William McNabb became chief executive officer of The Vanguard Group on August 31, 2008 — two weeks before the financial world went into free fall. On the evening of Sunday, September 14, the day Lehman Bros. declared bankruptcy, he was in Washington, D.C., welcoming institutional investors to the mutual fund company’s bi-annual conference. The next morning, as world ticker tapes bled and “all hell was breaking loose,” McNabb found himself in front of the company’s 300 largest pension fund clients, “talking to them about the importance of being long-term, balanced and diversified, and taking a very long-term perspective on the markets.” As he spoke, he recalled, a “soundtrack” looped in his head: “The world is melting down. What are we going to do?”
“It’s been an interesting adventure,” McNabb told an audience gathered for a recent Wharton Leadership Lecture. “We have come a long way in these past few years.”
McNabb, too, has come a long way since he joined the Malvern, Pa.-based firm in 1986. At the time, Vanguard managed under $20 billion and employed less than 1,000 people. “I didn’t know what a mutual fund was,” he remembered. John J. “Jack” Brennan, who became the company’s CEO in 1996, told McNabb during his job interview that he wanted to build a firm with “the intellectual rigor of Wall Street but with Midwestern values,” a phrase that stuck with NcNabb on his way home. “That really resonated with me. I wanted something that was intellectually stimulating but values-based,” he stated. “I remember saying to my wife, ‘I’m going to do this.’ [Yet] all the advice I was getting from my parents and my friends was, ‘This is a little firm. Who knows if it’s going to make it?’ But I really liked the values.” Since then, Vanguard has grown to become the nation’s largest mutual fund company, with 12,500 employees and $1.6 trillion under management.
Looking at the markets today, McNabb said the future could be interpreted as “a glass half empty or a glass half full.” Market confidence is down, doubts about Europe are up and housing remains uncertain. Fears about state and municipal bonds, shifting government regulations and the national debt leave many investors worried. On the flip side, the U.S. economy is recovering, equity markets are fairly valued and investors are recognizing the importance of saving and diversifying their investments, McNabb noted. Perhaps the best hope for America’s future lies in its past, he added: History shows that some of America’s greatest innovations were made in the midst of tough economic times.
Shaken Confidence — for Now
Short term, there are a number of issues creating uncertainty in the markets — including public perception of the markets themselves. “Confidence is shaken,” McNabb said. Market volatility has driven many investors away from stocks and into other investments that are perceived to be lower risk. Equity purchases “basically came to a halt” on May 6 with the “Flash Crash,” when the stock market plunged 900 points in a single day — an event McNabb attributes to concern about the emerging debt crisis in Greece. “The Flash Crash didn’t all of a sudden cause equity investors to get skittish,” he said. “We think the Flash Crash was just a catalyst. It was probably the Greek debt crisis that was actually getting people to be a little bit more cautious.”
Investor skittishness is nothing new. A look at market volatility in the S&P 500 over the past few decades shows a number of peaks and valleys, with the crash of 1987 and the global financial crisis emerging as “the two most volatile times in the history of the equity markets,” according to McNabb. The Russian debt crisis in 1998 saw a level of market volatility that was lower than those two, but in comparison looks very similar to recent investor reactions surrounding the Greek debt crisis, he suggested. “So to say confidence in the markets has been shaken is fair, but at the same time, it’s something we have seen before and we will see again. These things tend to be pretty cyclical.”
Confidence could erode further depending on how Europe fares financially in the coming months. A possible European debt crisis “is one of the uncertainties as we move forward over the next six to 12 months,” he said, noting that economists and market watchers at Vanguard are paying attention to credit default swaps for clues to Europe’s financial health. “Greece does not look great,” McNabb added. “The market is pricing that in as we speak. Ireland is not doing very well. You could argue that Ireland is really not solvent today. You hear a lot about Spain, [but] the market is treating Spain as though it will get through.”
