The global financial crisis was in my view the first symptom of what is a reckless attack on money itself. An attack undertaken by the supposed uber-capitalists, Ayn Rand disciples. It is thus especially dangerous because it is unintentional — the worst of all “unintended consequences”, as it were. The lingering sign of this attack is a weakening of the cost of capital in developed economies. A report by Deutsche Bank demonstrates the point. It looks at the decoupled relationship between the earnings yield on stocks and interest rates, concluding that equities are cheap. I have a different conclusion. The decoupling is a sign that the cost of capital is not working properly.
First, a quick explanation of what the earnings yield is. It is the price earnings ratio (the share price divided by the earnings per share) of companies turned upside down (i.e. earnings per share divided by the share price). So if the price earnings ratio is 10 times, the earnings yield is 10%. What is significant about this ratio is that it can be compared with interest rates, in the Deutsche Bank example the 10 year bond yield. Thus it allows a comparison of the cost of equity and the cost of debt. A track on the cost of capital, in other words.
The Deutsche Bank report (figures 5-7) shows that the two costs of capital have been decoupled since the financial crisis. In Australia the earnings yield is about 8% compared with just over 5% on bonds. In America the earnings yield is almost 8% compared with only about 3% on bonds, and in Europe the disparities are even wider: almost 10% on equities and 3% on bonds.
Deutsche concludes that this means equities are cheap:
The earnings yield and bond yield have tracked closely for most of history. At present, the gap is as large as it has been outside of the financial crisis, and suggests equities are cheap. On this metric, US equities look particularly cheap, which could provide support for ongoing gains in the US. The yield gap is also large in Germany and the UK, as bond yields have stayed low given their safe haven status in the region.
I have a different reading. I think this is showing that the basic discipline of capitalism is in trouble, a sign of distress. In the same way that it is no longer possible to measure money supply when $US4 trillion spins around the globe each day — vastly in excess of any QE2, QE3, or any other QE — the basic analytics of different kinds of conventional capital are not proving effective. Because of Western governments’ desperate attempt to save the system after the GFC by making debt extremely cheap — a tactic that mimics Japan’s unsuccessful attempts to recover from its asset bubbles since the early 1990s — the basic logic of capital is under pressure. To see how much this can end in tears, look at Japan for the last two decades.
In other words, it is not that equities are cheap. It is that money is being made cheap to save the system. In Japan in the 1990s, debt actually fell below zero in an attempt to reflate they system and still it did not catalyse borrowing. We are not there yet with debt in the West, but the same sort of stresses are occurring. And they do not add up to booming stock markets.
Now, there is a counter argument to what I am saying here. One of the ironies of the GFC is that non-financial companies mostly saw it coming and have very strong balance sheets. Margins are also strong, as The Economist points out:
BCA Research has some remarkable statistics in its research note on profit margins (no link available, I’m afraid). Since 1990, real domestic corporate profits in America have risen 200%, while real compensation for corporate employees has increased just 20% and real median family incomes are up just 2% (is this the American dream?). Since 2000, the relevant statistics are 80%, 8% and minus 5% respectively.
Profit margins in the non-financial sector as measured by ebitd (earnings before interest, tax and depreciation) are as high as they have been at any moment in the last 50 years. There was a big drop in margins in the 1970s as wage and commodity costs soared and it has only been in the past decade that profits have returned to 1960s level. What was remarkable about the 2007-2008 subprime crisis is the speed with which margins have rebounded.
BCA cites a number of factors to explain the rebound from aggressive cost-cutting, the use of technology, to a sharp rise in overseas margins arising from a weaker dollar and some “tax-planning” measures that routed profits to low-tax countries. On the basis of this analysis, BCA concludes that it will be extremely hard for margins to rise further from current levels. Yet the trend in margins tends to follow the economic cycle, so it would be unusual for margins to weaken sharply in the absence of a marked slowdown in the pace of economic growth.
Of course, a slowdown in growth might be just what’s occurring at the moment.
This does suggest that many public companies are strong financially. The catch, as the article implies, is that those profit margins are to some extent dependent on wealth distribution. If employees don’t get enough money, demand will fall and pricing power will weaken. That means the profit expectations may get some nasty hits. Sure, there does seem to be a productivity element as well. After all, in environments of high unemployment, it is easy to keep wages under control. But when will it loop around on itself?
The conclusion, it seems to me, is that investing in equities requires more non-financial analyses than is usual. That is, there is a need to concentrate more on a company’s commercial prospects and less on its financial position. Investing analysis always requires a balance of the two, but at the moment the balance is skewed more towards the commercial. Picking companies that have high dividends also seems in order. In such a stressed environment, relying on capital gains may be dangerous. But a dividend is cash, a certain outcome.