Disinflation + Good Governance + Solid Management = Superb Economic Rewards

Professor John J. McCabe ’65

Disinflation + Good Governance + Solid Management = Superb Economic Rewards

Much has changed in the equity investing arena over the last two generations and not all of it for the better. In 1960, the year John F. Kennedy won the Presidency and a young energetic securities analyst named Warren Buffett had yet to earn his first million dollars, individual investors dominated the equity marketplace. Institutional investors were minor participants at best.

Six decades ago, individual investors craved cash dividends more so than at present and most harbored a "buy and hold" mind set. Dividend yields were higher than today's levels and price-earnings multiples were below where they currently reside. The typical holding period for a New York Stock Exchange listed company was slightly more than eight years and the classic text book definition of a share of common stock was "the present value of a future stream of dividends." The term "growth stock" had yet to be fully minted. Average daily trading volume on the New York Stock Exchange hovered around seven million shares, a far cry from today's three to five billion shares. Portfolio turnover activity is also dramatically brisker than in the 1960's. The typical equity is now ensconced in a portfolio for slightly more than a year.

The majority of institutional investors in 1960 were financial intermediaries who were quite satisfied trolling for high quality corporate bonds. These well researched fixed income securities offered safety, liquidity and annual yields that surpassed the consumer price index. Moreover, throughout the life of the security, bond indentures are policed by highly proficient bond trustees.

The preponderance of fixed income portfolio managers had credit backgrounds and were not schooled in equity research. These investment professionals were critically aware of their fiduciary responsibility. After witnessing the Dow Jones Industrial Average plunge 89% from high to low during the deflation ravaged 1930's combined with the fact that the Securities and Exchange Commission only came into existence in 1934 simply reinforced the proposition that common stocks possessed too much market risk and company specific risks for their client base.

Fast forward to the present, it is blatantly clear that common equity investing has gone through almost a complete metamorphosis. It was not an easy challenge getting to this point. Investor confidence was riding high going into the 1960s. The youthful President Kennedy proclaimed in his 1961 inaugural address the US was entering a New Frontier and that "the torch had been passed to a new generation." Back in 1960 less than half the population had a high school diploma and only about five percent attained a bachelor's degree or above. JFK expressed the pressing need to rapidly improve education in general and science and technology in particular and promised to put a man on the moon.

Inflation Devours Savings

The ideal time in a capitalist society to create wealth and improve living standards is during extended periods of low inflation combined with declining interest rates and growing corporate profitability.

Disinflation Key to Robust Wealth Accumulation

Environment

Time Frame

DJIA Low

DJIA High

Percent Change

Up Years

Down Years

Disinflation

1982 to Present

777

29,551

3,703%

30

9

Inflation

1963 to 1981

767

1,024

33.5%

12

7

Deflation

1929 to 1932

41

381

89.2%*

0

4

*Percent drop from high to low
Source: Dow Jones Corp

In addition, frosting on the cake surfaces when monetary and fiscal policies are in sync. From an economic prospective, the future looked promising going into the new administration. Sadly, post the Kennedy Assassination, economic conditions started to wane.

President Johnson in his first year in office, declared War on Poverty and heavily added to the social programs already initiated under President Kennedy. LBJ won an enormous post assassination victory in 1964 gaining a smashing sixty-one percent of the vote. Two thirds of the House and Senate were also won by the Democrats. LBJ's Great Society Program sailed through Congress with alacrity and almost matched FDR's New Deal Program in size and scope. Head Start, Medicare, Medicaid, Civil Rights Act, Equal Opportunity Act and Food Stamp Act among others, were signed into law during LBJ's administration. On his watch however, the US fiscal budget deficit jackknifed from one billion dollars to over twenty-five billion dollars. Inflation fears were beginning to mount and disturb the capital markets.

