You hear that old saw that "the market is not the economy," a lot these days, and for good reason. As ConvergEx's Nick Colas notes, the S&P 500 breaks to record highs - but U.S. labor markets remain sluggish; investor portfolios do well - but over 47 million Americans (more than 15% of the population) are still in U.S. food stamp program – the same as August 2012. The important question now is: "Is the market TOO different from the economy?"
Record corporate profits – the reason for all-time highs in U.S. equities – come with little hiring or wage gains. The hottest growth stories are business models with lots of customers but very few employees. The recently purchased WhatsApp – for $19 billion – has 55 employees. Investment payoffs – and increasingly social outcomes as well – are technology-enabled, asymmetric and sporadic. How soon before we reach a tipping point?
Via ConvergEx's Nick Colas,
Last week the local government of San Francisco announced that Google has promised to give $6.8 million over the next two year to pay for over 31,000 low-income young people to use the city’s mass transit system for free. Mayor Edwin Lee applauded the company for helping ease San Francisco’s “Affordability crisis for lower and middle-income families”. Without Google’s help, the successful pilot program would have run out of money in July of this year.
Google’s initiative seems to be a direct response to numerous local protests over its practice of providing free shuttle busses throughout the city for the sole benefit of its employees. Local and often long-time residents, fed up with cost of living inflation from their new stock-option enriched neighbors, see the busses as a symbol of an out-of-touch elite and the companies they serve. Some of the protests have turned violent. Even Wired magazine, a widely read voice of the merits of technology, sees the problem. In the most recent issue: an editorial entitled “Breaking Point: Silicon Valley Can’t Avoid the Haters”, and a back page questionnaire – “Am I a Silicon Valley Douchbag?”
There’s an old Wall Street aphorism that goes “The market is not the economy”, something akin to “A Google bus is not the San Francisco economy.” In both cases, you’d think there were would some correlation. A hugely profitable Silicon Valley should mean a broadly wealthy and generally content “City by the Bay”. And a rocking stock market should indicate a U.S. economy solidly on the mend after the Financial Crisis and accelerating in 2014. Neither seems to be true.
That old school maxim about the market and the economy used to be accurate for the following reasons:
The eyes of the equity market face forward, not to the sides. Investors price assets based on future expectations of earnings and interest rates. In the depths of a recession, stock markets tend to rise – think the early 1980s and 1990s – as they anticipate improvements in corporate earnings. These moves may seem out of sync with current economic data at the time – high unemployment and low consumer confidence – but they eventually prove prescient as those indicators start to improve later in the cycle.
It takes time for the Wealth Effect of higher stock prices to translate into increased consumer spending. Consumers who own investment portfolios need to see their net worth rise for some time before they act on their improved financial situation and spend some of their gains. This feedback loop is important, for it ties the “Real world” economy – especially job growth - to the financial markets.
Recessions in the U.S. don’t tend to last very long, so the workforce in place at the end of the last expansion is still largely relevant and employable at the beginning of the next recovery. Of the 11 recessions since the end of World War II, 8 of them lasted less than a year. Workers who got a pink slip during a slowdown had some confidence that their next job would be available soon enough. This confidence limited the impact of a downturn on consumer confidence, spending, and even social policy.
At least by these factors, the current equity market’s link to the real economy is obviously different; “The market REALLY isn’t the economy” this time around. A few points here:
U.S. stocks are at record highs largely because public company profits are strong as well. There may not be much revenue growth, true. But that’s not exactly a secret. Interest rates remain low, providing support for stock market valuations.
Five years into the current economic “Expansion”, however, and the “Real world” remains sluggish. The U.S. Supplemental Nutrition Assistance Program (SNAP, more commonly known as Food Stamps) still serves over 47 million Americans on a monthly basis. That is 15% of the population, and this ratio is essentially unchanged since 2012. Unemployment may be down to 6.7%, but even the Federal Reserve acknowledges that this number is suspect for both demographic issues and unforeseen shifts in how many people want to work.
If you follow the “Smart money”, you’ll see more of a flashing yellow light than a verdant green one. Mergers and acquisitions, famously cyclical and tied to CEO confidence, are far from boom levels. Bet the corporate ranch on a big deal? “No, thank you” say most CEOs to their bankers. Low risk bolt-on purchases rule the day. Conversely, the pipeline for Initial Public Offerings, where private investors sell to the public, is very robust so far in 2014. “Good market to be a seller”, this patch of smart money seems to say.
Most commentary on this front tends to focus on income inequality, but this narrative may well miss the real point. Markets price securities based on whatever society deems most valuable. Earnings and cash flow are two indicators of value, to be sure, and historically the growth of a business was an alchemy of allocating human and physical capital to maximize the growth of the bottom line.
Now, the priorities seem different. Incremental improvement is out; disruption is very much the word of the day. Consider the following:
Facebook recently paid $19 billion for WhatsApp, a company with 55 employees. That’s the monetary equivalent of hiring 19,000 people and paying them $100,000 for ten years. Facebook itself only has about 5,800 employees, according to Bloomberg, and a market cap of $174 billion.
Other highly valued tech companies also sport relatively low total headcounts. Google, after the sale of its handset business, should have about 40,000 employees for its $408 billion market value. Relative newcomer Snapchat has 30 employees and turned down a $3 billion bid last year. Yep, from Facebook. We’re clearly not in Kansas any more.
Market commentators from Mohamed El-Arian to Larry Summers are warning that this trend has meaningful implications for capital markets and interest rate policy. El-Arian wonders if corporate America’s reluctance to invest in capital and people is tied to the risks of getting it wrong. If a new mobile app can disrupt a large company like Facebook, is anyone safe from innovation? And Summers points to the problem of piles of corporate cash with nowhere to go keeping interest rates lower than historical norms.
In the end, everything from Google’s busses to El-Arian’s conundrum and even equity prices reflect an increasingly “Winner take all” society. Again, that’s not an indictment but rather an observation. The Great Recession and its aftermath align precisely with an explosion in technological innovation. In a slow growth economy, public market investors see growth, rather than just capital, as the true scarce social commodity. Thanks to technology, growth no longer means incremental employment. In fact, recent transactions like WhatsApp seem to point to the opposite.
This trajectory seems unsustainable, but the answer does not need to be nihilistic. Markets, investors, and societies tend to self-correct with time. We do seem to be a point where the problems – slow growth and still-high unemployment – are obvious, while the answers are not.