The Great Stock Illusion
The enormous paper wealth
"created" by the stock market was bound to dissolve,
because it never existed, save a kind of mass delusion.
by Ellen Frank
Dollars and Sense magazine,
During the 1980s and 1990s, the Dow Jones
and Standard & Poor's indices of stock prices soared ten-fold.
The NASDAQ index had, by the year 2000, skyrocketed to 25 times
its 1980 level. Before the bubble burst, bullish expectations
reached a feverish crescendo. Three separate books-Dow 36,000,
Dow 40,000 and Dow 100,000-appeared in 1999 forecasting further
boundless growth in stock prices. Bullish Wall Street gurus like
Goldman's Abby Cohen and Salomon's Jack Grubman were quoted everywhere,
insisting that prices could go nowhere but up.
But as early as 1996, skeptics were warning
that it couldn't last. Fed chair Alan Greenspan fretted aloud
about "irrational exuberance." Yale finance professor
Robert Shiller, in his 2001 book titled Irrational Exuberance,
insisted that U.S. equities prices were being driven up by wishful
thinking and self-fulfilling market sentiment, nourished by a
culture that championed wealth and lionized the wealthy. Dean
Baker and Marc Weisbrot of the Washington-based Center for Economic
and Policy Research contended in 1999 that the U.S. stock market
looked like a classic speculative bubble-as evidence they cited
the rapidly diverging relationship between stock prices and corporate
earnings and reckoned that, to justify the prices at which stocks
were selling, profits would have to grow at rates that were frankly
In 1999 alone, the market value of U.S.
equities swelled by an astounding $4 trillion. During that same
year, U.S. output, on which stocks represent a claim, rose by
a mere $500 billion. What would have happened if stockholders
in 1999 had all tried to sell their stock and convert their $4
trillion into actual goods and services ? The answer is that most
would have failed. In a scramble to turn $4 trillion of paper
gains into $S00 billion worth of real goods and services, the
paper wealth was bound to dissolve, because it never existed,
save as a kind of mass delusion.
THE ILLUSION OF WEALTH CREATION
Throughout the 1990s, each new record
set by the Dow or NASDAQ elicited grateful cheers for CEOs who
were hailed for "creating wealth." American workers,
whose retirement savings were largely invested in stocks, were
encouraged to buy more stock-even to bet their Social Security
funds in the market-and assured that stocks always paid off "in
the long run," that a "buy-and-hold" strategy couldn't
lose. Neither the financial media nor America's politicians bothered
to warn the public about the gaping disparity between the inflated
claims on economic output that stocks represented and the actual
production of the economy. But by the end of the decade, insiders
saw the writing on the wall. They rushed to the exits, trying
to realize stock gains before the contradictions inherent in the
market overwhelmed them. Prices tumbled, wiping out trillions
in illusory money.
The case of Enron Corp. is the most notorious,
but it is unfortunately not unique. When Enron filed for bankruptcy
protection in November of 2001 its stock, which had traded as
high as $90 per share a year before, plummeted to less than $1.
New York Times reporter Jeffrey Seglin writes that the elevators
in Enron's Houston headquarters sported TV sets tuned to CNBC,
constantly tracking the firm's stock price and acclaiming the
bull market generally. As Enron stock climbed in the late 1990s,
these daily market updates made employees-whose retirement accounts
were largely invested in company shares- feel quite wealthy, though
most Enron workers were not in fact free to sell these shares.
Enron's contributions of company stock to employee retirement
accounts didn't vest until workers reached age 50. For years,
Enron had hawked its stock to employees, to pension fund managers,
and to the world as a surefire investment. Many employees used
their own 401(k) funds, over and above the firm's matching contributions,
to purchase additional shares. But as the firm disintegrated amid
accusations of accounting fraud, plan managers froze employee
accounts, so that workers were unable to unload even the stock
they owned outright. With employee accounts frozen, Enron executives
and board members are estimated to have dumped their own stock
and options, netting $1.2 billion cash-almost exactly the amount
employees lost from retirement accounts.
