Numerian over at The Agonist has a good post today on the state of the equity markets. Basically, it’s an argument that I agree with pretty much completely—tracking short term movements these days as if they’re meaningful misses the big picture. And the big picture is deflation. Numerian is not alone. Paul Krugman and Martin Wolf (courtesy of Brad DeLong) have been banging the drum on this for a while now. Of course, as Numerian points out, if this is true, what’s holding the market up to its current level? Well, earnings always seem to be better than expected. As we have laid out in a couple of earlier posts, however, it’s pretty clear that equity analysts in the US routinely and consistently under-predict earnings, so no wonder the market stays up. I just want to offer some further thoughts on why this is all problematic.
Here’s how Numerian lays it out, pretty correctly, as far as I can tell:
Corporate earnings trump everything in the stock market, and unless there is some sea change in the prospect for corporate earnings, the stock market can push upwards even in the face of a persistent economic recession, or even a depression, which is what many consumers are experiencing. What, then, is the sideways trading we have seen both short term and long term telling us about corporate earnings?
It is telling us that the real battle in the stock market is not with the bulls and the bears, but with the corporations and the consumer. Corporations since the Ronald Reagan presidency have taken a larger and larger slice of the economic growth in this country, to the point where the imbalance is seriously against the consumer. Wages and benefits have stagnated for over 20 years in the US, while corporate earnings have surged. An estimated 30 million people in the US are living below the poverty level, while the top 1% of the population, who are mostly corporate executives and their families, enjoy unprecedented wealth from their stock grants and options.
The sideways trading we are experiencing is expressing uncertainty as to whether the era of corporate dominance at the expense of the consumer is over. Corporations have held the trump cards for over 30 years, having shipped millions of jobs overseas, laid off tens of millions of Americans, held salaries and wages flat, cut benefits, eliminated overtime, increased the workload, and converted employees to contractor status to avoid paying any benefits at all. These initiatives, along with generous reductions in their tax bills, to the point where any number of large corporations pay no tax at all, have fed directly into corporate net income and executive compensation.
All well and good. Numerian then goes on to wonder whether this state of affairs is likely to persist, and he thinks not, a point with which I would agree. It’s an important argument, because it reflects some of the political tensions we’re currently seeing in America, tensions that are likely to become more severe as time goes on unless there is a genuine populist revival. Numerian goes on to discuss why there’s no particular reason why stocks shouldn’t crater further. It’s a good piece. I just want to add a couple of points on why consumers are going to remain in tough shape for a while.
First, what’s wrong with deflation? There’s the obvious stuff about making debt more expensive, but consumers appear to be reducing debt levels. But if we’re talking about food and energy prices, maybe not much. Given the fact that payrolls have remained pretty stagnant over the past several decades, while food and energy prices have not, some reduction of price pressures in these areas would in theory be welcomed. But it’s not that simple. In fact, food and energy prices, which are currently pretty stable (and have been declining in the case of most agricultural commodities), are not likely to remain so. China has become the world’s largest energy consumer, according to the International Energy Agency, and is going to continue to import as much oil, coal and iron ore as it can for the foreseeable future. So much for energy prices remaining where they are. And we saw what happened to food prices two years ago when some shortages looked as if they were emerging. Since then, global food stocks have rebounded somewhat, but the UN Food and Agricultural Organization has cautioned that prices are unlikely to fall to their ten year average even with an improved outlook this year (and there are some commodities that remain near historic price highs at present). It’s not likely we’re going to see long term deflation for these categories. And this is before the medium term impacts of climate change start kicking in meaningfully. So in these two critical areas, we’re more likely to see long term inflation, not deflation.
Moreover, given that wages and payrolls have been stagnant for so long, the only real source of wealth creation for Americans over the past several decades as been in house price appreciation—or else getting that second job in the family, which has happened as well. As a result, we had the lending frenzy that led to the crisis of the past several years, which the banks have come out of sort of all right, but not many consumers have. And, as Numerian points out, the banks aren’t really in that great shape either, when you think about it. And then there’s this, courtesy of Bloomberg (via The Big Picture):
It’s pretty clear that there’s a $4 trillion differential between mortgage values and actual assets. Where did that go? Into the ether, or it was never really there in the first place. In either case, how is it going to come back? Well, it might not, especially in the Sunbelt, although people continue to move there. But there’s still a glut of housing, new home construction remains in the dumps, and it may be a while before the average US homeowner may look at improving asset values. And as far as commercial real estate goes, yes, REITs were able to raise a whole lot of money last year (Zero Hedge has some interesting conspiracy theories on how this occurred), but those strip malls on the outer suburbs of Phoenix are still worth crap, and they’re not going to appreciate any time soon. And remember, that $4 trillion in devalued assets is probably still showing up at its original stated value, or close to it, at most financial institutions that carry them or assets based on them–most of this hasn’t been written down yet.
Where does this leave us? With a stock market that remains disconnected to much of the rest of the US economy. And if it’s going to reconnect, it will probably involve a move down, not up.