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Pension Fund Perspective: Pension Fund Asset Allocation and the Economic CycleAuthor(s): Patrick J. ReganSource: Financial Analysts Journal, Vol. 34, No. 6 (Nov. - Dec., 1978), pp. 10-11Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4478186 .

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PENSION FUND ,

by Patrick J. Regan, BEA Associates, Inc.

Pension Fund Asset Allocation and the Economic Cycle In a recent column, we noted that the equity portion of pension portfolios tends to rise and fall with the stock market indexes.' Some of this is due to market fluctuations, but much of it can be traced to the asset allocation decisions made by pension fund trus- tees. Since this is the season when money managers review the past year's performance results with clients and make next year's asset mix deci- sions, it is an opportune time to ex- amine why they usually make the wrong decisions at key points of the economic cycle.

The facts speak for themselves. David R. Atkinson of Morgan Stan- ley, after examining quarterly pension fund cash flow figures of the last 25 years, concluded that "it can be ar- gued that when the largest factor in the equity market devotes maximum cash flow to stocks, the market is at or near its top and, conversely, when the percentage going into equities is at or near its lowest point, the market is close to its bottom."2 Atkinson pointed out that between 1952 and 1967, a period of generally rising equity prices and declining bond prices, the percentage of pension fund cash flows directed into equities rose gradually from 30 to 60 per cent. However, the figure has been quite volatile since then, rising above 140 per cent in 1969, 1971 and 1972 and plunging below 20 per cent in 1974, 1977 and 1978, when historically high bond yields offered a tempting alternative to stocks.

Pension trustees who allocate their cash flow to bonds when the stock market is depressed and to equities when it is ebullient apparently don't realize that the stock market is a lead- ing indicator; stock prices precede economic events, not vice versa. As their own business deteriorates, many companies press managers for a more conservative asset mix in their pen- sion portfolios. As history shows, this is a key mistake made by businessmen

who don't understand the stock mar- ket's discounting mechanism. Earlier this year, Treasury Secretary Michael Blumenthal told the Wall Street Journal that he didn't understand why the market declined in 1977, when the economy continued to im- prove: "I can't understand the stock market. I didn't understand the mar- ket when I was in business, and I don't understand it now."3

Since most portfolio managers be- gan their investment careers as securi- ty analysts, following select industries and companies, it is not surprising that they expect stock prices to move with earnings; after all, the correlation holds for individual companies. In 1972, when Victor Niederhoffer and I studied the relation between stock performance and earnings estimates, the best performing stocks were the ones whose earnings rose more than expected, while the worst stocks were the ones whose earnings disappointed expectations. But when we examined the market as a whole, we found little correlation between stock price movements and earnings changes.4

What does the record show? The Dow Jones Investors Handbook

lists the "per share" earnings of the Dow Jones Industrials Average (DJIA) from 1929 to 1977. I com- puted both changes in the earnings figures and annual percentage changes of the DJIA; the accompany- ing contingency tables show at a glance whether there is any statistical correlation between the dependent and the independent variable. In Ta- ble One, for example, I tested to see whether the direction of earnings changes (reflecting swings in the gen- eral economy) altered the probability of a market advance. But-and this may surprise some economists-the probability of a market advance was

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1. See "Pension Funds Grapple with the Asset Mix Decision," Financial Analysts Journal, May/June 1978.

2. "Factors Favoring Both A Cyclical and Secular Bull Market For Equi- ties" (Morgan Stanley, September 6, 1978).

3. Wall Street Journal, 13 February 1978.

4. Victor Niederhoffer and Patrick J. Regan, "Earnings Changes, Analysts' Forecasts, and Stock Prices," Finan- cial Analysts Journal, May/June 1972, pp. 65-71.

10 El FINANCIAL ANALYSTS JOURNAL

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the same in years when earnings de- clined as when they advanced. In- deed, as Table Two shows, some of the best years for stock market gains in the postwar era were periods when earnings of the DJIA companies fell or rose only marginally. Conversely, the years of strongest earnings gains were characterized by market losses or nominal gains.

If there is one lesson here it is that an ability to forecast the direction of corporate earnings and the economy will be of little help in forecasting the stock market. Over the last half cen- tury, the market has advanced 60 to 65 per cent of the time, regardless of the direction of the economy or cor- porate earnings. Nor will an ability to forecast the market necessarily help in forecasting the short-term direction of earnings. As Table Three shows, the earnings of the DJIA companies rose in two-thirds of the 48 years, regard- less of whether the market was up or down.

Table Four illustrates the stock market's longer term forecasting abil- ity, comparing earnings in the follow- ing year to price changes in the cur- rent year. When the market rose, the odds were five to one that the earnings of the DJIA companies would rise the following year. By contrast, when the market fell, there was less than a 50-50 probability that earnings would advance in the next year. This is cer- tainly non-random, but the fact that earnings fell only 10 times in the 18 years of lower stock prices accords with the famous Paul Samuelson quip that the market predicted nine of the last five recessions.

The facts show that the best market gains occur when earnings are at their worst. The notion that the general lev- el of stock prices rises and falls in sync with the general level of output, employment and earnings is falla- cious. Unfortunately, the growing practice of employing multiple fund managers under a master trust has op- erated to put the asset allocation deci- sion into the hands of clients, many of whom are businessmen who subscribe to this notion. As a result, the fallacy is now a greater threat to investment performnance than ever before. U

Table One: Direction of Stock Market Prices Not Dependent on Direction of Earnings Changes

Market Market Up Down Totals

Earnings Up 20 12 32 Earnings Down 10 6 16 Totals 30 18 48 Note: Market prices and per-share earnings changes are the annual

fluctuations of the DJIA companies since 1929.

Table Two: Best and Worst Years for Stock Market and Earnings of DJIA Companies in Postwar Period (1945-77)

Stock DJIA (I) Best Market Gains Year Prices Earnings

1954 +44.0% + 3.5% 1975 +38.3% - 23.6% 1958 +34.0% -22.5% 1945 +26.6% + 4.9%

Stock DJIA (II) Worst Market Losses Year Prices Earnings

1974 -27.6% +14.4% 1966 - 18.9% + 7.5% 1977 - 17.3% - 7.9% 1973 -16.6% +28.4%

Stock DJIA (Ill) Best Earnings Gains Year Prices Earnings

1947 + 2.2% + 37.9% 1950 + 17.6% +30.4% 1946 - 8.1% +29.1% 1973 - 16.6% + 28.4%

Stock DJIA (IV) Worst Market Losses Year Prices Earnings

1975 +38.3% -23.6% 1958 +34.0% -22.5% 1951 + 14.4% - 13.4% 1970 + 4.8% - 10.5%

Note: Percentage figures reflect changes in the prices and earnings of the DJIA companies from December 31st to December 31st.

Table Three: Direction of Earnings Changes in Current Year Cannot Be Predicted From Direction of Stock Market Prices

Earnings Earnings Up Down Totals

Market Up 20 10 30 Market Down 12 6 18

Totals 32 16 48

Table Four: Direction of Earnings Changes in Following Year Can Be Predicted From Direction of Stock Market Prices in Current Year

Earnings in Following Year

Earnings Earnings Up Down Totals

Market Up 25 5 30 Market Down 8 10 18 Totals 33 15 48

FINANCIAL ANALYSTS JOURNAL / NOVEMBER-DECEMBER 1978 0 11

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