Back on this side of the Atlantic, housing news continues to rattle the market and put a drag on the economy. “The big question is: Has it bottomed?” McNabb said. Based on a comparison of housing prices and the consumer price index (CPI), housing may still be somewhat overpriced. “In the long run, housing prices have tracked CPI almost perfectly. There’s a very, very strong correlation,” he noted, referring to a chart showing the uptick of both over time. The two lines danced closely on the same slope for decades, until the housing boom in the mid-2000s sent housing prices steeply upward. “What you see here is this massive bubble, where housing prices got way, way ahead of what inflation predicted they should be, and obviously that fueled a lot of consumer behavior. Often when you have this kind of bubble, the reversion, if you will, doesn’t stop at that nice little inflation line. It tends to go below it. So there’s probably still some room for housing prices to fall further.”
State and local government finances are another cause for concern over the next few months, but McNabb calls it “probably overblown” and mostly “headline risk.” Many state and local governments are struggling with budget gaps as obligations rise and revenues fall. Fears have been growing that widespread defaults could cause another subprime-style crisis. McNabb disagrees with independent analyst Meredith Whitney, who has predicted up to $100 billion in defaults. “In 2008, the worst year of the crisis, there were only $8 billion of municipal defaults. So we don’t think Meredith Whitney is correct,” McNabb said. The debt burden does not make up a large part of state budgets, he added.
The last of the short-term risks McNabb identified is the shifting regulatory landscape resulting from the Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law in July. A response to the financial crisis, the reform act is the most sweeping financial regulatory overhaul since the Great Depression. “Dodd-Frank [is] 2,300 pages, and none of us has a clue as to what to do,” McNabb said. “There are literally 270 studies contemplated over the next 18 months as a result of Dodd-Frank…. There’s a whole bunch of uncertainty, and that’s going to [influence] the markets.” He is “particularly worried” about the future of money markets, the way derivatives are traded and the notion of systemic risk. “If Dodd-Frank allows this oversight committee to designate anybody as ‘systemically risky,’ then you have no idea what you’re going to be subject to. The Fed is going to come in and essentially dictate how you operate. That’s obviously a concern.”
McNabb’s biggest worry about the future — what he calls the “single biggest overhang to long-term economic health” — is the rising level of U.S. debt, which is roughly $13.5 trillion and predicted to double by 2021, according to the Congressional Budget Office (CBO). It could grow even higher than that, given that the CBO uses what McNabb calls “very optimistic” assumptions to arrive at this estimate. “The CBO has unemployment dropping to 5% in the next three to four years. And if you believe that’s going to happen, we’ve probably got some really bad muni bonds we’d like to sell you.”
Another way to analyze U.S. debt levels is as a percentage of gross domestic product (GDP). By that measure, U.S. debt is projected to surpass 100% of GDP. “So it kind of looks like Greece, looks like Ireland, looks like Portugal and so forth,” he said. “This is the thing that haunts me the most…. This has to be solved.”
The ‘Half-full’ Approach
Despite the litany of worries, McNabb says he remains “cautiously optimistic” about the future for a number of reasons.
First, the U.S. economy is recovering. Vanguard’s economists track a series of leading indicators that measure about 75 different variables in the nation’s economy, he noted. Some of the variables are very specific, such as credit card receipts from interstate truckers. Put together, these variables indicate where the economy may be headed. In June 2006, the model suggested that the economic expansion was slowing down. By 2007, it was predicting a “pretty strong recession.” Today, the model is showing signs of modest growth. “What this suggests to us in the next six to 12 months is a slow recovery — not a typical recovery out of such a deep recession, but growth in the 2.5% to 3.5% range.” The probability of a double-dip recession also appears to have declined since last spring, dropping from about a one-in-three chance to 20% or maybe even 15%, he said.
