By John Maggs
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Saturday, May 7, 2005

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On the morning of Monday, January 3, 1966, very few people on Wall Street were thinking about buying and selling stocks.

At midnight the previous Friday, members of the Transportation Workers Union had stopped the trains, opened the doors, and walked off the job. It was the first time that New York's subway system had ever shut down, and on Monday, the strike paralyzed the Big Apple. Stockbrokers, floor traders, and clerks walked miles in the cold to get to work from Turtle Bay and Inwood and Canarsie and Flatbush. Trading opened that day, but volume was light. Those who did make it to work left early for the long trek home. The Standard & Poor's 500 stock index, introduced only nine years before, closed at 92.18, off three-tenths of a point.

The transit strike was a rude welcome for the new mayor, John Lindsay, and two weeks later he capitulated to the union, agreeing to a 15 percent raise. It was a characteristically generous act by Lindsay, who would go on to wreak havoc on the city's finances, but in the late 1960s, workers everywhere were getting big raises. It was the beginning of a wage-price spiral that would set off the worst inflation in the United States since the 1940s.

No one knew it at the time, but it was also the beginning of a bad era for the stock market. January 1966 had none of the drama of October 1929, but it marked a very gradual start to Wall Street's worst run since the Great Crash. For most people, 25 years of growth in stock prices has erased the memory of that time. It is, however, a chapter of history worth examining, as the nation considers whether to make a much larger commitment to Wall Street than ever before.

Critics of President Bush's Social Security reform plan warn that volatility makes the stock market a too-risky investment for pensions, but even the critics acknowledge that stocks have been the best-performing investment over the long term. Millions of Americans agree, and have already committed trillions of dollars of retirement money to stocks, through their 401(k) savings plans.

The market's last few weeks have not helped Bush make his case. After rallying 8 percent after Election Day, and almost breaching the 11,000 mark, the Dow Jones industrial average has fallen 7 percent and is again in the narrow trading range that has been the norm since the technology bubble burst in 2000. Worse than the disappointing end to the post-election rally has been the market's volatility -- down 191 points one day and up 206 points two days later. These gyrations have undermined the president's efforts to convince people that putting their Social Security money into stocks is a good idea. If Bush is wondering why his recent barnstorming for personal accounts has been a bust, he should pick up the business section of the newspaper. Stocks peaked five years ago, and anyone with a 401(k) plan is starting to wonder when growth will resume.

However, these are short-term problems, assert the stock market's legion of supporters. For a retiree willing to invest for the long term, they say, the superior returns offered by stocks more than make up for any short-term losses. Since 1929, the S&P index of 500 blue-chip companies -- where many people choose to put their 401(k) money -- has risen an average of 7.43 percent a year, based on measurements made each January. The increase corresponds with the long-term averages for corporate profits tracked by the Commerce Department, which makes sense, because the intrinsic value of a company's stock is ultimately based on what the company earns. As stock market experts in the Social Security debate have noted, the long-term average return on stocks is at least 3 percentage points a year above inflation, and it's significantly better than the returns for bonds, real estate, and other investments.

But these long-term averages mask some very long slumps in the stock market. This is important because a lot is now riding on the argument that stock returns will beat the Social Security system's traditional annuity approach to retirement savings. Individuals who take a chance on the short-term ups and downs of stocks are betting on those superior returns over the long run. At the same time, government advocates of partial privatization are betting that the superior returns will, one way or another, help to finance the multitrillion-dollar cost of moving toward private accounts. Proponents say that retirees could weather a few years of a down market like the one we have seen since 2000. A much longer slump, however, could create serious problems for the national budget, as well as hardships for retirees.

Stephen Goss, chief actuary for the Social Security Administration, acknowledges the lengthy periods when stocks returned less than bonds and other forms of investment. "People are going to have to be aware of the risks involved" when choosing whether to trust their retirement money to the stock market, he said.

Sobering Figures
One gauge of the risks involved lies in the data that Robert Shiller, an economist at Yale University, compiled and analyzed for Irrational Exuberance, his 2000 book about the economics of the stock market, republished in March in an updated edition. Shiller took the S&P 500's prices going back to its 1957 inception, added data from predecessors to the S&P 500 and a host of other financial-securities information, and came come up with a widely respected chronology of stock prices going back to 1871.

