by Archie M. Richards, Jr., CFP^®
March 31, 2003

Horace writes, "I think your recommendations of index funds and exchange-traded funds are faulty. The pension plans of companies like Ford, General Motors, and General Electric are worth too little to meet their pension obligations. Other companies, like Bristol Myers, are overstating their earnings. Index funds and ETFs don't distinguish between companies that are in good financial health and those that are not. They just buy them all.

"I would even go one step further," he writes. "Because of these many financial problems, I think your optimism is unjustified."

The pension plans of some companies, Horace, are indeed underfunded. But investors are aware of this; it's no secret. The stock prices of those companies are therefore lower than they would be if the underfunding didn't exist.

Professional money managers know the financial conditions of individual companies as well as anyone. If the stock prices did not take the financial conditions into account, the money managers would have a leg up on the rest of us and perform better than the market as a whole.

They don't. On average, professional money managers perform worse than the market as a whole. This means that those who are the most skilled at distinguishing between "good" and "bad" companies have a worse investment record than whose who just buy across the board. Doesn't this show that stock prices take all financial conditions into account?

I think it does.

Here's another way of looking at the matter. Publicly-held U.S. stocks number about 15,000. The people who study individual stocks number in the tens of thousands. The stock-studiers outnumber the stocks available to study. The rest of us can therefore assume that stocks are always priced right. This is especially true of well-followed companies like Ford, GM, GE, and Bristol Myers.

Once in a while, I recommend the purchase of stocks of small, generally overlooked companies that are on the forefront of technology. (So far, almost all of them are down.) But big, well-analyzed companies I disregard. I prefer index funds and exchange-traded funds. Except for tiny costs, they equal the performance of market indexes. Equaling is better than performing worse.

This, then, is my first response to your comments: The prices of stocks take into account everything that everyone knows about them. Don't assume that the prices of "good" stocks will outperform the "bad" ones. You're better off using index funds or exchange-traded funds to just buy them all.

Here's another point: If the Dow recovers to 11,000 by the end of 2003, as I predict, how many of the stocks you're worried about would find that their pension plans are funded with too much money?

Quite a few, I warrant.

A third point: You assume that the underfunding of pension plans causes the prices of stocks to decline. This implies an inevitable downward cycle. Assume, for example, that pension plans become underfunded. This drives the price of stocks down. But the plans hold stock whose values have dropped. Therefore, the plans become more underfunded. Stock prices fall more. Plans become even more underfunded . . . You got it; everything points downhill.

I don't share this mode of thinking. Market trends are never inevitable.

It's not financial considerations, it's the political environment that most affects the stock market. The U.S. political environment is gradually improving, which is why I'm generally optimistic.

Oh, there are problems. As I explained in a recent column, the Federal Communications Commission is causing great harm. (In www.ArchieRichards.com, the column is dated 3/3/03.) Also, President Bush is too unwilling to fight for smaller, less intrusive, domestic government. He's been busy running a war lately, I realize. But from the beginning, he should have trumpeted that government isn't the solution; it's the problem. If Mr. Bush had done this, stock prices would be higher than they are now.

No matter whether companies are financially sound or unsound, I seldom have opinions about what the prices of their stock will do. But the market as a whole will rise. I therefore continue to recommend index funds and exchange-traded funds. They're the safest way to invest.