Soon after Enron's collapse, telecommunications
giant Global Crossing imploded amid accusations of accounting
irregularities. Global Crossing's stock, which had traded at nearly
$100 per share, became virtually worthless, but not before CEO
Gary Winnick exercised his own options and walked away with $734
million. Qwest Communications director Phil Anschutz cashed in
$1.6 billion in the two years before the firm stumbled under a
crushing debt load; the stock subsequently lost 96% of its value.
The three top officers of telecom equipment maker JDS Uniphase
collectively raked in $1.1 billion between 1999 and 2001. The
stock is now trading at $2 per share. An investigation by the
Wall Street Journal and Thompson Financial analysts estimates
that top telecommunications executives captured a staggering $14.2
billion in stock gains between 1997 and 2001. The industry is
now reeling, with 60 firms bankrupt and 500,000 jobs lost. The
Journal reports that, as of August 2002, insiders at 38 telecom
companies had walked away with gains greater than the current
market value of their firms. "All told, it is one of the
greatest transfers of wealth from investors-big and small-in American
history," reporter Dennis Berman writes. "Telecom executives
... made hundreds of millions of dollars, while many investors
took huge, unprecedented losses. "
Executives in the energy and telecom sectors
were not the only ones to rake in impressive gains. Michael Eisner
of Disney Corp. set an early record for CEO pay in 1998, netting
$575 million, most in option sales. Disney stock has since fallen
by two-thirds. Lawrence Ellison, CEO of Oracle Corp., made $706
million when he sold 29 million shares of Oracle stock in January
2001. Ellison's sales flooded the market for Oracle shares and
contributed, along with reports of declining profits, to the stock's
losing two-thirds of its value over the next few months. Between
1999 and 2001, Dennis Kozlowski of Tyco International sold $258
million of Tyco stock back to the company, on top of a salary
and other compensation valued near $30 million. Kozlowski defended
this windfall with the claim that his leadership had "created
$37 billion in shareholder wealth." By the time Kozlowski
quit Tyco under indictment for sales tax fraud in 2002, $80 billion
of Tyco's shareholder wealth had evaporated.
Analyzing companies whose stock had fallen
by at least 75%, Fortune magazine discovered that "executives
and directors of the 1035 companies that met our criteria took
out, by our estimate, roughly $66 billion."
THE ILLUSION OF RETIREMENT SECURITY
During the bull market, hundreds of U.S.
corporations were also stuffing employee savings accounts with
corporate equity, creating a class of captive and friendly shareholders
who were in many cases enjoined from selling the stock. Studies
by the Employee Benefit Research Council found that, while federal
law restricts holdings of company stock to 10% of assets in regulated,
defined-benefit pension plans, 401(k)type plans hold an average
19% of assets in company stock. This fraction rises to 32% when
companies match employee contributions with stock and to 53% where
companies have influence over plan investments. Pfizer Corporation,
by all accounts the worst offender, ties up 81% of employee 401(k)s
in company stock, but Coca-Cola runs a close second with 76% of
plan assets in stock. Before the firm went bankrupt, WorldCom
employees had 40% of their 401(k)s in the firm's shares. Such
stock contributions cost firms virtually nothing in the short
run and, since employees usually aren't permitted to sell the
stock for years, companies needn't worry about diluting the value
of equity held by important shareholders-or by their executive
option-holders. Commenting on recent business lobbying efforts
to gut legislation that would restrict stock contributions to
retirement plans, Marc Machiz, formerly of the Labor Department's
retirement division, told the Wall Street Journal, "business
loves having people in employer stock and lobbied very hard to
kill this stuff. "
Until recently, most employees were untroubled
by these trends. The market after all was setting new records
daily. Quarterly 401 (k) statements recorded fantastic returns
year after year. Financial advisers assured the public that stocks
were and always would be good investments. But corporate insiders
proved far less willing to bank on illusory stock wealth when
securing their own retirements.
