I’ve had a few discussions lately about the economy and the markets. And it amazes how the media moulds our thought processes. And I don’t mean just throwing out facts and figures that are shady at best but about the actual way we think. A while back I got irritated hearing about the bloody mortgage numbers every week and wrote on the matter because they are completely irrelevant today. Once upon a time they had some relevance to a wealth effect but that simply isn’t the case today. And certainly was never important enough to be moving markets a full percentage point one way or the other. The reason being the number of new mortgages is so far removed from the actual cashflow that we are using it to signal, that it has very little impact.
You see the wealth effect used to create additional cashflow from increased consumption and thus equity valuations should rise on that news. However, in today’s post housing apocalypse the wealth effect is a distant memory at best. Nobody feels wealthier because of their home equity (where that may even exist) anymore because the memory of how quickly it all disappeared is far too fresh. It’s the same reason millennials are not interested in home ownership. And so if the wealth effect is dead then mortgage numbers simply do not matter. So why is it we still hear about these damn figures all the time? The reason is because it is one more ‘indicator’ that can be used to sell a story and that’s the media’s job today. They are simply selling a story. Today’s world is about what can be made to feel real as opposed to be proven real.
Similarly I had a discussion about GDP early this morning. Specifically I was asked what drives GDP growth. I said expenditures and expenditures are a function of income, both total and, more importantly, distribution. The person I was discussing the matter with said well actually lots of things can drive GDP growth. They talked about government spending, about net exports and about population growth. And it hit me as very funny. You see the media has everyone so focused on certain variables that we’ve lost sight of what it is those variables are telling us. The problem with that is obvious, it means policies are being directed at the indicator rather than the actual subject.
Thing about GDP growth is that it is inherently worthless. That’s right. GDP growth means nothing and has absolutely no significance whatsoever. Let’s say the population increases by 50% in a year and that pushes GDP up by 5%, is that a good thing? I mean 5% GDP growth is considered exceptional right? So the market would rip to even higher all time highs and everyone would be high fiving each other and we’d all be very excited. The problem is that would actually mean that the vast majority of people had quite a significant reduction in their standard of living. And so when we look to GDP growth as having some inherent value we are being foolish. Now we use it because, all else equal, higher GDP is indicative that people’s standard of living on a broad scale has improved. But in the real world all else is not equal. And so we cannot accept that a rise in GDP is necessarily a good thing. In the example above if we looked only as far as GDP we would have missed a very serious problem.
Likewise a rising stock market as a gauge for economic health will only lead us to poor policy decisions. That is true because 99.99% of secondary market transactions have absolutely no beneficial impact on the economy. The secondary market is completely outside of the economy except in the rare instance where cash flows to corporate balance sheets. In fact, net-net, secondary markets have a negative impact on the economy as it is very much a vacuum of dollars that would otherwise remain in the economy. It all comes down to cash flows. Specifically, whether cash is flowing into the economy or out of the economy. Every time a dollar flows outside of the economy it is a drag on economic growth, meaning a decline in standard of living. We can see this very clearly over the past several years while corporate dividends and share buy backs have engrossed corporate strategy, having a devastating economic impact. Let’s have a look.
So this shows us what percentage of GDP has been allocated to dividend payouts and fixed capital reinvestment over the years. We see that dividend payouts averaged less than 2.5% of GDP until about the 1990’s when it began a very steep rise to 5.75% of GDP today. That is an all time high… funny where have we heard that phrase lately?? The chart also depicts a fairly disturbing trend in fixed capital reinvestment in the US. Historically it averaged around 7% of GDP but has fallen sharply since 1999 to under 3% of GDP today, so about a 60% decline from the historical average.
This is meaningful in that it tells us while economic boosting investments have been plummeting, we’ve been pushing much larger amounts of money outside of the economy and into financial investments. This is problematic because cash on a company’s balance sheet can be used for economic investment. Once that cash is paid out in dividends the vast majority of it is then reinvested into the financial market. The cash has therefore been moved from inside to outside the economy. If you don’t believe me that financial markets i.e. secondary markets are outside of the economy and if you are correct, then we should see comparable moves between the nation’s median standard of living and financial market indices. However, if I am correct then based on the above chart, we should see a divergence between the two with a significant rise in financial markets. Now let’s have a look.
What we’re looking at is median standard of living, namely, real median incomes (blue line). We also have the Wilshire large-cap price index (red line) which is a conservative proxy for financial markets (we could have used essentially any US market and gotten the same result). What this suggests is that while financial markets saw significant gains, the nation’s median standard of living actually declined by around 10%. This is because while financial markets have received significant increases in investments the economy has been losing significant amounts of investment.
Every time we remove a dollar from the economy and reallocate it to a financial market we make it harder to achieve economic growth, meaning we make it harder for people to be better off. Again this goes back to our above discussion that we always need to be cognisant that we don’t confuse the indicator as being important but rather that which the indicator is representing e.g. increased consumption not increased mortgages and increased standard of living not increased GDP or financial markets. But we do get lost in the indicators. And we do see the result being horrendously destructive policies. The Fed understands all of this but they know most of us do not. And so while their objectives of increasing wealth for the top .1% are being met by the policies they have implemented, they are selling you and I on their policies by pointing us to the indicators and not discussing the subjects behind the indicators.
I can hear some of you saying well my life doesn’t and the people I know don’t seem to be living too far below where we were. And so let me show you why.
The American working class is losing real income but has gained around 150% more debt than they had 15 years ago. This is completely logical. The only way to keep GDP or standard of living stable if incomes are declining is by filling in the void with debt. And as the chart above shows, that is exactly what’s happened. And so you and your friends might not feel like you’ve lowered your standard of living but you have. You’ve simply lowered your future standard of living. And that’s a choice each of us are free to make. But do understand the trade off.
It all seems to take a hell of a lot of effort to keep on top of all this money policy stuff. And it does but the consequence of giving criminals carte blanche to do as they will unchecked is akin to leaving a neon flashing sign on the front door of your home that says “family is gone for a week on vacation please help yourself to our stuff”. You are simply inviting them to rob you. And they will and they do and they are. The Fed has completely incentivized corporations to reallocate cash from economic investments and into financial investments by guaranteeing an upward moving market. At the same time the government is disincentivising corporations to make economic investments by way of incredibly high tax rates and mind numbing regulations. The decision then for the CEO has been made for him. He has almost no choice at this point.
The problem with this is that it is not sustainable. So while shareholders and CEO’s are being rewarded in the short term for these strategies they too will be devastated by them in the end. The same strategies were prominent between late 2005 and 2008 and while investors rode the high for a couple years they gave it all back in the end. The lesson here is that there is no free lunch. While the secondary market is outside of the economy and may be immune to economic conditions in the short term it is very much reliant on a strong economy for sustainability beyond the short term. As with debt, when you borrow money from somewhere it must eventually be paid back. And we saw the financial markets pay it all back in 2001 and 2008 and 201?. These are the laws of economics and they are absolute.