The United States had been unofficially involved in the quest to avoid a Communist takeover of Vietnam since the late 1950's. The Gulf of Tonkin Incident in 1964 was the event that resulted in Congress giving war making powers to President Johnson. The North Vietnamese massive military Tet Offensive in January 1968 convinced more than half the US population polled that sending five hundred thousand solders into battle for more than three years was a costly mistake. The war could not be won on the battlefield without massive casualties on both sides. It had to be settled at the negotiating table. President Johnson fell out of favor with voters and after almost losing the New Hampshire primary to Senator Eugene McCarthy dropped out of the race for a second term. The President's inflationary "Guns and Butter" policies however, further unnerved the fixed income and equity markets.

Damaging inflationary forces worsened in the 1970's. A plethora of confidence draining political and economic disturbances enveloped the nation through most of the 1970's. The long drawn out Nixon resignation, the Arab Oil Embargo, Iran Iraq War, Chernobyl, runaway crude oil prices and witnessing 52 Americans held hostage in the US Embassy in Iran for 444 days were reflected in the capital markets. Legions of investors were convinced that runaway inflation was here to stay. Any worker with just a W2 form and a savings account was having a horrendous time simply trying to maintain their living standard. Financial assets did not offer much relief. Hard asset investing in residential real estate, commercial real estate, gold, diamonds and other commodities were forecast to be the investing preferences of the future. The consumer price index climbed from one percent at the beginning of the Johnson Administration to over fourteen percent at the end of Jimmy Carter's four years at 1600 Pennsylvania Avenue.

Financial capital gravitates to its most efficient use and stays where it is welcome. Corporate America no longer wanted to be saddled with the fixed costs associated with guaranteed pension obligations if inflation could not be corralled. Defined contribution plans began displacing defined benefit plans. No longer would an employer guarantee an employee an annual pension. Some employers for example, would agree to paying a worker an annual pension equal to 1.5% for each full year of employment. If a worker was on the job for forty years, he or she would be guaranteed an annual retirement pension equal to 60% of their last year's salary.

Define contribution plans place much more of the retirement burden on the employee. In define contribution programs an employer may say to an employee that for every dollar you put into your 401k, the firm will contribute fifty cents. The employer will emphasize this results in an immediate fifty percent return on every dollar the worker puts into the plan. They further will underscore that the more money the employee annually places into the plan the larger the dollar amount in the retirement account over time. A cadre of equity, fixed income, money market and other investment vehicles into which the worker can direct monies is also presented to the employee.

Inflation is not an ally of equity shareholders. The Dow Jones Industrial Average was moving slower than a snail's pace throughout the long seventeen inflation prone years surrounding the Johnson and Carter office tenures. The Dow closed at 874 in 1964 and 875 in 1981. Another innovative investment product gaining popularity in the 1970's, however, was the equity index fund and like the define contribution plan was putting heavy emphasis on long term common stock ownership. Both vehicles spawned a growing quest for equity investing knowledge, understanding and availability.

The two types of risks stock pickers entail when purchasing common equities are systematic risk and unsystematic risk. Systematic risks such as inflation, wars, landslides and pandemics cannot be controlled by the investor. Unsystematic or company specific risks including underperforming senior management or intolerable financial leverage are controllable risks. Index funds are considered passively managed investment portfolios because they incur only market risk and not company specific risk. Actively managed investment portfolios are more costly and incur both market risk and company specific risk.

The Standard and Poor's 500 Equity Index is simply a microcosm of the US economy. By purchasing an S&P500 equity index mutual fund the investor captures the fearsome recuperative powers of our economy along with its dynamic upside growth potential without worrying about individual stock selections. Index funds are also much cheaper than professionally managed equity portfolios. Some index funds have an annual fee of only ten basis points. Active portfolio management companies charge approximately seventy to ninety basis points. The difference between what an index fund charges annually versus active managed funds spread say over thirty years, can be somewhat of a financial drain on portfolio results.

Interestingly, index funds have rather consistently outperformed active portfolio managers. In addition to being less costly these funds are always on hundred percent invested. Most of the major upward moves in the equity market come in less than ten percent of the time period measured. Active portfolio managers periodically may be ninety percent invested and keep ten percent in cash. They do so waiting to put the cash back into the market at a lower entry point. They run the risk however, of missing out on one or more of the rewarding short quick squirts in equity prices.

