afternoon when American Home Mortgage announced its own demise and saw its shares trade lower by about 90% after being halted for a day and a half.

Part of the problem with all this arterial blockage in the debt markets is that the entire American economy has become so overwhelmingly financialized (if you'll pardon the term) in the last couple decades, and especially in the last few years. How do automakers generate profits? If they do at all, it's primarily through their financing units. How do retailers boost their bottom lines? In part through the company credit cards they push out to consumers. And of course financial firms per se--brokers, asset managers, banks, &c.--constitute roughly one-fifth of the capitalization of the U.S. stock market.

So when borrowing gets tougher and more expensive and lending gets (or seems, or threatens to become) significantly riskier...we're talking about the very heartbeat of the post-industrial American economy.

Sure, we still make stuff. And thanks in part to the devalued dollar, we even export stuff--and not just music, movies, and software. But finance in all its forms is truly the essence of our economy. So a perceived/potential/actual disruption in that domain is indeed cause for concern.

For several years, investors have been compensated handsomely for perching their portfolios well out on the risk curve. For now, anyway, the name of the game is prudent risk management.

Source

Bradley Keoun, "American Home Can't Fund Loans, May Liquidate Assets," Bloomberg, July 31, 2007

A Quick Thought on Rebalancing

Yesterday afternoon, CNBC ran a segment on how investors might manage their 401(k)'s in turbulent times. With self-directed defined contribution plans supplanting traditional pensions, there's a sense in which we're all money managers now, so this stuff matters in a big way. (For our perspective on this problematic state of affairs, see this June item.)

When one of CNBC's guests suggested that the key to long-term success is to establish the right asset asset allocation and keep it that way, we nodded in agreement. But when another guest insisted that the way to do that was to sign up for automatic quarterly rebalancing, we stared in disbelief.

As we've noted elsewhere, the only advantage of calendar-driven rebalancing is that it can be automated (or, in do-it-yourself accounts, relatively automatic). In the absence of better decision rules, rebalancing once-per-period is generally better than not rebalancing at all. But two questions arise: (1) What's the right period? And (2) can we rebalance for better reasons than the mere passage of time?

First, the right period is not quarterly. By trimming all high-performing asset classes back every quarter, investors would preclude their winners from carrying their portfolios. After all, asset class outperformance tends to persist for years, not quarters.

Think of small-cap, international, and emerging market stocks, which outperformed large-cap stocks and domestic bonds for several years. Small-cap stocks have clearly underperformed in 2007, so periodic rebalancing (i.e., active risk management) is important. But cutting those positions back every quarter would have been very costly. In the context of long-term retirement accounts, the opportunity cost of foregone compounding would be enormous.

And that leads us to our second question. If quarterly rebalancing is too frequent, what better decision rules can investors use? If one must opt for a calendar-based answer, we'd suggest nothing more frequent than annual rebalancing, which is more than adequate to manage risk and less return-impairing than more frequent alternatives.

But even better than calendar-driven rebalancing is a discipline rooted in tolerance intervals, or how far you'll let an asset class deviate from its target portfolio weight before you rebalance. The idea here is simple: Rebalancing should be driven by actual developments in the capital markets, not by the arbitrary and irrelevant passage of time.

The problem with tolerance-driven rebalancing is that it takes a little work and discipline. But the likely payoffs--improved long-term performance, reduced trading expenses, and better tax efficiency, all in the context of appropriate risk management--make this alternative to the typical calendar-driven formula a clear winner.