If equity markets represent the flawless leading economic indicator generally believed, investors should be very comfortable nowadays. After all, the S&P 500 is up almost 12% so far this year. Yet, economists remain generally concerned.
Is it not then unreasonable to ask: Are the glorious headlines trumpeting rising free cash flows portending a sustainable and durable continuation of the economic expansion or perhaps the result of severe cost cutting with a dose of imaginative accounting?
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Ken Hackel, president of institutional equity manager, CT Capital, and author of Security Valuation and Risk Analysis (McGraw-Hill, 2010), warned about six months ago, of the impending pension liability. Now, as expected, firms with large defined benefit plans are fessing up to the power of the discount rate on the ultimate liability, which is now resulting in stepped-up contributions. Hackel estimates that for many firms, with 10-year Treasury bonds at 2.5%, a further 1% reduction in current yields could very well have the same impact as a 20% reduction in the estimated long-term investment return assumption. When Kenneth first started writing of the liability, a 1% reduction was roughly equivalent to a 15% decline.
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Despite today’s large equity rally, the S&P is still down over 2% for the year, in sharp contrast to a median S&P 8% pension actuarial investment assumption, while 10-year bonds yield 2.64%, a long way from the needed 5.8% median discount rate assumption.
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