Stock market economics
Can economists learn anything from the Boston Celtics’ loss to Steph Curry’s Golden State Warriors in the NBA Finals? I’m thinking particularly of Game 5, when the Celtics poured all of their defensive resources into stopping Curry – the greatest shooter to ever play.
The Celtics won this close battle. Curry scored just 16 points and for the first time already in a playoff game, he didn’t make a single 3-pointer. But they still lost the game. Why? Unintended consequences. Other players, considered lesser threats, were released and their score handed Boston a devastating loss.
Andrew Smithers, a well-known financial analyst and author of a new book The economics of the stock market, believes that economists are making the same mistake as the Celtics. Specifically, they focus on one thing – the balance between planned savings and planned investments – and ignore other threats.
His book is comprehensive and stimulating. Market professionals are ready to roll up their sleeves and think to profit from it. If that’s not for you, read on to pick up the key insights and listen to our conversation on the most recent Top Traders Unplugged Podcast.
The stock market also matters
When people see an economic crisis coming, they worry. When they worry, they decide to save more. Companies – which after all are run by these same people – are also changing their intentions to save more, which they accomplish by reducing their investments. These two changes lead to a reduction in activity, which reinforces the economic slowdown. The Fed thwarts these intentions by lowering interest rates – making saving less attractive and (theoretically) making investing more profitable.
But lowering interest rates, especially if done through quantitative easing, has other effects – in particular, it drives up stock prices. By focusing primarily on planned savings and investment and using interest rates to balance them, central banks disrupt other relationships.
One of these key relationships is called “Q” – the value of companies attributed by the stock market in relation to the replacement cost of the net assets held by these companies. These two things must be tied together; there should be a close relationship between the value of an entity (its stock price) and the value of what it owns, after deducting what it owes to others.
It’s not controversial. However, conventional economics assumes that if q it’s unbalanced investment who adjusts to set things right. Imagine a company that owns a stock worth $10 and owns one thing: an asset worth $5 at current replacement value. It may seem strange. The market says, “This company is able to do something unique with this $5 asset that generates additional profit. When they own it, it’s definitely worth $10.
It’s not completely crazy, at least temporarily. The theory says that company executives will see an opportunity – sell another stock for $10 and use the money to buy more of those same assets. The market will quickly say that the new stock is worth $20.
But all good things must come to an end, and competition will mean that the company will get less and less extra profit as it invests in more assets. In other words, as the investment increases, q begins to decline and eventually the market value of the business and the assets it owns will realign.
It’s true, but for the wrong reason
Smithers demonstrates that market value and replacement cost are indeed linked – q rotates slowly around an average level. But that does not mean returning in the sense that I have described. When q rises companies don’t invest more. The ratio is brought down by a drop in stock prices. And – as we are experiencing this year – stock prices generally fall much faster than they rise. These steep drops can trigger financial crises – destabilizing the economy and causing lasting damage.
pay me now
One of the main reasons companies don’t invest more is what Smithers calls “the bonus culture.” Senior corporate executives derive much of their compensation from stocks and stock options. Investing is a trade-off – lower profits now versus higher profits in the future. But lower earnings now mean a lower share price and a smaller bonus.
The alternative is to invest less, which increases reported profits, and then use those profits to buy shares in your own business. Both of these drive up stock prices and lead to bigger bonuses.
You don’t have to have a degree in psychology to guess which option managers choose. They invest less, buy back shares and collect their bonuses. The problem is that these collective decisions to invest less slow down both productivity and economic growth. And – as I wrote last week – we need all the growth we can get to manage rising health and pension costs as our society ages. Thus, it is very important to change the incentives of managers to generate more investments.
Unmask the investment
Smithers thinks that classifying intangibles as R&D as an investment masks what’s going on. Its purpose: R&D is a source of competitive advantage; if successful, it takes away market share from a rival company. For every winner, there is a loser. It does not increase the productive capital base in the same way as investment in fixed assets and is therefore less important for economic growth.
The graph below shows that while total investment appears to be holding up, investment in tangible productivity-enhancing assets continues to decline. The high value of q over the past 30 years has not led to an increase in material investment.
How to Increase Growth and Reduce Instability
What can we do? I may be extending the analogy, but Smithers suggests both tangible and intangible change. The tangible change is to modify taxes to encourage business investment and to pay for this by increasing taxes on current consumption.
An increase in investment should bring two concrete benefits: in the long term, it will increase the rate of economic growth and gradually bring stock prices in line with asset values, thereby reducing the risk of financial crises. The tricky part is ensuring that this happens without increasing the budget deficit.
If taxes are lowered to encourage business to invest, this will reduce government revenue and, if nothing else changes, the budget deficit will increase. To compensate for this, Smithers says we need to raise consumption taxes – for you and me, that means higher income or sales tax.
Its “intangible” goal is also ambitious – to change the economic consensus so that the importance of the stock market is widely understood and recognized. If that were the case, central bankers facing recessions in the future would be able to say – “we’ve lowered rates as much as we could, more and the stock market will be dangerously out of balance and another crisis will occur “.
It is an ambitious program with obvious political challenges. It may take another financial crisis for us to find the will to make the changes he proposes. Yet his work gives us a better understanding of how the economy really works and how it can work better. It’s a good first step.