Staying Fully Invested Key to Investment Success

"Major Upward Moves Come Fast and Quick"
$10,000 invested 12/30/1980 – 12/31/2019

Time Period

Total Return

Fully Invested

$881,343

Minus 10 Best Days

$424,762

Minus 20 Best Days

$259,247

Minus 30 Best Days

$166,961

Minus 40 Best Days

$112,108

Source: Ned Davis Research

Inflation Squelched

President Jimmy Carter's White House years was plagued with stagnant profit growth, rising inflation, a faltering bond market and a weak dollar. In 1978, he appointed Federal Reserve Board Chairman G.William Miller, Secretary of the Treasury. Miller did not believe that aggressively propping up interest rates was an appropriate way to curtail rising inflation without damaging the economy. The term "stagflation" was coined during his chairmanship. As luck would have it, President Carter with congressional approval, in the summer of 1979, appointed the Federal Reserve Bank of New York President, Paul Volcker, the next Chairman of the Federal Reserve Board.

Paul Volcker a true patriot, will surely go down in financial history as one of the most outstanding Fed Chair's since its 1918 starting point. He gets the most credit for breaking the back of runaway inflation. The six-foot seven-inch, cigar chomping Chairman was well known in financial circles and had served as an Undersecretary of Treasury during the Nixon Administration. He vehemently disagreed with those in academia who maintained that higher inflation reduces unemployment and was deeply concerned about the sinking value of the US dollar. There was little doubt that "Tall Paul" would be reappointed Fed Chairman under Ronald Reagan.

In early 1981 with unemployment running above seven percent, the yield on the ten-year treasury note approaching fourteen percent and a thirty-year fixed mortgage rate of thirteen-point nine percent, the Fed Chairmen met with the new president. Chairman Volcker informed Reagan that with the Democrats controlling both houses of Congress and a Republican White House, he had little confidence that fiscal policy initiatives would be sufficient enough to slay the inflation dragon. The only solution was to execute a tremendously painful tight monetary policy. One that would expeditiously result in a hurtful economic downturn. President Reagan concurred.

From August of 1981 through October of 1982, the nation suffered through a fifteen month long crippling recession. The cost of debt capital went through the roof. The fed funds rate leaped to an all-time high of 20% while the prime rate jackknifed to 21.5%. Unemployment topped out at 10.8% and consumer durable goods demand abruptly went into reverse gear. The reversal up to that time, was the most devastating recession since the Great Depression. Chairmen Volcker as predicted, made many enemies. The construction industry sends bricks and 2-by-4s to his office and farmers surrounded Federal Reserve Headquarters in Washington DC. Henry Gonzalez, a Democrat Congressman from San Antonio, Texas shouted that Volcker "legalized usury beyond any limits imaginable."

The "no pain, no gain" harsh medicine did the trick. By year end 1982, inflation had quickly sunk to an annualized rate or 3.8% and over the last thirty-eight years has averaged 2.6%. Interestingly, the median age of a US citizen is just over 38 years which reveals that half of our 330 million population has enjoyed the luxury of living their entire life in a prosperous wealth enhancing low inflation environment. Not having to worry about a major dent in the purchasing power of the US dollar has led to a willingness to take on more potentially rewarding entrepreneurial and profit elevating risks.