Pearl Meyer and Partners, an executive
compensation research firm, estimates that corporate executives
eschew 401(k) plans for themselves and instead negotiate sizable
cash pensions-the average senior executive is covered by a defined-benefit
plan promising 60% of salary after 30 years of service. Under
pressure from the board, CEO Richard McGinn quit Lucent at age
52 with $12 million in severance and a cash pension paying $870,000
annually. Lucent's employees, on the other hand, receive a 401(k)
plan with 17% of its assets invested in Lucent stock. The stock
plunged from $77 to $10 after McGinn's departure. Today it trades
at around $1.00. Forty-two thousand Lucent workers lost their
jobs as the firm sank.
When Louis Gerstner left IBM in 2002,
after receiving $14 million in pay and an estimated $400 million
in stock options, he negotiated a retirement package that promises
"to cover car, office and club membership expenses for 10
years." IBM's employees, in contrast, have been agitating
since 1999 over the firm's decision to replace its defined benefit
pension with a 401(k)-type pension plan that, employee representatives
estimate, will reduce pensions by one-third to one-half and save
the firm $200 million annually. Economist Paul Krugman reports
in the New York Times that Haliburton Corp. eliminated its employee
pensions; first, though, the company "took an $8.5 million
charge against earnings to reflect the cost of its parting gift"
to CEO Dick Cheney. Business Week, surveying the impact of 401(k)s
on employee retirement security, concludes that "CEOs deftly
phased out rich defined-benefit plans and moved workers into you're-on-your-own
401(k)s, shredding a major safety net even as they locked in lifetime
benefits for themselves."
Since 401(k)s were introduced in the early
1980s their use has grown explosively, and they have largely supplanted
traditional defined-benefit pensions. In 2002, three of every
four dollars contributed to retirement accounts went into 401(k)s.
It is thanks to 401(k)s and other retirement savings plans that
middle-income Americans became stock-owners in the 1980s and 1990s.
It is probably also thanks to 401(k)s, and the huge demand for
stocks they generated, that stock prices rose continuously in
the 1990s. And it will almost certainly be thanks to 401(k)s that
the problems inherent in using the stock market as a vehicle to
distribute income will become glaringly apparent once the baby-boom
generation begins to retire and liquidate its stock.
If stocks begin again to rise at historical
averages-something financial advisors routinely project and prospective
retirees are counting on-the discrepancy between what the stock
market promises and what the economy delivers will widen dramatically.
Something will have to give. Stocks cannot rise faster than the
economy grows, not if people are actually to live off the proceeds.
Or rather, stock prices can't rise that
fast unless corporate profits-on which stocks represent a legal
claim-also surpass GDP gains. But if corporate earnings outpace
economic growth, wages will have to stagnate or decline.
Pension economist Douglas Orr believes
it is no accident that 401(k)s proliferated in a period of declining
earnings and intense economic insecurity for most U.S. wage-earners.
From 1980 until the latter half of the 1990s, the position of
the typical American employee deteriorated noticeably. Wages fell,
unemployment rose, benefits were slashed, stress levels and work
hours climbed as U.S. firms "downsized" and "restructured"
to cut costs and satiate investor hunger for higher profits. Firms
like General Electric cut tens of thousands of jobs and made remaining
jobs far less secure in order to generate earnings growth averaging
15% each year. Welch's ruthless union-busting and cost-cutting
earned him the nickname "Neutron Jack" among rank-and-file
employees. GE's attitude towards its employees was summed up by
union negotiator Steve Tormey: "No matter how many records
are broken in productivity or profits, it's always 'what have
you done for me lately?' The workers are considered lemons and
they are squeezed dry." Welch was championed as a hero on
Wall Street, his management techniques widely emulated by firms
across the nation. During his tenure, GE's stock price soared
as the firm slashed employment by nearly 50%.
