What’s Happening With the Stock Market?
European Straits #159
Hi, it’s Nicolas from The Family. Today, I’m sharing a look at all the reasons why the US stock market seems to be on a never-ending wild ride.
⚠️ I wrote a new column for Sifted. We at The Family work a lot with portfolio companies confronted with the so-called “techlash”. We help them fend off hostility from government, incumbents, academia, journalists, and the public, to the point of having developed over the years a playbook to deal with the whole thing. I don’t reveal all of it in the column, of course, but it is a glimpse of how to keep your startup safe when governments, regulators, the press, and the public begin to take a hard look at your activity 👉 When the world turns against tech 👀
🇬🇧 Also, I know: Brexit happened. At some point, maybe I’ll get back to that and discuss the consequences for European entrepreneurs.
In the meantime, on to today’s issue. Recently, one of our shareholders was reflecting on how his investment in The Family was doing compared to the stock market, which has more than doubled over the past decade!
But why has the stock market fared so well over a period that nobody remembers as particularly flourishing? I went back through my Evernote to try and understand, and here’s what jumped out at me 👇
1/ First of all, the stock market is divided along geographic lines. Indeed, there are different regional categories of stocks whose performances are relatively uncorrelated. There are European equities (which, according to this article, were “slammed by the sovereign debt crisis and a feeble economic expansion”). There are emerging market equities (where performance was even worse than European stocks). There are Chinese equities (where prices, apparently, don’t mean much in any case).
When people talk about “the stock market”, they usually mean the US stock market, of which the S&P 500, Dow Jones Industrial Average, and Nasdaq Composite are the most representative lists. Clearly that is the segment of the global stock market that has been flourishing and attracting the most capital, as investors are fleeing non-US equities these days. (BTW, beware the home-country bias.)
2/ Another dividing line depends on how stocks generate revenue for their holders:
The most familiar category is that of income stocks, mostly discussed relative to their quarterly dividends. Those are typically stocks in old, established incumbents that make a lot of profits.
Then come the growth stocks, those with a high price-to-earnings ratio but whose prices continue to increase anyway. This category, which includes fast-growing tech companies, is the one that’s been on the rise over the past ten years.
And finally there are value stocks, those that seem to be down but that investors buy in the hope that their intrinsic value will be revealed over time. Value investing is going through rough times these days, although it could be due for a resurgence. (See my previous issue on the topic.)
Just keep in mind that those different categories attract different types of investors. As I once wrote in a (long) piece about Berkshire Hathaway and value investing in general, “Growth investors like to follow the leader (hence the occasional bubble). Income investors, conservative by heart, don’t like surprises. Value investors like to beg to differ and to be proven right on the long term.”
3/ Another thing that you should bear in mind is the nature of the relationship between the stock market and the bond market. Typically, an investor with a lot of capital to deploy will aim to allocate to both stocks and bonds. Bonds, including government bonds, are assets you rely on for safety and steady payments over time: their price doesn’t fluctuate much, except with interest rates (typically the price of issued bonds will go down when interest rates go up). Meanwhile, stocks are assets you want to hold in order to piggyback on economic growth: it’s the way for any investor to participate in the capitalist feast.
However, you’ve likely heard about the macroeconomic anomaly of the day: negative interest rates. From a stock market perspective, those have triggered an interesting phenomenon whereby bonds have become stocks and stocks have become bonds! As written by the Financial Times, “Investors are forced to live with the opposite [of what they’re used to] — bonds that yield nothing but that gain in price, and equities that are relied on for their streams of dividends rather than their rising prices.”
4/ Now, one overarching reason why the stock market has done so well is that we’re recovering from the 2008 crisis. As always, after the downs come the ups. The lower you fall in times of crisis, the longer it takes to recover, and the period of recovery lifts up the stock market for several reasons:
Low interest rates, the central banks’ response to the crisis, trigger an influx of capital that boosts the price of assets, including on the stock market (see below)—even more so if stocks are the new bonds (too much capital overall, plus investors fleeing bonds to invest in stocks).
Meanwhile, the companies that survived the crisis are so fit and resilient that they make the most of the recovery period, with some (in this case, tech companies), racing ahead.
It helps that the overall context is changing, with the world economy now relying on better logistics and stronger infrastructures: have a look at this wonderful article that explains how the global supply chain explains the length and strength of the current recovery.