And despite investor skittishness, equity markets “actually look pretty attractive based on historical numbers,” McNabb added. “I would not tell you that they’re cheap, but I would tell you [that] stocks actually look fairly valued.” Price-to-equity ratios are in line with long-term averages, earnings are robust and “companies have the strongest balance sheets we’ve seen in the last 15 years.” This suggests that, “over the next decade or so, equity returns are likely to return to more normal levels.” About half of the simulations Vanguard has performed using capital markets models show equities earning “between 6% and 14% over the next decade,” he said. Bonds look slightly less than normal, falling somewhere in the 3% to 4.5% range. McNabb sees the positive numbers as one of the reasons investors will eventually wade back into equity markets. “Generally, if you tell investors that over the next decade a diversified portfolio is going to earn between 6% and 8%, they would feel pretty good.”
Balance and diversification still works, McNabb insists. Although the global financial crisis has sparked a lot of discussion about investing, with some saying that it has fundamentally changed markets and how people will invest, “we [at Vanguard] think the last decade has reinforced the importance of balance and diversification. It reinforced how important it is for people to save more than they think they need, take a long-term perspective and keep their portfolios highly diversified.”
McNabb illustrated his point with a simple chart showing the value of different types of investments from the market’s peak to its most recent trough. A portfolio with nothing but equities fell 55% from peak to trough. However, “a 50/50 portfolio was down 24% and is now back in positive territory, despite the fact that equities are still 20% below their peak,” he said. The numbers are similar when applied to 10-year returns. “Despite the heavy duty crisis, people who are willing to stay disciplined and stay diversified actually made money during the last 10 years and made progress.”
There are signs that Americans are taking their finances more seriously since the crisis hit. McNabb is encouraged that consumer debt has gone down and savings rates have gone up to around 6%. Although the rate has been higher in the past, the actual number of dollars Americans are saving (after adjusting for inflation) is as high as it has been for 30 years. “We view this as a very positive thing. Again, I did not understand a lot of the commentary last year or the year before encouraging consumers to spend, spend, spend and [that] savings was a bad thing. Of course, it was meant to spur the economy, but having a high long-term savings rate is an incredibly important element in a healthy economy.”
The belt-tightening could work out well for Vanguard, which brought the first index fund to the small investor in 1976 and prides itself on low-cost investing. McNabb sees more investors turning to indexing — or “passive” investing — as they realize its value compared with actively managed funds that charge high fees. “We’re in a lower-return environment, so people are paying more attention to cost,” said McNabb. “Today, index assets represent about 15% of mutual fund assets overall. The preponderance of assets is still in actively managed funds. That’s going to change over the next decade. We’re going to see a continued move towards indexing. Indexing doesn’t work because markets are efficient…. Indexing works because it’s low-cost. And the cost differential between active and passive is so dramatic that it’s tough for an active manager to out-perform an index fund on an after-cost basis…. People are starting to figure this out.”
In the end, McNabb is very optimistic about America’s future because of what he has seen in its past. “I think there’s a lot of old-fashioned ingenuity” in the United States, he said. Throughout American history, he noted, tough economic times spurred innovations, inventions and the growth of new businesses — from zippers to fiberglass, instant coffee and the creation of the assembly line. “[Vanguard] looked at when companies were formed and [found that] 80% of the S&P 500 [companies] were created either during a recession or within two years of coming out of a recession,” McNabb said. “This is one of the reasons I remain incredibly optimistic, because we just went through a really deep recession.”
And as the world economy grows, so do opportunities for the next wave of businesses and innovations, McNabb suggests. Emerging economies hold promise for American entrepreneurs who can find ways to work with new expanding markets. “I don’t like the term ’emerging’ anymore because China is the second-largest economy in the world,” McNabb said. “At this point, it’s hardly emerging. It’s emerged. You’re going to see faster growth in some of those areas rather than traditional places, and I think that’s going to be a big trend for business start-ups…. The next innovations [in the U.S.] are going to serve some of those markets…. I think there are going to be a lot of opportunities like that for people who are nimble … and who can figure out what that wave is going forward.”