Disinflation is the Fed's and Economy's Key Ally

Chairman

Tenure

Economic Arrival

Climate Departure

Percent Change in DJIA

Jerome Powell

Feb '18 to Present

Disinflation

Disinflation

-6.6%*

Janet Yellen

Feb '14 to Feb '18

Disinflation

Disinflation

+60.1%

Ben Bernanke

Feb '06 to Jan '14

Disinflation

Disinflation

+48.1%

Alan Greenspan

Aug '87 to Jan '06

Disinflation

Disinflation

+305.4%

Paul Volcker

Aug '79 to Aug '87

Inflation

Disinflation

+215.9%

G. William Miller

Mar '78 to Aug '79

Inflation

Inflation

+13.0%

Arthur Burns

Feb '70 to Jan '78

Inflation

Inflation

-3.5%

William Martin

Aug '51 to Jan '70

Disinflation

Inflation

+202.3%

*As of Close May 15, 2020
Source: Thomson Financial, WSJ, Dow Jones

Bear markets defined as a 20% or greater decline in stock prices, ordinarily commence close to the start of recessionary environments. The equity market is a leading economic indicator that discounts events roughly six months to a year before they occur. Given the cyclical nature of our consumer dominated society, the stock market usually signals a turn in economic behavior before it materializes. This is the prime reason why bull markets are born in bear markets. The Dow Jones Industrial Average touched bottom on August 12,1982. The National Bureau of Economic Research declared the 1981-1982 recession ended in October of 1982. The Dow's low price came in at a confidence bleeding 777, miles away from this year's record-breaking pre-pandemic high of 29,551.

At its low, the Dow was trading at less than eight times earnings and posted a hefty dividend yield of almost five percent. Historically, the DJIA trades around sixteen times earnings with roughly a two to two and a half percent dividend yield. There were two glaring reasons why most individual and institutional investors were not tempted to put big bucks in the market. After plodding through seventeen painful years of purchasing power erosion where common stocks adjusted for inflation went nowhere or lost money, countless investors were still unconvinced that the inflation genie would stay locked in the bottle. The second reason was that the "risk free" 10-year treasury note was yielding a whopping 13.6%. Today's yield is .71%.

Governance Cracks

Given all the ongoing press coverage surrounding outlandish executive compensation packages, it is hard to fathom back in the inflation drenched seventies and early eighties senior executives and board members generally were not overly share price conscious. Stock options were considered a "nice to have" but not necessarily a "must have" perquisite. Cold hard cash was the most sought-after ingredient along with health, travel and transportation fringe benefits. In certain Fortune 500 companies and large New York City banks there were board members and senior executives who owned less than five hundred shares of the company stock.

Corporations go public essentially for three astute reasons. One is to tap the large pool of available institutional and individual capital. Another is to share the "going concern" risks of the business with public investors. The third is to win a market value for the business entity the selling owners built and to give these insiders an opportunity to liquify a portion of their ownership interests.

The downside risks associated with becoming a public entity are challenging and cannot be underestimated. Costs are high. Regulatory requirements and disclosures can place once held competitive secrets in the public domain. Public shareholders under certain instances, can vote to displace management and the board. A company can become vulnerable to an unfriendly tender offer or a hostile takeover and all the negative publicity that accompanies these occurrences. Faltering companies can be put in play before management has a chance to correct problems. These impediments are part of the reason why over forty percent of all public corporations have disappeared in the last twenty years.

The swift inflation collapse resulted in equity investing especially on the part of institutional Investors such as corporate pension plans, insurance companies, eleemosynary institutions and mutual funds, becoming the long-term investment asset of choice. Consumer demand hit the accelerator. Economies of scale led to improved operating profit margins, lower interest costs raised pretax margins and the Reagan corporate income tax cuts hyped net profit margins. Even though bottom line growth was on an upward trajectory something was amiss. Equity prices for many large capitalization NYSE listed companies did not reflect the positive intrinsic value of the company.

Today, they are referred to as shareholder activists. Thirty-five years ago, they were labeled "corporate raiders" and "quick buck artists". Financiers such as T.Boone Pickens, Carl Icahn, Nelson Peltz and Harold Simmons all recognized that a gaggle of prominent widely known public corporations were under managed and undervalued. Through tender offers combined with garnering an abundance of anti-management press coverage and knowing that most short-term performance oriented professional money managers would support their actions, it did not matter if the target company was acquired or not. Upon the announcement of the attempted take over the marked company's share price might leap twenty percent or more. Some companies with board approval actually paid "greenmail" to have the raiders drop their tender offer. Others ran to investment bankers to find a "white knight" to get themselves acquired by a friendly partner.