His data reveal four lengthy periods -- averaging just over 23 years -- of stagnation in stock prices. A dollar invested in stocks at the start of each slump would have been worth less at the end of the downturn. While that dollar may have grown a bit for brief periods during those slumps, the troughs persisted until the markets had bypassed the price at the outset, decades before. Shiller bases his calculations on average stock prices from January of each year.

Of course, it's not just stock price appreciation that lets people make money from stocks -- dividends are another way. In the early years of the market, dividends were a company's primary way of returning value to investors. But focusing on stock prices is appropriate now, for two reasons.

First, dividends are shrinking. Despite the government's decision in 2003 to slash dividend taxes, dividends now make up only a very small proportion of returns for stock market investors. Since 1998, dividends have returned slightly more than 1 percent on stock values, whether the stock price rose or fell. The S&P 500 gained 26 percent in 2004, the first full year in which dividend taxes for most investors went down from 35 percent to 15 percent; yet dividend payments actually dropped, from 1.94 percent to 1.64 percent of the stock's value. Shiller ascribes this phenomenon to an evolution in investor expectations, which hardened during the 1990s boom: People became less interested in earning dividends on their stock than in making a quick profit from rising stock values. These days, dividends don't rise or fall with a company's fortunes; they have pretty much become a formality for companies and an afterthought for even the most active investors.

The second reason is that dividends no longer figure in the investment decisions of most people who would invest their retirement funds in the stock market. Most mutual funds and private pensions, for example, pay no dividends to investors. Although no blueprint yet exists for Social Security private accounts, they would likely take the same approach, and investors would rely on stock price appreciation alone to see their account grow.

The history of U.S. stock prices is not reassuring. The first slump that Shiller records started in 1873, at the beginning of a turbulent period of financial crisis for the United States, and it lasted until 1898. Stocks worth $5.11 in January of 1873 were worth $4.88 in January of 1898, the year of the Spanish-American War. It wasn't until later in 1898 that the stock market rose above the prices reached 25 years before.

The next slump began in 1906, when the S&P-equivalent index reached $9.87, and it lasted nearly 30 years. A dollar invested in the stock market in January 1906 was worth about 94 cents in January 1935, the year in which the market finally eclipsed its 1906 values for good. Toward the end of those 30 years, of course, came the most memorable stock market drop of all -- the Great Crash of 1929. While it is true that some of the people whose savings were wiped out in the crash had overcommitted themselves during the speculative bubble of the 1920s, many other investors had been patiently waiting for decades for their stock values to increase. As late as 1924, 18 years into the slump, every dollar that investors had put into stocks in 1906 had shrunk to 89 cents.

Another Worry
It might seem easy to dismiss these examples as relics of another era, before the Securities and Exchange Commission and the modern banking system were born. But slumps are part of the history of the stock market -- that long history that privatization supporters cite to help reassure investors unnerved by the recent slide in stocks. Although dividends did, in that earlier era, return 3 to 5 percent of a stock's value each year, stocks were not a very good investment for very long stretches of the 20th century. And the stock market's slumps haven't always corresponded to bad economic times. The U.S. economy generally boomed from 1906 to 1924, but stocks lost value during that time.

And not all of the lengthy slumps were in the early days, before government regulation and modern banking. After the 1929 crash, the government established the SEC and overhauled banking rules, but that was not enough. It took 23 years -- until 1952 -- for the stock market to return to its pre-crash level. A dollar invested in 1929 was worth 97 cents in 1952. Even counting dividends, the stock market was not a good investment over this period. Savings banks and government bonds have always been safer than stocks for the short term. Over that quarter-century, however, they were probably also a superior long-term investment.

Fortunately, the latest of Wall Street's long price slumps has actually been the briefest. Stocks worth $93.32 in January of 1966 were worth only $90.25 in January of 1978. By the beginning of 1979, they had climbed to $99.71 -- beginning a 10-year rally during which stocks appreciated, on average, more than 10 percent a year.

For a retirement system in which people may wait 20 to 30 years, or more, to draw on their investments, a 13-year slump might not sound too bad. But this leaves out a very important factor that entered the picture after 1966 -- inflation. The 15 percent raise won by New York's transit workers that year, combined with price increases throughout

the economy, helped set off an inflationary spiral that plagued the United States for a generation. The inflation rate jumped from 2.9 percent in 1966 to 5.5 percent in 1969. From 1974 through 1979, inflation averaged 8.5 percent a year. In 1980, it was 13.5 percent.

