What’s with the stock market?

by John Q on August 12, 2020

In a couple of recent posts, I’ve been looking at returns to capital. First, there’s the fact that real returns on long-term (up to 30 year bonds) are now below zero in most countries. I argued that such a situation is inconsistent with the existence of capitalism in the traditional (say, pre-1970s) sense of the term. Then there’s the fact that the biggest contributor to corporate asset values is “intangibles” which is a polite word for monopoly.

An obvious question that arises is: if this is the case, why is the stock market doing so well, holding most of an already high valuation even as the pandemic raises the prospect of a long and deep recession? In one sense, there’s no puzzle at all here. Stocks generally yield higher returns than bonds (this is the “equity premium puzzle” on which I’ve written a lot), but if bonds are paying zero, then investors will be willing to buy stocks with a small (expected) positive return. That implies, for any given expectation of future returns, a higher share price. On this argument, the fact that sharemarket investors have done well in the last ten years or so doesn’t mean that they will do well in the future. Rather, at current stock prices, they will be taking more risk for less return than in the past.

All of this raises more questions about what is going on with corporations. Although corporate profits are increasing at the expense of wages, that masks growing inequality between firms. According to this study from 2017 (abstract over the fold). “Earnings of public firms have become more concentrated – the top 200 firms in profits earn as much as all [other] public firms combined.” Firms are also paying out more in dividends and share buybacks and investing less, implying once again that (at least as regards public markets) the scope for capital investments yielding positive returns has become more limited. I suspect (but haven’t yet got good evidence on this) that a growing share of corporate profits are being captured in privately-held firms (for example, those owned by private equity firms), where there is more scope for various kinds of arbitrage and rent-extraction.

[click to continue…]