5/ Another reason for the booming stock market is described in Thomas Philippon’s remarkable book The Great Reversal. Thomas is a friend, and a brilliant economist. In the book, he makes the case that various market imperfections and institutional barriers in the US have helped dominant companies in a growing number of sectors to exert unprecedented market power, thus fending off competition, increasing prices for consumers, and imposing low wages on workers. The US used to be the land of free-market competition; but today, it’s Europe that performs better on that front while the US has become the land of market-gouging and rent-seeking.
This, by the way, explains why there are discussions about how Elizabeth Warren winning the next presidential election could crash the stock market. It’s not that she’s anti-capitalism (she’s really not). Rather, she’s committed to reviving sound competition across the various markets for goods and services in the US. This would result in slashing profits for those predatory firms described in Thomas’s books and could very well lead to their stocks performing less well.
6/ Of course, it has helped that the US Congress dramatically slashed the corporate taxation rate at the end of 2017, with the stated goal of boosting corporate investment and job creation. The reasons why it was a bad decision were widely discussed at the time, especially when compared with similar decisions at the end of the 1970s by the Carter administration and then in the 1980s by the Reagan administration: namely, we’re not struggling to attract investors into the stock market, and so we don’t need to slash taxes so as to increase dividends!
In fact, there’s too much capital invested in the stock market, and listed companies have more money on hand than they know how to invest. So what options do they have? They pay higher dividends and buy back their shares, thus driving the stock market even higher, all without the need for new streams of outside investors. But this is not without adverse consequences when it comes to economic output, as discussed by William Lazonick here, and the late Clayton Christensen here.
7/ And then there’s the big thing: the shift to the Entrepreneurial Age, which comes with three distinctive features:
Concentration, with struggling incumbents merging with one another, which is bound to boost returns on their stock: if you swallow your competitors, like Universal once did with EMI for instance, you end up with superior market power and a greater ability to generate profits.
Listed tech companies racing ahead because progress in the current shift is accelerating—which explains a significant proportion of the stock market’s performance over the past decade. This phenomenon is correlated with the previous one, although the two phenomena are quite different. While before they were risky assets, the winning tech companies become safe havens—even though they might be left behind over the next decade, says UBS. (By the way, Netflix has been the best performer on the stock market over the past decade.)
In sum, the paradigm shift is bound to lift up the stock market because it boosts the few fit incumbents who manage to survive (the old giants) while also boosting the new giants—which are driven by increasing returns to scale. You shouldn’t miss Marc Andreessen’s grand theory on the topic: The investors that are impatient with incumbents (income stocks, dividends moving higher) are patient with tech companies (growth stocks, valuations skyrocketing).
8/ The structure of the stock market is changing in ways that contribute to boosting it on average. Here are a few things:
Indexing is one factor. Basically, the stock market has been taken over by indexing giants such as BlackRock, Vanguard, and others. That means we’ve come to the end of the legendary stock pickers. (And do have a look at the phenomenon known as “Quant Winter”.)
In times of slow economic growth, “concentration is driving the market”: some ‘mega-cap’ firms are riding high on the stock market, while others are just doing OK. Average measures such as the Dow Jones or the S&P 500 fail to capture those disparities.
9/ Overall, I think the main reason why the stock market is doing so well is this: too much money chasing too few stocks. And there are two factors contributing to that:
There’s simply too much money, period. This is what economists call the global savings glut. It always sounds weird because it doesn’t make it easier for the average household to borrow money from their bank, or for the average entrepreneur to raise money from a VC firm. The clearest explanation for why too much money can coexist with lack of opportunity was given by Matt Stoller in his essay about How Monopolies Broke the Federal Reserve: when you have a lot of money to invest, the stakes are so high that you don’t want to take too much risk. And therefore you end up not investing in most asset classes, instead concentrating on what you know best, including the stock market! (See this article: The Multitrillion Cash Hoard.)
There’s also too much money in the stock market in particular, because fewer and fewer companies go public these days. The consequence is that if you want to make money off the ones that don’t, you need to invest in private equity (venture capital included). There are so many reasons why allocators tend to ignore the invitation, including regulations, risk profiles, and the transformation that private equity is currently going through. But there’s a powerful message here: the stock market is not the default performance measure anymore because it doesn’t represent the whole of the economy. Michael Mauboussin calls that phenomenon The Incredible Shrinking Universe of Stocks (also see this article). Others write about private equity being the new stock. And still others point out that the two markets might be correlated anyway.
