Bogle and Siegel on the Stock Market and Corporate ReformPublished: September 25, 2002 in Knowledge@Wharton
What will it take to restore public trust in corporate America? And what kind of stock market returns can today’s depressed investors expect over the next decade? Ask John C. Bogle, retired founder of The Vanguard Group, and you get the impression it will take a lot of work to get even the most modest results.
It’s going to require major reform of executive compensation practices, corporate governance and accounting rules to get the public to trust public companies again, according to Bogle. But that doesn’t mean stocks will pick up where they left off two years ago. Stock investors will have to adjust to much lower returns than they enjoyed in the 1990s – perhaps an annual average of just 6-9%.
“There are just a few bad apples out there,” he said, referring to high-profile financial scandals. “But I believe the barrel is bad – the barrel with the apples is bad … I believe the corporate system, the financial system, generally is bad – is corrupt.”
Bogle, 72, has never been known for mincing his words.
In 1974, he founded Vanguard and served as chairman through 1997 and senior chairman through 1999, when he retired. Vanguard, the second largest mutual fund company, behind Fidelity, is best known for its extremely low management fees and index funds tied to indicators such as the Standard & Poor’s 500. Bogle’s view, which has been well supported by research over the past two decades, is that high trading costs, taxes and fees eat so deeply into the gains of actively managed funds that those funds rarely succeed in beating low-cost index funds. This view, and Bogle’s eagerness to express it to any audience, has long made Bogle the fund industry’s biggest gadfly.
Though retired from Vanguard, Bogle has hardly moved to the sidelines. In 2000 he founded the Bogle Financial Markets Research Center on Vanguard’s Valley Forge, PA campus. He has a busy speaking schedule, and is currently a member of The Conference Board’s Commission on Public Trust and Private Enterprise, formed this year to address issues arising from recent corporate scandals. Among the commission’s 12 high-profile members are Intel chairman Andrew S. Grove, former SEC chairman Arthur Levitt Jr. and former Fed chairman Paul A. Volcker.
On Sept. 17, the commission released the first of three planned reports on executive compensation, corporate governance and accounting. The first installment pinned much of the problem on the excessive use of qualified stock options, which give executives incentives to manipulate financial statements to boost stock prices. To discourage this, the commission recommended rule changes to require that options be carried as expenses. This would encourage companies to instead use performance-based options, which are already expensed.
The commission also said corporate directors’ compensation committees should hire their own executive compensation consultants rather than use consultants hired by CEOs. Finally, it said senior executives should be required to disclose in advance their plans to sell company stock; currently, those disclosures can come as long as 40 days after a sale.
“The light being shined on executive compensation – that was a good place to begin,” Bogle noted. “We want to get a much better link between how the executives do and the performance of their company, if you will, rather than the performance of the stock.”
Stock price, he said, “is not a good measure of executive performance at all,” adding that executives concerned about short-term price gains too often avoid making decisions that can improve their companies’ long-term health.
According to Bogle, treating all forms of options as expenses would encourage the use of performance based options. One type is profitable for the executive only if he meets certain revenue goals or satisfies other elements of a long-term corporate plan. Others might have strike prices well above the market price on the date the options are granted. Or the options might be exercisable only if the stock beats a market or industry average.
The reduced emphasis on dividends, Bogle pointed out, is partly attributable to the heavy use of qualified options. Dividends are of no value to an executive who holds options rather than actual shares. Consequently, it’s in his interest to see earnings reinvested in the company or used to buy back shares – techniques meant to boost share prices. A number of experts have argued recently that if companies were given incentives to distribute more of their profits as dividends, it would be more difficult to fudge financial reports. When a dividend check is sent, there must be cash on hand to back it.
Bogle said the changes recommended by the commission could also lead more companies to reward executives with restricted stock – shares that can be sold only after a set time has passed or some other goal has been met. Executives with a lot of money tied up in the stock have the same risk of loss borne by ordinary shareholders. Since there is no money tied up in an option, the option-rich executive is free of such downside risk.
The Fed: Behind the Curve?
“It didn’t surprise me, but I think it was a mistake.”
That’s Wharton finance professor Jeremy Siegel’s view of the Federal Reserve’s Sept. 24 decision to leave interest rates where they are, despite mounting evidence of economic weakness and plummeting stock prices. It would have been smarter to cut rates, said Siegel. “By not easing now, it means they are more likely to ease in the future … It’s another example of the Fed being a little behind the curve.”
Prior to the Fed’s afternoon announcement, Siegel had expected a rate cut that he believed would trigger a stock market rally. With stocks near or below lows set in July, and with housing and auto markets softening, it seemed clear that the economy needed stimulation, Siegel said. Anecdotal evidence suggests that while third-quarter financial results may not be too bad, the fourth quarter may be weaker, he added.
Siegel warned that if major stock indexes fall below the July lows, investors may decide the markets have not yet found a bottom. The psychological effect could then drive stocks down another 10% or 15%, he said. He stressed that he is not predicting this will happen, only that it could.
In announcing its decision to stand pat, the Fed’s Open Market committee reported that two of its 12 voting members had wanted an immediate rate cut. It is the first time in 10 years that two members have dissented in favor of easing, according to Siegel. “Obviously, there was a lot of discussion at that meeting,” he said, “but the majority was not willing to move with it … I thought they could have taken an insurance cut.”
Bogle’s view of the stock market is that future returns will depend almost entirely on the growth of corporate earnings. That’s quite a change from the past two decades, when the lion’s share of returns came from investor enthusiasm.
The S&P 500’s annual return averaged 17% from 1981 through 2001, Bogle said. Of that, however, eight percentage points a year was attributable to the rise in the price to earnings ratio from around 8 to about 30: In 1981, investors paid $8 for the right to share in $1 of earnings; by 2001 they were paying $30 for the same $1 in earnings.
This rise is purely attributable to investor emotion – the belief that future earnings would somehow rise enough to justify the high stock prices, or that investors would continue to be so excited by stocks that the P/E ratio would never return to its long-term average of around 15.
The other 9% in annual returns during this period came from an average dividend yield of 3.5% a year and stock price gains driven by annual earnings growth averaging 5.5%, he said. Today, dividend yield averages around 1.8% and earnings growth can be expected to continue at its historic level of around 6%, Bogle said. That would produce an annual return just shy of 8%.
The other component of the 1981-2001 return – rising P/E ratios driven by investor enthusiasm – is unlikely to return anytime soon, Bogle predicted. On the contrary, investors are more likely to have a negative view of stocks for some time, reducing this “speculative” or emotion-driven portion of return, to zero – or perhaps less, if investors drive the P/E below its current level of around 20 or 22.
Bogle said he believes a P/E level of around 18 should be considered normal today, despite the historic average of 15. Many experts say slightly higher P/Es are justified during periods of low interest rates.
Indeed, this issue is made more complex by the growing uncertainty over just what should be included in a proper earnings figure. If investors cannot trust earnings statements, or can’t settle on what should be included in the calculation, it’s difficult to accurately measure the P/E ratio. “We are in an environment where prospective [stock] returns are very low,” Bogle said. He is comfortable, he added, predicting stock market returns of 6-9% over the next decade, which actually makes stocks a desirable investment next to their chief competitor, bonds. The 10-year Treasury currently yields less than 4%.
“If I were to tell investors anything, I would say don’t just think about the possibilities of return … Consider the consequences of loss,” Bogle said. “If you can’t stand a loss, you should not own any stock, period.”