The Institute for Policy Studies, in a
recent study, found that rising stock prices and soaring CEO pay
packages are commonly associated with layoffs. CEOs of firms that
"announced layoffs of 1000 or more workers in 2000 earned
about 80 percent more, on average, than the executives of the
365 firms surveyed by Business Week."
Throughout the 1980s and 1990s, workers
whose jobs were disappearing and wages collapsing consoled themselves
by watching the paper value of their 401(k)s swell. With labor
weak and labor incomes falling, wage and salary earners chose
to cast their lot with capital. In betting on the stock market,
though, workers are in reality betting that wage incomes will
stagnate and trying to offset this by grabbing a slice from the
profit pie. This has already proved a losing strategy for most.
Even at the peak of the 1990s bull market,
the net wealth-assets minus debts-of the typical household fell
from $55,000 to $50,000, as families borrowed heavily to protect
their living standards in the face of stagnant wages. Until or
unless the nation's capital stock is equitably distributed, there
will always be a clash of interests between owners of capital
and their employees. If stocks and profits are routinely besting
the economy, then either wage-earners are lagging behind or somebody
is cooking the books.
Yet surveys show that Americans like 401(k)s.
In part, this is because savings accounts are portable, an important
consideration in a world where workers can expect to change jobs
several times over their working lives. But partly it is because
savings plans provide the illusion of self-sufficiency and independence.
When retirees spend down their savings, it feels as if they are
"paying their own way." They do not feel like dependents,
consuming the fruits of other people's labor. Yet they are. It
is the nature of retirement that retirees opt out of production
and rely on the young to keep the economy rolling. Pensions are
always a claim on the real economy-they represent a transfer of
goods and services from working adults to non-working retirees,
who no longer contribute to economic output. The shift from defined-benefit
pensions to 401(k)s and other savings plans in no way changes
the fact that pensions transfer resources, but it does change
the rules that will govern how those transfers take place-who
pays and who benefits.
Private defined-benefit pensions impose
a direct claim on corporate profits. In promising a fixed payment
over a number of years, corporations commit to transfer a portion
of future earnings to retirees. Under these plans, employers promise
an annual lifetime benefit at retirement, the amount determined
by an employee's prior earnings and years of service in the company.
How the benefit will be paid, where the funds will come from,
whether there are enough funds to last through a worker's life-this
is the company's concern. Longevity risk-the risk that a worker
will outlive the money put aside for her retirement-falls on the
employer. Retirees benefit, but at a cost to shareholders. Similarly,
public pension programs, whether through Social Security or through
the civil service, entail a promise to retirees at the expense
of the taxpaying public.
Today, the vast majority of workers, if
they have pension coverage at all, participate in "defined
contribution" plans, in which they and their employer contribute
a fixed monthly sum and invest the proceeds with a money management
firm. At retirement, the employee owns whatever funds have accrued
in the account and must make the money last until she dies. Defined-contribution
plans are a claim on nothing. Workers are given a shot at capturing
some of the cash floating around Wall Street, but no promise that
they will succeed. 401(k)s will add a huge element of chance to
the American retirement experience. Some will sell high, some
will not. Some will realize gains. Some will not.
Pearl Meyer and Partners estimate that
outstanding, unexercised executive stock options and employee
stock incentives today amount to some $2 trillion. Any effort
to cash in this amount, in addition to the stock held in retirement
accounts, would have a dramatic impact on stock prices. American
workers and retirees, in assessing their chances for coming out
ahead in the competition to liquidate stock, might ponder this
question: If, as employees in private negotiations with their
corporate employers, they have been unable to protect their incomes
or jobs or health or retirement benefits, how likely is it that
they will instead be able to wrest gains from Wall Street where
corporate insiders are firmly in control of information and access
This article is adapted from the author's
Ellen Franck teaches economics at Emmanuel
College and is a member of the Dollars & Sense collective.