10/ In conclusion, I’d like to ask a question: Is the current performance of the stock market a good thing or a bad thing?
Well, first of all, the stock market going up doesn’t mean that investors make money: because future earnings are factored in the price of stocks, investors tend to pay for future proceeds when they buy the stock, thus they won’t make money over the long run. As recently written by Shawn Tully in Fortune, Stocks Are Now Shockingly Expensive by Every Measure.
A bullish stock market is good for those who can save money, because a significant part of that money is then invested in stocks. And that’s the paradox of the US situation: yes, the stock market is doing well, as Donald Trump likes to boast; but no, it doesn’t really benefit Americans, because few among them manage to save money (the current boom is passing over at least half of US families, and millenials are sitting it out entirely). Further, the stock market’s strong performance essentially mirrors the relative weakness of consumers and workers within the corporate contract. If shareholders make a lot of money, it also means that consumers lose under the form of high prices (see Thomas Philippon’s work above) and workers lose under the form of low wages. And so there’s an ongoing class struggle on Wall Street.
Here’s the key: We should help people save more and invest more, and tech startups are tackling that challenge. We should also make sure that those savings are invested where the actual returns are—that is, in tech companies. And here startups are also hard at work, including our own portfolio company Fairmint—see my recent issue about Capitalism Today: Customers as Shareholders.
And coming back to The Family and European tech, well I guess you understand now why it’s difficult to compete against the US stock market. But then again the fact that the stock market is booming is related to the transition to the Entrepreneurial Age, which is precisely the opportunity we’re seizing as long-term investors—so, to be settled at a later date!
Here are more readings to dig deeper into the stock market:
Profits Without Prosperity (William Lazonick, Harvard Business Review, September 2014)
The global savings glut (Dominic Rossi, Fidelity, May 2015)
Here is Marc Andreessen's 'grand unifying theory' for what's going on in markets right now (Business Insider, June 2015)
The Incredible Shrinking Universe of Stocks – The Causes and Consequences of Fewer U.S. Equities (Michael J. Mauboussin, Dan Callahan, and Darius Majd, Credit Suisse, March 2017)
The Stock Market Is Shrinking. That’s a Problem for Everyone. (Jeff Sommer, The New York Times, August 2018)
This Stock Market Rally Has Everything, Except Investors (Matt Philips, The New York Times, February 2019)
Historic Asset Boom Passes by Half of Families (David Harrison, The Wall Street Journal, August 2019)
America is Great. Home Country Bias Ain’t. (Rich Friedman, Evergreen Gavekal, September 2019)
Buyout Funds and Stocks Show ‘Almost Perfect Co-Movement’ (Alicia McElhaney, Institutional Investor, September 2019)
How bonds became stocks and stocks became bonds (The Financial Times, October 2019)
Investors Flee International Stock Funds (Christine Idzelis, Institutional Investor, October 2019)
Ready to Boost Stocks: Investors’ Multitrillion Cash Hoard (Ira Iosebashvili, The Wall Street Journal, November 2019)
Some of the World’s Richest Brace for a Major Stock Sell-Off (Joanna Ossinger, Bloomberg, November 2019)
Huge Disparity in Corporate Profits Hints at Something Amiss (The Wall Street Journal, December 2019)
Emerging-market stocks have had a miserable decade. The slowdown in Chinese growth suggests they won’t break out as the next one begins. (Mike Bird, The Wall Street Journal, December 2019)
Stocks More Than Doubled Over the Last Decade. Many Investors Missed Out. (Julie Segal, Institutional Investor, January 2020)
Why Global Stock Markets Rise Despite an Economic Collapse (Medium, January 2020)
The Hidden Dangers of the Great Index Fund Takeover (David McLaughlin and Annie Massa, Bloomberg, January 2020)
It’s a strange new world where tech stocks are safe havens (John Plender, The Financial Times, January 2020)
‘Quant winter’ raises tricky questions for a hot industry (The Financial Times, January 2020)
The downside of a stellar 2019? Stocks are now shockingly expensive by nearly every measure. (Shawn Tully, Fortune, January 2020)
Capitalism Today: Customers as Shareholders (me, European Straits, January 2020)
Ultrafast Trading Costs Stock Investors Nearly $5 Billion a Year, Study Says (The Wall Street Journal, January 2020)
Prelude to Crisis (John Mauldin, Evergreen Gavekal, January 2020)
From Half Moon Bay, California 🇺🇸