The Making of an Equity Culture


By Christopher Farrell Here we go again. For three years, people have been arguing over whether the stock market is overvalued or not. The pessimists believe the recent stock market rally is unsustainable and that the bulls are running on fumes. The optimists point out that stocks are attractive relative to bonds, and that the recent economic data are largely pointing to an economy turning upward.

It all reminds me of the Sherlock Holmes dialogue about the dog that didn't bark in the short story Silver Blaze:

"Is there any point to which you would wish to draw my attention?"

"To the curious incident of the dog in the night-time."

"The dog did nothing in the night-time."

"That was the curious incident," remarked Sherlock Holmes.

Well, the curious incident in the stock market is what didn't happen: Individual investors haven't fled the market in a panic, despite the searing economic and business trauma of the past three years. Think about it: America has just lived through the bursting of the greatest stock-market bubble in history, the tragic attacks of September 11, and wars in Afghanistan and Iraq. A recession and feeble recovery. A three-year bear market vicious enough to rank among the worst in U.S. history. Business scandals that revealed widespread corruption in executive suites and ethical bankruptcy in professional circles.

WORST TO COME? Today, the fear is that global deflation is a harbinger of another Great Depression. Federal budget deficits extend out as far as the eye can see. Now, if somehow you had known back in 2000 that this was the future, wouldn't you have forecast the biggest stock market panic in Wall Street history? After all, experience suggests investors would have fled stocks.

Many commentators have noted the striking parallels between the stock market boom of the 1920s and the 1990s. Frederick Lewis Allen's 1931 book Only Yesterday memorably tells of 1920s New York City subways crowded with riders skimming the financial pages and of loud dinner-table conversations about the latest speculative gambit. But after the crash of 1929, individual investors spurned stocks for the next three decades.

America's newly prosperous middle class did return to wagering on stocks during the Go-Go Years of the 1960s and the Nifty-Fifty craze of the early 1970s. Yet the cult of performance spectacularly flamed out, and prices of big-capitalization growth stocks cratered. Disgusted with Wall Street, net annual outflows from equity mutual funds in the 1970s ranged between 1.2% and 11.9%. That compares to an outflow of less than 1% from equity mutual funds in 2002. So far this year, investors are net buyers of stock mutual funds.

RATIONAL RESPONSES. So, why have individual investors in the aggregate largely stuck with stocks this time? One theory among Wall Street veterans is that investors simply haven't endured enough pain yet. The bloody moment is still to come, the theory goes.

Now, it's certainly possible that the stock market will collapse if the powerful combination of monetary and fiscal easing fails to deliver a solid economic recovery by yearend. Yet it's hardly credible that investors are still myopically suffering from a mass delusion, considering all that has occurred in the past three years. Sure, a steady stream of money is being allocated away from stocks and into fixed-income securities and residential real estate. But the retreat has been quite orderly and a rational response to market forces.

One reason for the lack of panic is that individual investors may be more diversified than common lore holds. Everyone know someone or has read about investors that suffered an 80% or 90% loss on their portfolio, usually by putting all their eggs in one basket -- high-tech stocks. Sad to say, some of these unwitting gamblers have had to postpone retirement or go back to work.

MUTED IMPACT. Still, the tales may be misleading in the aggregate. For instance, the average 401(k) balance fell 4% in 2001 -- while the market declined by 12% -- for participants in a pension plan over the past three years, according to the Employee Benefits Research Institute.

New contributions helped mute the impact of the market decline, as did portfolio diversification. The Employee Benefits Research Institute/Investment Company Institute database covers 14.6 million active plan participants in 48,786 401(k) plans holding $633 billion in assets. Taken altogether, 47.7% of the retirement money was invested in equity mutual funds, 8% in balanced funds, and 26% in fixed-income securities.

The youngest workers had more of their retirement money saved in equities -- 58.6% -- while the oldest workers had the least -- 36.2%. These are reasonable asset allocations and indicate that the bulk of workers with access to a retirement-savings plan are behaving rationally with their long-term investing.

SOLID FOUNDATION. I see hope in all this. America's equity culture is intact. The democratization of the financial markets represents a remarkable change in U.S. economic and social history. Americans turned to the stock market to fund their retirement, their children's college education, and other long-term aspirations. About half of U.S. households own equities, yet that figure understates just how widespread is the public's embrace of the market.

Over the past two decades, entrepreneur-driven businesses have grown ever bigger, spreading across the country, constantly innovating, creating new products, and offering better service than established companies. Many large companies, despite the controversy over expensing stock options, remain eager to push stock ownership throughout employee ranks. Microsoft's announcement that it would end its stock-option program is being treated as a momentous move (see BW Online, 7/10/03, "This May Be the End of the Options Era"). But it's really just another evolution in America's equity culture. All Microsoft employees will be eligible for restricted stocks, a valuable form of compensation typically reserved for senior management at most companies.

Adam Smith believed that in the good society, everyone would be a merchant, an owner, with an economic stake in society. More than two-thirds of Americans own their own home. But stocks are the foundation of the equity culture. More than half of all households own equities today. America still has a long way to go. But the traditional divisions between capital and labor, owner and renter, are breaking down. What individual investors are saying by not fleeing the market is that there's no turning back. Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online


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