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Nadeem Walayat Financial Markets Analysiis and Trend Forecasts

The Stock Market As Time Machine

Stock-Markets / Dividends Dec 10, 2008 - 01:37 PM GMT

By: David_Haas

Stock-Markets Best Financial Markets Analysis ArticleI am sure very few people look at it this way but, in reality, the stock market is actually used by most investors as a means of “cheating time” rather than simply as a means of making money. Please read on and allow me to explain.


There was a time when stocks were purchased primarily as a means of buying into profitably-operating corporations with the intention of participating in the income they produced through the steady receipt of dividends. If an investor were fortunate enough to accumulate a large holding of shares, he might eventually be able to live entirely off of his dividend income and enjoy a life of leisure. Income was the primary goal of most investors.

The markets basically operated such that, if stock dividends were high relative to what an investor could earn more safely as a bondholder, then stocks would be considered “attractive” and investment capital would migrate toward stocks. If stock dividends were low when compared with bond yields, then stocks were generally considered to be overpriced and capital migrated back toward the safety and yield of bonds. This symbiotic relationship between stock and bond yields tended to keep markets in a healthy state of equilibrium and helped to avoid the formation of runaway speculative price bubbles (until the next central bank “intervention”, anyway).

Those “buying for yield” days disappeared long ago (though I strongly suspect they will be returning in the not-too-distant-future) and investors haven’t really thought this way - en masse - for decades. Over the past few decades, we’ve evolved into or have been driven to become price speculators rather than true investors seeking income and, like all trends eventually must, this one also had to reach its end.

Tick-tock, tick-tock…

As young people entering the workforce, we have all been advised to start regularly saving 10% of our income “for our future”. This arbitrary 10% figure is based more on tradition than any form of rational or scientific analysis of what we actually should be saving, but 10% is the figure we’ve all heard.

In today’s world, when we look around us and survey the savings and investing landscape, what we see is our “viable” savings options are few. Should we invest for safety and put our money into a savings account in a local bank? If we choose this option, even the least-sophisticated among us can readily see that we will, most likely, fall dismally behind the persistently rising cost-of-living and be forced to work for all of our remaining years because of the low interest rates banks are willing to pay savers for the use of their money.

The sad fact is, most bank savings vehicles do fall behind inflation on an after-tax basis (even for savers in the lowest tax brackets) and virtually guarantee that we’ll lose a considerable amount of purchasing power on any money placed into them over time. Because of this, saving is not an attractive option for many of us but is, instead, a source of great frustration. Not surprisingly, along with over-consumption, historically low savings rates have been the result and the low yields offered by savings vehicles have been a primary driver behind the trend of increasing stock speculation we’ve been experiencing for many years.

For the money we do save, the rising cost-of-living propels us into a never-ending quest for higher yield and faster growth. But where do we look next in our search for yield? Of course, all of us are reminded time and again - by the financial media, “financial planners”, and “advisors” - that we must look to “risk-oriented” vehicles such as the stock market or mutual funds to find our solution if we are to have any hope of coming out ahead in the end. We’re continually reassured with such platitudes as “in the long run, your money will be safe” and “the market is the only place to put your money to keep ahead of inflation” and “the long-term trend is always up” and “you’ll never have to take a loss unless you sell”, etc.

Many representatives of the industry even go so far as to boldly tell us that we can anticipate returns in the range of 12% per year compounded “over the long haul”. When compared with the idea that we may have to work until we drop if we go the “safe” route, most of us will jump at the opportunity to earn these high returns on our investments, even if it means that we must risk the total loss of our capital to have a chance to bag them.

Lunging Ahead

So where does the “time machine” aspect of the stock market enter the picture? Well, consider the following simplified examples:

If we were to have an income of $100,000 per year in a 32% combined federal and state income tax bracket and save 10% of our gross income in a savings account yielding an average of 4% interest (2.72% after taxes), over the course of 40 working years our ending balance would be $727,160.

However, if we used the same income scenario above and increased our investment yield to the 12% we’re told is possible in stocks and mutual funds, our investment might produce an after-tax yield of 8.16% (depending on capital gains percentages vs. income) and we could look forward to having an account worth $2,922,679 over the same 40 years! There’s simply no comparison.

If we attempted to accumulate this amount of money using the bank account yielding 4%, IT WOULD TAKE US OVER 78 YEARS to accomplish what we did in just 40 years with our more aggressive market-based approach. In other words, our stock market “time machine” moved us dramatically further ahead 38 YEARS INTO THE FUTURE in terms of what we would have accumulated employing the “safe approach” at the bank.

Rapid Time Travel Is Possible In Both Directions

Alas, if we stay in the game long enough we learn that the same machine that can transport us swiftly ahead and deliver us deftly into the future can also SET US BACK DECADES within the course of a few short weeks and it might just keep us there. Time travel in both directions is compressed by the stock market and, as we’ve recently seen, things can move exceedingly quickly.

