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The following article appeared in Left Business Observer #76, February 1997. It was written by Doug Henwood, editor and publisher. It retains its copyright and may not be reprinted or redistributed in any form - print, electronic, facsimile, anything - without the permission of LBO.
This updates and replaces the "Bloated Market" supplement, which has now been trashed.
For a longer version of a related argument, see the text of Doug Henwood's talk at the Brecht Forum, New York City, which was televised by C-SPAN on June 30 and July 1, 1997.
America is back. That was reportedly the theme of the real Renaissance Weekend, the annual ruling class retreat to Davos for the World Economic Forum. Proof of this resurrection are the U.S.'s boomy 2.5% growth rate, when Europe and Japan are dead in the mud; the Internet; and the stock market's ceaseless rise. Claims of a U.S. boom are dispensed with elsewhere in this issue (page 7) [though not on this website, alas - webmaster] - and who wants to read another article on the Internet? Let's stick with something easy, like explaining the stock market.
A writer strains for fresh adjectives to describe the stock market's course since the bull market began in August 1982. Over the last 15 years, the real (inflation-adjusted) Standard & Poor's 500 index, a proxy for blue-chip corporate America, is up 574%, by far the biggest 15-year real rise since good statistics start in 1886; in 1964, it was 434%; in 1929, 205%. By most conventional measures of whether stocks are reasonably priced, the market is at or near historic extremes. In the past, such extremes of ebullience have eventually given way to their opposites; in fact, a statistical model of that observation yields the prediction that the stock market is in line for a 68% decline over the next 10 years. But everyone says those old measures don't apply anymore.
It's tempting to open an explanation of the stock market's rise by saying that it's happened because new money is flowing in. But sometime, years ago, the market entered a phase when its very rise lured in new money. People who had never owned a speculative asset before are now playing around in a world of small-cap "growth" stocks, whose main asset is often little more than a clever name, and "emerging" Third World markets, whose main asset is their relative obscurity. Since the market has been going up for so long, people have forgotten that markets often go down, too - and none more rapidly than "growth" stocks and "emerging" markets. A recent Harris poll of mutual fund investors showed just 14% thinking the coming decade will see a slowdown in the bull market's pace; more thought that the next 10 years will see a faster rise in prices than the last 10, and most thought the performance would be about the same.
Though there is a great deal of "irrational exuberance" about the stock market, as Fed chair Alan Greenspan suggested last December, there is a core of rationality to the market's behavior. The upward redistribution of income of the last 15-20 years means that rich people have more money on hand, some of which finds its way into stocks. That same redistribution has resulted in corporate profits being higher than they would otherwise be, and since stock prices are driven ultimately by underlying corporate profits, fatter profits should mean higher prices. And then there is a psychocultural element (an influence that orthodox Marxists and free marketeers wrongly reject with equal vehemence): stock markets are celebrating the political triumph of capital worldwide. If labor has been permanently weakened, then there's nothing to keep the upward redistribution from continuing indefinitely - a great excuse to buy stocks. The monied are feeling deeply good about themselves.
Of course, if labor hasn't been permanently weakened, or if the upward redistribution contains the seeds of its own demise (if, for example, there won't be enough buying power to sustain a mass consumption economy if the masses' belts are continually tightened), then the stock market will cease to look like a perpetual money machine. But the accumulation of "ifs" over the last few sentences is a sign to move on.
Who's been doing all the buying that's driven the market up? Of all the major sectors covered in the flow of funds accounts (FoF - a detailed mapping of financial flows produced by the Federal Reserve), only three have been major net buyers since 1990 ("net" meaning total purchases less total sales): mutual funds, state and local government pension funds, and life insurance companies. Private pension funds have been sellers, on balance - a reflection of employers' shift away from old-style pensions and towards self-directed schemes like 401(k)'s, typically invested in mutual funds. That shift, plus fears of Social Security's insolvency, is behind a good bit of the mutual fund mania.
Households, surprisingly, have been big net sellers for most of the last 20 years - meaning that individuals are giving up on the direct ownership of stock. That household behavior could mean several things. It may be that individuals, rather than doing their own research and management, prefer to let mutual funds do the mediating work for them. Or it may be that the very rich people who are more likely to own stock directly have been selling while the middle class people who are more likely to use mutual funds have been buying. If that's the case, then that old saw about being wary of buying stuff from the rich comes into play: they may know something everyone else doesn't. It may be easier to decide which is the case when the Fed releases data from its 1995 Survey of Consumer Finances later this year.
Stock buying has also come from another place: corporations themselves, who have traditionally been thought of as issuers, not consumers, of stock. Since 1982, nonfinancial corporations have bought a net of $737 billion of stock, thanks to buybacks (purchases by firms of their own stock in order to boost its price) and takeovers.
In myth, common both to professors and New York Stock Exchange PR officers, the capital markets - where debt and stock certificates openly trade - exist to transfer the capital of cash-rich savers to cash-short investors, who in turn thrust the proceeds into productive activity like real-world businesses. These real investments will produce enough income over time to make the paper promises worthwhile and make the economy as a whole grow.
In fact, little real investment is funded on the markets. According to the FoF, corporations fund almost all their capital expenditures - investment in plant, machinery, and inventories, or capex for short - internally, through profits and depreciation credits. Since 1952, internal funds have covered 95% of capex; since 1990, 109% - meaning that firms had more money on hand than they could invest in their business.
