There has been much debate about the demise of equities, inspired by PIMCO’s Bill Gross’s comment that equities are in a state of terminal demise. An interesting response came from Grantham’s Ben Inker, who argues that the relationship between GDP and earnings per share for equities is non-existent. And that therefore trying to pick stocks by looking at GDP forecasts is not valid. Pronouncements like Gross’ are the kind of overstatement that certainly attracts attention, without necessarily having much substance. Brand marketing remains as important as ever in financial services. But what I find interesting about the discussion is that does not pay much attention to the meta money world of derivatives or high frequency trading that is coming to dominate the financial markets. Conventional transactions, whether it be bonds, equities, bank debt are being superseded with meta transactions. The collapse of the collateralised debt obligation (CDO) market that led to the GFC is a case in point. The conventional mortgage transaction was compromised by the meta transaction of mortgage securitisation. When it failed, it was no longer possible to work out how the conventional transactions were working. Who owned what, for example.
But analysts are concentrating on the conventional transactions because they are just that. Conventional. And therefore amenable to analysis using well established methods. Since the GFC the greater threat to returns is obviously the systemic threat, but that is extremely hard to analyse, not least because it is a disappearing point: money made out of money made out of money. It is also weirdly symmetrical. Money is made or lost when prices go up, money is made or lost when prices go down. Welcome to meta money.
So what does analysis of the conventional tell us? Inker makes the point that GDP and corporate earnings do not follow each other:
Here is a graph showing a weak relationship between earnings per share, GDP and total return:
Long term earnings growth trends also suggest that they do not really drive share returns:
Inker observes that dividends have throughout history provided the bulk of returns for equity holders, a point worth remembering in the current uncertain environment. I have long thought that equities do better because they entail a higher level of trust, and that trust has positive operational and financial benefits that over time tends to result in better business outcomes and therefore returns. Debt is an obligation, equity is only an implied obligation and that creates an ease of operation that can be highly beneficial (or betrayed, of course). The instigation of debt for equity swaps in the current travails of the European banking system, for instance, will be when the problems start to turn around. Inker makes a similar point:
The problem with such historical analysis, however, is that it assumes that the basic transactional behaviour does not change, that equity investment now is much like equity investment in the 1920s. For retail investors that may be so, but with institutions using devices like dark pools or derivatives to change their use of equities and high frequency trading creating a massive disconnect between what is happening in the market and the basic purpose of raising equity capital — funding medium to long term business activity — the transactions have very definitely changed. Inker makes a reference to this in passing, when he is discussing the expectation that share returns should get a risk premium, equating with about 6% return above inflation:
Note how he only refers to short positions in passing. The assumption is that the derivative, the meta money play, is only on the margin, a side issue. Trouble is, meta plays are not on the margin, especially now that so much of share trading is algorithmic plays that take no account at all of company fundamentals. Inker provides a fine historical analysis which suggests that corporations have been the unofficial beneficiaries of US and other governments’ deficits, which have held up aggregate demand at a time that the corporations were shedding costs and cutting jobs. He argues that the deficits are not sustainable, so the profits are not either. The S&P will deliver 3.5% real returns instead of 5.5-6% returns. Very much worth a read. But it does not address the question of what the meta money marauders will do to equity markets, and what they will look like in the future.