Practical analysis for investment professionals
25 May 2020

The New Depression: COVID-19 and Stocks’ “Rightful Owners”

“In bear markets, stocks return to their rightful owners.”

Benjamin Roth’s marvelous The Great Depression: A Diary contains the following entry from 11 December 1931, just several months short of the bottom of the worst bear market in US history:

“A very conservative young married man with a large family to support tells me that during the past 10 years he succeeded in paying off the mortgage on his house. A few weeks ago, he placed a new mortgage on it for $5,000 and invested the proceeds in good stocks for long-term investment. I think in two or three years he will show a handsome profit. It is generally believed that good stocks and bonds can now be bought at very attractive prices. The difficulty is that no one has the cash to buy.”

Or as Benjamin Graham put it

“Those with enterprise haven’t the money, and those with money haven’t the enterprise, to buy stocks when they are cheap.”

In other words, those with the enterprise — the plungers — had long since run out of cash, and those who kept themselves in cash hadn’t the courage.

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The forlorn equities markets of the early 1930s were not entirely illiquid. Someone was usually there to take equities off the hands of the distressed and the panicked, and it’s a good bet that Roth’s “conservative young man” did well.

Most of those who bought stocks in the early 1930s fire sale were far wealthier and older than Roth’s mortgager. As J.P. Morgan supposedly said, “In bear markets, stocks return to their rightful owners.” (This quote, like most ascribed to Morgan, as well as to Albert Einstein, Mark Twain, and John Maynard Keynes, is apocryphal.)

Economic historian Richard Sylla recently pointed out a better documented summation of this process from Matthew Josephson’s The Robber Barons:

“[During a market panic] there are many casualties, cruel transfers of individual fortunes. Yet he who possesses even a modicum of unimpaired capital is as one who watches the sand run down in an hourglass, while fully aware that he may, at the given moment, turn the glass over and begin the process anew.”

Just who turns over Josephson’s metaphorical hourglass to purchase equity from the distressed and the panicked during bear markets? Roth’s assertion that no one had the cash to do so was incorrect, as his “conservative young man” demonstrated. Morgan and Josephson had a far better idea of just who stocks’ “rightful owners” were: society’s wealthiest, the possessors of “unimpaired capital” with which to accumulate shares at low prices.

Today, as then, unimpaired capital usually means Treasury securities. One does not need to be a Warren Buffett scholar to know that the Sage of Omaha is fond of them. No matter how low the yield, almost every Berkshire annual report contains some variant of “We shall continue to hold our liquid reserves in T-bills.”

Book jackets of Financial Market History: Reflections on the Past for Investors Today

If investors have learned anything from the dark days of 2008 and now 2020, it’s that when things go to hell, those wishing to deploy fixed-income securities of lesser quality — municipals, corporates, and mortgage-backed bonds — for stock purchases are going to take a haircut at the approximate level of the clavicle. Buffett’s apparent equanimity at the worst of times in no small part derives from sitting on a comfortable pile of such “unimpaired capital.”

In 2013, the top quintile of the population owned 92% of stock wealth. The bottom four quintiles held the remaining 8%. This discrepancy has likely grown in the years since and will continue to in the coming decades as the upward distribution of equities toward their “rightful owners” plays out, most of the time gradually, but sometimes in paroxysms.

Over the past generation, as ever fewer US workers participate in defined-benefit plans that provide a reliable stream of retirement income, ever more have become their own portfolio managers via defined-contribution plans such as 401(k)s.

This burgeoning mass of defined-contribution assets will be ground zero for the upward redistribution of equity assets. This regressive reshuffling will occur for three reasons:

1. Poor Trading Habits

This turns out to be the least important factor. During the financial crisis of 2008–2009, defined-contribution investors, at least at Vanguard, did not in fact panic. An exhaustive study of its 401(k) participants showed that during the crisis only 11% sold significant amounts of equity. For the other 89%, inertia seemed to overwhelm panic. (Nonetheless, while Vanguard may do a better job of instilling good investment hygiene among participants than other investment companies, it’s not clear how well “Vanguard discipline” applies to its defined-contribution-plan clients. These clients likely did not themselves choose to work with Vanguard, but were placed there by their presumably enlightened employers. Moreover, receipt of an investment statement did seem to trigger selling, and it’s not clear how Great Depression–level market falls would further erode investment discipline.)

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2. The Decline in Defined-Contribution Assets from Older to Younger Retiree Cohorts

A recent study from the Center for Retirement Research (CRR) shows that the pre-retirement balances of “late boomers” born between 1955 and 1960 are an astounding 46% less at the same age than those of the “early-boomers” born between 1946 and 1953 and of the “war babies” born before 1946.

The authors postulate that this alarming fall in retirement assets is due to work loss and deteriorating employment quality in the wake of the global financial crisis (GFC). Since every share of stock must be owned by someone, falling 401(k) balances among younger pre-retirees through decreased real wages implies an upward redistribution of stocks to the wealthy.

3. 401(k) Raids

The last and most alarming mechanism of this upward redistribution: “cashout leakages” from workers withdrawing plan balances consequent to job changes, non-repaid loans, and, critically, emergencies such as job loss and medical expenses. A 2015 CRR paper estimated this leakage at around 1.5% per annum, or about 25% over the span of total employee participation.

These cashout leakages will become a flood. As I write, millions of Americans, newly out of work due to the response to the COVID-19 pandemic, have come face to face with the cruel mistress of financial destitution. The luckier among them will stave off ruin by liquidating what little assets they have, mainly in the form of their 401(k) and IRA accounts. Other small investors, both inside and outside retirement plans, while not immediately threatened by penury, will sell their equities in panic. One does not have to venture too far into the social media sphere to see evidence of this.