But firms still borrow - an average of 32% of capex from 1950 to 1996. (Borrowing started slowly in the 1950s, rose to a mad peak in the late 1980s, and has subsided to earlier, more prudent levels.) They rely little, in the aggregate, on stocks; with the exception of the 1920s, little real investment has been financed with fresh stock offerings, and since the early 1980s, more stock has disappeared than has been issued. The stock disappeared in about $1.4 trillion in mergers and acquisitions (M&A) and through $500 billion in buybacks. Dividends are a more traditional way of siphoning cash to stockholders; because stock prices are so high now, making dividend yields low, it's easy to miss the fact that firms are paying out near-record shares of their profits to their stockholders - 70% of after-tax profits since 1982, not far from twice historical averages. Through all these mechanisms (M&A, buybacks, and dividends), nonfinancial firms paid their shareholders an amount about three-quarters as much as they spent on capital expenditures. The portion of that booty not spent on BMWs and Hamptons beachhouses goes back into the markets, to buy more stocks and bonds. Instead of accumulating merely as physical capital, corporate profits accumulate in pure money form as well.
Of course, some individual corporations do raise money on the stock market, but surprisingly little of the proceeds go to real investment. Typically, the money raised in initial public offerings goes to cash out founding investors rather than to fund an investment program.
It should be clear from this that money poured into the stock market won't directly boost real investment. It seems not to do so indirectly either: there's no evidence that higher stock prices cause corporate managers to revise their investment plans upward. Sure enough, the market boom hasn't resulted in any great boom in real investment over the last few years. Those partisans of Social Security privatization who argue that shifting pension funds out of government bonds into stocks will increase investment and guarantee a more prosperous future are arguing from cliche, not from evidence. Not that evidence matters, since the real goal of privatization is to get Wall Street's hands on all that retirement money.
Rather than a being a corporate fundraising mechanism, the stock market is an institution for organizing the ownership of large corporations. In the U.S., this is mainly visible in M&A, which allows firms to gobble up others, or to spin off whole divisions as freestanding businesses, In the Third World, large stock offerings have turned family- and state-owned firms into ones owned by private shareholders. Easily tradeable stocks allow the very rich to own an economy as a whole, rather than being tied to the fate of a single firm.
Mentions of wealth and class and the stock market almost always inspire claims about the democratization of ownership through mutual funds. Shareholders' democracy is even more a joke than the political kind. In 1992, the most recent year available, the richest 1% of households - about 2 million adults - owned 39% of the stock owned by individuals; the top 10%, over 81%. Even if that's shifted a bit, thanks to the mutual fund boom, there's no changing the fact that the bottom 90% of the population has a smaller share (23%) of investable capital of all kinds to play with than the richest 1/2% (29%).
Which isn't to say that a deep bear market couldn't savage household finances, especially those who've put all their money into mutual funds, with maybe a few having borrowed against their houses to do so. If this bull market dies violently, the consequences might not be localized to Wall Street. Is history on the side of the mutual funders surveyed by Harris?
These charts [click here for technical details] offer a look at the relation between stock valuations and returns over the long term. In theory, stocks offer the worst prospects for gain when they're "expensive," and the best when they're "cheap." One way to measure the dearness of stocks is through the price/earnings (P/E) ratio - "earnings" being Wall Street's euphemism for profits. A P/E ratio divides the price of a stock by the value of underlying corporate profits per share. A firm whose stock sells at 60 and whose profits equal 3.00 per share of stock outstanding has a P/E of 20. Similarly, the corporations making up the Standard & Poor's 500 stock index had profits equal to 36.00 over the last year when the index was at 808.48 as of February 15; the index's P/E was 22.5.
Instead of just using the trailing year's profits, it's possible to average profits over a much longer term to smooth out some of the short-term noise - an idea first suggested by the legendary "value" investors (buy cheap, sell dear) Graham & Dodd, and updated by Robert J. Shiller of Yale. Using January 1996 data and 30-year averages for profits, Shiller projected a 38% real decline in stock prices over the next decade. Using full year 1996 data and 10-year averages, and techniques somewhat more rudimentary than Shiller's, LBO's stat program forecasts a 68% real decline by 2006.
A bear market is very unlikely to start, though, without a tightening move by the Federal Reserve, and the Fed is unlikely to tighten without signs of rising inflation. But from the highly sanitized minutes of their policy-setting meetings, Fedsters seem a bit worried about the increasingly bubble-like stock market. From the minutes of the December meeting: "The rise over recent years had been extraordinary and had brought market valuations to fairly high levels relative to earnings and dividends. In these circumstances, the members recognized the need to monitor with special care price movements in the stock market and asset markets more generally...." Fedwatcher David Jones told the New York Times that he hadn't seen a comment like that in the 45 years of minutes he's read. For the first time since the late 1920s, the Fed seems worried about how to deflate the bubble gently without harming the real economy, a very difficult task to accomplish.
Of course stock markets can fall without taking the sky with them, though major falls, like those of the 1930s and 1970s seem to come with extensive economic and political side-effects. And overvalued markets can always get more overvalued - stunningly so. And finally, as they say in the mutual fund ads, past performance is not a guide to future results. Maybe the market is a perpetual money machine after all. Maybe the very nature of history has changed, and we are in a New Era, the Nirvana of Capital.
© Copyright 1997, Left
Business Observer. All rights reserved.
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