I could choose from any number of vehicles but here is a real-life example of what might have happened to long-term investors in the Fidelity Magellan mutual fund - one of the largest, most respected mutual funds in the world. As you can see on the chart below, Magellan investors had been thrilled with their time machine’s fast-forward rapid-transit during the 1980’s and 1990’s. (Of course, this admirable performance is what made Magellan large and respected.)

Fidelity Magellan Price Chart

What Magellan investors may not have seen coming was the VERY REAL POTENTIAL FOR THEM TO BE TRANSPORTED EVEN MORE QUICKLY BACK IN TIME - in terms of share price - from 2008 all the way back to where they began in 1988! That’s right, you can see on the graph that, in 1988, Magellan shares were trading around $45 per share. After ascending toward $150 per share in the early part of 2000, the shares have plunged quickly down to $45 again in late 2008. At a current price around $45 per share, Magellan investors who bought their shares in 1988 are probably THINKING they’re right back where they started from, but are they really?

STILL, MORE TO THE STORY…

Though it seems bad enough that our Magellan “time-machine” has whisked investors back to where they were some 20 years ago, there’s even more serious damage than meets the untrained eye. The Magellan fund made distributions of dividends, short-term, and long-term capital gains in most years and, of course, income taxes had to be paid in the year these distributions were made. Those tax dollars are long gone along with any interest they could have earned over the years. Many investors would have chosen to pay those taxes out of other accounts (thereby indirectly increasing their investment in Magellan) so they could re-invest their full pre-tax distributions back into Magellan shares - since the fund appeared to be doing consistently well. Any gains that were re-invested were also put in harm’s way inside the Magellan time machine so, along with gains, risks were also being compounded.

And then there’s the steely bite of inflation. Obviously, $45 today will not buy nearly as much as what $45 bought back in 1988 due to the effects of inflation and its attendant erosion of purchasing-power. The fact is, if inflation averaged just 3.5% over the past 20 years (which may be conservative) it would take $92.65 today to buy what $45 bought for an investor in 1988. This means that the moment Magellan shares traded beneath $92.65 in early 2008, investors who’d held their shares since 1988 dropped below their original inflation-adjusted purchase price if they’d paid around $45 per share back then. In other words, their shares at $45 today are actually worth only about $21.30 when adjusted for 20 years of inflation. It’s amazing when you take the time to do the math, isn’t it? Who’d have guessed that the break-even share price would have climbed to $92.65 just due to inflation?

Lastly, by ruthlessly transporting long-term investors back in time, the stock market time machine has stolen year-upon-year of productive work and labor, years of income taxes that had to be paid to produce after-tax “investable” income, years of gas money and car payments transporting the employee to and from his or her job and, for some, perhaps even stealing the years that were the most productive years the person will ever live working at a job or a business that has now disappeared, never to return again.

In Conclusion

We humans love machines because they enable us to magnify our power to test or even challenge the laws of nature and recreate many aspects of our world. By their very nature, machines enable us to do things that would be impossible to accomplish without them.

Like the jet transport plane that whisks us around the world in a matter of hours where it used to take many months of arduous, often dangerous travel by sea, the stock market holds the potential to effortlessly whisk us off to a world of luxury, leisure, and riches by compressing what would have taken many years of hard work, sacrifice, and systematic saving into a few decades of lucky speculation.

What the markets have shown us since October 2007 is that time-travel is not something that we have any control over and moving ahead is certainly not something we should ever take for granted. Moving sharply backward in time may be just as likely and the penalty can be severe.

The stock market is the machine and it operates itself. No matter how confident we may become as passengers, we must accept the fact that we are never at the controls. By stepping on board, you have agreed to take your chances, go wherever the machine takes you, and step out into the world it delivers you to… even if that quick trip costs twenty or more years of your life and labor and leaves you destitute.

As with any enormously powerful machine, the stock market demands both skill and respect as its awesome power can both create and destroy. Millions are learning for the very first time in their lives that this is true. Millions more are realizing that the machine they were relying on to create money and buy them time has actually destroyed both. Of course, of the two, time is the most precious resource because it can never be replaced. People need to be made aware that, above all, time is what’s really being risked in the markets and time, once lost, will never be recovered - even if markets do. Only then will they begin to truly give the market the respect it deserves.

For more interesting articles and commentary please visit: http://www.haasfinancial.com

    By David Haas
    Consultant

    http://www.haasfinancial.com

    In my consulting practice, I work with individuals, business owners, and professionals.  I assist business owners and professionals in several critical areas ranging from business start-up, marketing, operational challenges, employee retention, and strategic planning to personal asset protection, financial, and retirement income planning.  Often, these areas relate and need to be integrated to work most effectively.  I also assist business owners in developing exit-strategies that enable them to maximize the value of their business interests and preserve their lifestyle in retirement.  For individuals, I primarily focus on tax reduction, financial, and retirement income planning.

    © 2008 David Haas, Consultant

    David Haas Archive

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