On paper, wealth was increasing, but inflation was eating away at those assets, stocks included. A dollar invested in stocks in 1966, when adjusted for inflation, was worth a little more than 49 cents in 1978. Even adding in dividends, the average 1966 investment would not break even for 18 years and wouldn't show more than a negligible gain until 1986. A dollar invested in 1966 was worth $1.06 in 1985, after inflation.

The results are similar for other stock market slumps, when dividends and inflation are factored in. A dollar invested in the stock market in 1929 would have lost value for 20 years, after inflation and including the hefty dividends that companies paid out in that era. In 1949, people were still waiting to gain wealth from their stock market investments of the 1920s.

Today, very few people putting aside income in a 401(k) stock plan imagine that they will actually lose money for the next 15 or 20 years, but that kind of long-term loss has happened -- twice -- since 1929, in periods covering 40 of those 76 years.

Timing Is Everything
The stock market peaked five years ago, and it is a testament to the trust that people have come to place in Wall Street that investors haven't panicked. Most of us want to believe that last year's 26 percent gain in the S&P 500 is the beginning of another rally. Much of our confidence in the economy -- and much of the expectation that our present level of consumer spending will hold steady -- depends on the belief that our retirement savings will grow strongly in the future. And much of the case for Bush's Social Security plan rests on this confidence.

But what if the 2000 plunge in the stock market was the beginning of another lost generation for stocks? One disturbing parallel with the 1966 to '84 slump is the threat of inflation. Economists haven't really figured out what drives an extended bout of high inflation, but a surge in oil prices is one key factor. Psychology also seems important, and Federal Reserve Board Chairman Alan Greenspan's warnings about inflation over the past year are surely affecting the public's expectations.

Since inflation hurts bondholders as well as shareholders, a significant jump would be bad news for any kind of pension plan. Adjusting stock prices for inflation simply helps us to see how long retirees might have to wait to see a gain in a pension tied to the stock market. A 20-year slump is not a short-term problem.

Productivity, another factor in the market's last big slump, also continues to puzzle economists. Higher productivity allows companies to pay workers more, and productivity growth above 2 percent a year is associated with higher living standards. But starting in the late 1960s, productivity dropped below 2 percent, and that brought declining living standards for the next 20 years. After seeing a strong recovery in productivity in the 1990s, most economists are predicting a slowdown in productivity growth in the coming years.

Michael Tanner, the top expert on Social Security at the Cato Institute and an advocate of personal accounts, has argued that losses during a long slump on Wall Street could be softened if an investor chose to reinvest his or her dividends in stock. But that wouldn't help during a down market for stocks -- the reinvested dividends would just lose more value.

Goss, of the Social Security Administration, said that the risks of a long slump on Wall Street come with the gains from price increases during bull markets. He noted that some reform advocates have urged "life-cycle" investing, where older workers would risk proportionately less in stocks and only people with 30 or 40 years to go before retirement would risk everything for those potentially higher gains.

But if stocks or any investment option can lose money for as long as 20 years, the lowest-risk option for an individual would be to stick with the current Social Security approach, with the inflation-induced growth in benefits financed by contributions from current workers.

If we are at the beginning of a 20-year lull in stock prices, it will be disastrous for anyone who has a 401(k) plan and is contemplating retirement in the next 30 years. However, retirees who had a substantial amount of their Social Security funds tied up in the market would be in double trouble.

The larger point here isn't whether stocks would perform better than bonds, or even better than a savings account, provided an investor can postpone retirement long enough to balance out bear markets with bull markets. The point is that those who propose to rescue Social Security with private accounts are counting on a certain level of return -- appreciation, growth in wealth -- from stocks. But the average stock market investment, for long periods of our history, has lost money. Twenty years is a long time for a retiree to have to wait for a payoff from the money invested in a pension plan.

And history suggests that another 20-year slump is a real possibility. Like those New Yorkers in 1966 who had much better things to worry about than where stock prices would be 20 years in the future, many of us get up every day and go to work believing that the stock market will grow enough to provide for us when we can't work anymore. If we end up diverting some of our Social Security nest eggs to personal accounts, we will be acting in large part on that faith -- justified or not -- in Wall Street.

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