1st Quarter 2005 Review

From the Desk of Ron Rowland

Social Security reform has moved to the front burner. The "official" estimate is that the current system will start operating at an annual loss around the year 2017 and will completely run out of money in 2041. There are of course other "unofficial" estimates and data to support both earlier and later dates.

The question of solvency for the system is nothing new. I first started making my personal contributions (payroll withholding) into the system in the 1970s, more than 30 years ago. Many people were questioning the long-term viability of Social Security even then. At that point, I started to think that I might never receive anything back from the system, and I decided to take responsibility for my own retirement. Today, I still operate under the same assumption: my personal retirement plan assumes that I will not receive any Social Security checks. If I do, I will just consider those checks a bonus.

As a result, I believe I can look at the current situation with a slightly more objective view than someone who is dependent on the system, and with a significantly more objective view than most politicians can. The reason for this is simple: the politicians are using scare-tactic marketing techniques to push their agendas, and since I am not directly dependent on the outcome, those tactics are not effective on me. As an active investor, you are probably in the same category.

However, I am aware that I am probably in the minority of U.S. citizens in this respect. Furthermore, I love this country and its people, and therefore, I do have an interest in the outcome of this debate.

Suggested changes from various experts fall into three categories: raising taxes, cutting benefits, or adding money from outside the current system. The following is a summary of the various proposals along with the estimated percentage of Social Security's long-term deficit that would be erased (sources include Social Security Administration, President's Commission to Strengthen Social Security, Brookings Institution, and the Austin American-Statesman):

Raise Taxes
a. Eliminate cap on wages subject to payroll tax, but keep cap on benefits (116%).
b. Increase payroll tax rate by 2 percentage points: 1% for employees and 1% for employers (104%).
c. Raise share of total U.S. wages subject to tax from 85% to 90% over 10 years (40%).
d. Tax benefits similar to private pension income (14%).

Cut Benefits
a. Base calculation of initial benefits on inflation instead of wage growth (99%).
b. Reduce benefits for high earners (85%).
c. Reduce annual cost-of-living adjustment by 1% (80%).
d. Speed up retirement age to 67 and then gradually raise it to 70 (36%).
e. Reduce benefits for new retirees by 5 percent (32%).
f. Increase number of wage years used to calculate benefits from 35 to 40 (22%).

Help From Outside the Current System
a. Invest Social Security Trust Fund in equities market with a 6.5% return (48%).
b. Earmark estate tax on bequests over $3.5 million per individual and $7 million per couple (25%).
c. Bring new state and local government workers into Social Security (11%).

The implementation of all of these suggestions (assuming no overlap on the benefits) would be a 712% reduction of the current estimated long-term deficit. This is enough to fix the problem seven times over. I would like to believe that reasonable people could devise a reasonable mix of these solutions that could fix the problem while not creating any undue hardships on any particular class of citizens.

A key component of the White House plan is to allow workers to direct part of their Social Security taxes into private accounts for investing in the stock market. There are pros and cons with this approach, but the larger point is clear: Americans need to take more responsibility for their own futures, just as you and I have done. The methodology used to accomplish this goal will be a subject of continuing debate. Doing nothing, however, is not an option.

The Quarter in Review

After a strong year-end rally, the New Year was not a happy one for most investors when stocks plunged almost from the opening bell in January. The carnage in individual stocks was far worse than the benchmark indexes reveal. The balance of the quarter was consumed with a battle of field position as bulls and bears fought for the upper hand.

Dominated by large-cap technology stocks, the Nasdaq Composite was the weakest major index. The 4Q rally had almost entirely disappeared by the end of March.

The picture was slightly better at the more diversified S&P 500. Unlike the Nasdaq, this benchmark managed to remain above its 200-day moving average, often used as a long-term trend indicator. Nevertheless, the S&P 500 was down for the calendar quarter.

So was anything doing well? Generally speaking, mid-cap stocks did better than either large-cap or small-cap stocks during the first quarter. Even there it was only a question of losing less, not making more.

In terms of actual gains, energy has definitely been the bright spot this year. The bull market in energy of the last two years went into overdrive in January as the Amex Oil Index shot up almost +25% in just two months. After a peak in early March, energy stocks dropped back some.

Corrections of 8-10% have been common throughout this long-term uptrend. In hindsight, an ideal strategy would have been to buy these corrections and hold on for the following rally. That is, of course, easier said than done. Energy prices are prone to sharp, sudden moves, and trading in and out of these is difficult even for professional day traders. As the quarter ended, our intermediate-term indicators remained positive for energy, and negative or flat for most everything else.

As the quarter ended, bearish sentiment seemed widespread, which suggests markets may be oversold and a rally forthcoming. On the other hand, the Federal Reserve seems determined to continue raising interest rates. Energy prices, while maybe overdone for the moment, seem unlikely to fall back significantly. Public companies in the U.S. are facing a deadline to recognize stock-option costs as current expenses, which will cause some to take a big hit to earnings. Fundamentally speaking, it is hard to make a bullish projection right now, but times like this often turn out to be key market bottoms. We will continue to follow our indicators and strive to avoid emotional extremes in either direction.