Occurrences like these fed into an already mounting controversy regarding corporate governance, shareholder rights and proxy voting. It demanded that securities analysts and other custodians of capital involved in the investment process become as knowledgeable as possible on a bevy of complex and controversial wealth impacting ownership issues. There was no denying that a fissure had burst in the management shareholder covenant.

Member proxy voting surveys of the New York Society of Security Analysts revealed that much needed reforms had to be implemented in the voting process. Only thirty nine percent of respondents worked for firms that possessed a formal policy on proxy voting. Twenty two percent of the investment professionals who voted proxies "felt undue pressure" to vote a certain way. A mind blogging eighty eight percent of the respondents thought that proxy voting procedures favored management over the shareholder.

Further investigations into these wealth jolting issues revealed that share owners and their investment advisors were not doing sufficient enough research before purchasing a company's stock. It was also discovered that in some instances, corporate managements were utilizing the proxy voting process as a job security vehicle. Management controlled the proxy voting apparatus and what was to be published in the annual proxy statement. In many instances proxy voting was not confidential and management counted the votes. Numerous employees and retired share owners as well as individual suppliers of products and services to the company were reluctant to vote against management sponsored proposals. In other cases, if a shareholder did not vote, it was counted as a vote in favor of the management sponsored proposals. Sadly, various management recapitalization proposals more commonly known as "shark repellents", were nothing more than management entrenchment schemes.

As time passed, it became apparent that too many boards of directors were not taking their fiduciary responsibility seriously enough. Interests of senior management and the equity owners were not always on the same page. In certain instances, senior management via the proxy voting process and with board approval, were insulating themselves in the executive suite and disenfranchising the shareholders at the same time. Invariably, pressure mounted, and lawsuits were filed charging that negligent boards permitted the fiduciary link between the ultimate risk takers of the corporation, the shareholders and the operating management to be broken. The colorful T.Boone Pickens was yelling that "there was more oil on Wall Street than in Texas." He was signaling that the "take over" and liquidation value of some of the largest NYSE listed energy companies were twice the current market price. Carl Icahn would tell anyone who would listen that there too many " frat boys" and country club golfing buddies on each other's boards of directors.

The New York Society of Security Analysts jointly with The Financial Analysts Federation in 1988 held a conference on the complex subject of corporate governance and shareholder rights and the fallout in the management shareholder covenant was having on a free and competitive United States. The conference centered on five questions. Does the proxy voting system in the country need a major overhaul? Have investment professionals violated their fiduciary responsibilities by being coerced into voting certain ways on shareholder and management sponsored proxy proposals? Do corporate directors demonstrate enough independence and courage in looking after shareholder interests? Can corporate executives affectively run their businesses in light of the current wave of financial restructurings? How will equity valuations and America's worldwide competitive position be affected by these issues?

The SEC's Division Head of Corporate Finance, The Associate Director of Law Enforcement at the US Department of Labor, the Comptroller of New York State and other government executives along with a host of top finance, legal, and investment professionals packed the house. Post this enormously successful conference, the growing need to correct the shortfalls in the management shareholder covenant picked up an enormous head of steam. Good fortune had it that the then Secretary of Treasury, Nicholas Brady was the former CEO of Dillion Read and Company, a Wall Street investment banking firm. He was up to snuff on many of the governance issues. The Secretary let it be known that he was one hundred percent behind the conference initiatives as was the Deputy Assistant Secretary for Corporate Finance. Secretary Brady and his colleagues were constantly watching to identify "laws and regulations that inhabit the efficiency and competitive position of our capital markets and financial services firms."

It's truly mind boggling when pondering there are 193 member-countries in the United Nations and the United States, the globe's sole super power, with less than five percent of the world's seven billon inhabitants delivers a spell binding twenty four percent of world GDP. Had runaway inflation not been defeated, the management shareholder covenant not been repaired and much of the mediocrity in the executive suite and board rooms not been expunged over thirty years ago, the United States could not possibly be the economic Goliath it is today.

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