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Who will buy up these equity assets at distressed prices? J.P. Morgan’s “rightful owners,” who sit on large piles of Josephson’s unimpaired capital.

Eventually, the bull market will resume, amnesia for the carnage will set in, and stocks’ wealthy “rightful owners” will sell some of their shares back to plan participants at higher prices. This chasm between the total unimpaired capital available to the rich and to the average 401(k) participant will continue to cycle equity-derived wealth ever upward.

This, by itself, is bad enough. But it is unconscionable that we allow such a process to be accelerated by a retirement system that forces the vast majority of the population to compete against the few J.P. Morgans and Warren Buffetts armed with their massive amounts of unimpaired capital.

The current system doesn’t need a few tweaks and nudges. It needs dynamite and replacement with a new system that actually protects workers, their families, and their retirements.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images / John Coletti

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About the Author(s)
William J. Bernstein

William J. Bernstein is a neurologist, co-founder of Efficient Frontier Advisors, an investment management firm, and has written several titles on finance and economic history. He has contributed to the peer-reviewed finance literature and has written for several national publications, including Money Magazine and The Wall Street Journal. He has produced several finance titles, and also three volumes of history, The Birth of Plenty, A Splendid Exchange, and Masters of the Word, about, respectively, the economic growth inflection of the early 19th century, the history of world trade, and the effects of access to technology on human relations and politics. He was also the 2017 winner of the James R. Vertin Award from CFA Institute.

3 thoughts on “The New Depression: COVID-19 and Stocks’ “Rightful Owners””

  1. Kirk Cornwell says:

    “Things are different now.” (But it probably makes no difference.) The debasement of the currency in trillion dollar leaps is 2008-9 at another level. Every time the Fed bolsters the banks it solidifies the top 10% and our growing share of both equity AND cash reserves. This isn’t about the 1%, but it is a “you have to be in it to win it“ game with regard to the inevitable inflation of financial assets. Covid-19 is merely an accelerant.

  2. Daniel McGrath says:

    An entertaining but nonconstructive if not outright inflammatory article. The repeated references to “rightful owners”, the pitting of ‘unimpaired capital’ against the average guy, etc. does well to paint a picture of class struggle if not instill a sense of the need for class warfare.

    However, a somewhat different view that can be taken away from points 1 though 3 (Poor Trading Habits, the Decline in Defined-Contribution Assets from Older to Younger Retiree Cohorts and 401(k) Raids) is that the Financial Advisor industry on the whole has demonstrably failed their clientele. These “workers, their families, and their retirements” typically have minimal or no functional knowledge of equity markets and likely expect the advisors that collect fees from their accounts to help them avoid the pitfalls as listed. Per the article, they do not. Yet, the financial advisor that ‘assist’ these clients and the firms that manage those 401(k)s generally profit whether the bull is running or the market is distressed.

    Are we really forcing the “vast majority of the population to compete against the few J.P. Morgans and Warren Buffetts” or are we misleading them by having them trust the firms that are supposed to assist them in managing their retirement assets? It would seem from this article that such trust may be misplaced.

    In light of the article, I would agree the system needs improvement but I did not see any specifics other than dynamiting the current system and replacing it. The specific question is: With what? If the specifics of the replacement are not yet delineated then perhaps this old phrase applied to another profession wherein trust is supposedly recognized as fundamentally important might be taken into account: Medice, cura te ipsum.

  3. Mr. Bernstein’s article does great service in framing a longstanding issue in a topical way. As I write this comment more than six months after the article was posted there is hope with the arrival of vaccines (though still a long roll-out process), but also increasing evidence of the types of economic stresses of which the author writes.

    In his comment above, Daniel McGrath notes that Bernstein offers no recommendations or solutions, and rightly calls out a financial system that looks after its own needs first even as a small but well trained body of investment professionals looks to work “for the ultimate benefit of society”. I don’t think the point of the article is to offer solutions, but rather to provoke exactly the type of discussion that McGrath and (previous commenter) Cornwell offer. Bernstein highlights an issue famously re-invigorated by Thomas Picketty in his book Capital in the Twenty-First Century – that the system naturally favours capital over labour. The power of Bernstein’s article is that it combines this with the salient point that – as Cornwell points out – necessity and behavioural finance combine as an “accelerant” in the current health and economic crisis.

    To non-Americans like me, the debate in the United States about how systems should be designed to address structural health and welfare issues emphasizes a long-standing frontier spirit and a suspicion of government’s efficacy that differs from the discourse in other countries. To outsiders the US debate seems tilted towards ‘if’ the system should address social and economic inequity, whereas in many other OECD countries the debate drifts towards ‘how’ or ‘how much’.

    The Harvard economic historian Norman Gras (ironically a Canadian transplant (though writing about 20 years before Canada’s ‘socialized system of healthcare’ started under Kiefer Sutherland’s grandfather) highlighted the perils of ‘socialism’ in a his 1942 essay “Capitalism – Concepts and History”. Gras’ conceptualization of socialism almost a century ago is different than today (he was really addressing Marxism), but his charged word unhelpfully endures in political discourse as shorthand for any government intervention. This lexical quick of history points even more strongly to the importance of Mr. Bernstein’s central aim – to re-invigorate debate about ways to nudge or (re)structure the system to more equitable outcomes.

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