stock market economics

Boston Celtics’ Jaylen Brown (7) (left) and Marcus Smart Guard Warriors Stephen Curry. (photo by … [+] John Tlumacki / The Boston Globe via Getty Images)

Boston Globe via Getty Images

Can economists learn anything from the Golden State Warriors’ loss to the Boston Celtics’ Steph Curry in the NBA Finals? I’m thinking specifically of Game 5, when the Celtics devoted all their defensive resources to stopping Curry – the greatest shooter ever.

The Celtics won that narrow battle. Curry only scored 16 points and not a single 3-pointer in a playoff game for the first time. But they still lost the game. Why? unintended consequences. Other players deemed less of a threat were freed and their scoring caused a devastating loss to Boston.

Renowned financial analyst and author of a new book, The Economics of the Stock Market, Andrew Smithers, believes economists are making the same mistakes as the Celtics. Specifically, they are focusing on one thing – the balance between intended savings and intended investments – and ignoring other threats.

His book is thorough and challenging. The market pros are ready to roll up their sleeves and think a lot will come out of it. If that’s not for you, read on for our take on key thoughts and listen to our talk on the most recent Top Traders Unplugged podcast.

The stock market matters too

When people see an economic downturn coming, they worry. When they worry, they decide to save more. Companies – which are ultimately run by the same people – also change their intentions to save more, which they accomplish by cutting back on investments. Both of these changes reduce activity, which reinforces the economic slowdown. The Fed counteracts these intentions by lowering interest rates – making savings less attractive and (theoretically) making investments more profitable.

But lowering interest rates, especially if done through quantitative easing, has other effects — notably it drives up stock prices. By focusing primarily on intended savings and investments, and using interest rates to balance them, central banks take other relationships out of the kilter.

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One of those key relationships is called “Q” — the value of the companies assigned by the stock market relative to the replacement cost of the net assets owned by those companies. These two things must be tied together; There should be a close relationship between an entity’s value (its stock market value) and the value of the goods it owns, after ascertaining what it owes to others.

It is not controversial. However, conventional economics assumes that if q becomes unbalanced then it is investment that adjusts to bring things back. Imagine a company that has a share price of $10 and owns one thing – an asset worth $5 at current replacement price. This may sound strange. The market is saying: “This company is able to do something unique with that $5 asset that generates additional profit. When they own it, it really costs $10.”

It’s not completely insane, at least temporarily. Theory says the company’s managers will see an opportunity — sell another share for $10 and use the cash to buy more of the same asset. The market will soon say that the new share price is $20.

But all good things come to an end, and competition will ensure that the company at least gets additional profits as it invests in more assets. In other words, as investment increases, q will begin to fall and, eventually, the market value of the company and the assets it holds will be back in alignment.

right, but for the wrong reason

Smithers demonstrate that market price and replacement cost are indeed tied together – q moves slowly around an average level. But that doesn’t mean back the way I’ve described. When q increases companies do not invest more. The ratio has been brought back by a fall in stock prices. And — as we’re experiencing this year — stock prices typically fall much faster than they rise. These sharp declines could trigger financial crises – destabilizing the economy and causing long-term damage.

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The market value of the US stock market relative to net worth at replacement cost.

Andrew Smithers pay me now

A big reason companies don’t overinvest is what Smithers calls a “bonus culture.” Top corporate managers get a large portion of their compensation from stocks and stock options. Investing is a trade-off – lower profits in the future versus higher profits in the future. But lower profits now mean a lower share price and a smaller bonus.

The alternative is to invest less, which increases the reported profits, and then use those profits to buy shares in your company. Both of these things drive up share prices and lead to bigger bonuses.

A degree in psychology is not required to predict which options managers make. They invest less, buy back the shares and collect their bonus. The problem is that these collective decisions to invest less slow down both productivity and economic growth. And – as I wrote last week – we need all the growth we need to manage the rise in health and pension costs as our society ages. Thus, changing manager incentives is very important to generate more investment.

unmasking investment

Smithers wonders what’s causing the classification of intangibles like R&D as an investment mask. His point: R&D is the source of competitive advantage; If successful, it takes away market share from a rival company. For every winner there is a loser. It does not add to the productive capital base in the same way as investment in fixed assets and is therefore less important for economic growth.

The graph below shows that while total investment seems to be stalling, investment in productivity-enhancing tangible assets keeps falling. The high value of q has not led to an increase in tangible investments over the past 30 years.

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investment relative to GDP. Source: Bureau of Economic Analysis

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what can we do? Perhaps I’m exaggerating the analogy, but Smithers suggests both a tangible and an intangible change. The tangible change is to encourage investment by companies to revise taxes and pay for it by raising taxes on current consumption.

Higher investment should have two tangible benefits – in the long term it will increase the rate of economic growth and gradually bring stock prices in line with asset values, reducing the risk of financial crises. The tricky part is making sure this happens without increasing the budget deficit.

If taxes are lowered to encourage companies to invest, it will reduce government revenue and if nothing else changes, the budget deficit will increase. To offset this, Smithers says, we need to raise taxes on consumption – for you and me that means higher income or sales taxes.

His “abstract” goal is also ambitious – to change the economic consensus so that the importance of the stock market is more widely understood and accepted. If that were the case, central bankers facing a future recession would be in a position to say – “We’ve lowered rates as far as we can, and more and the stock market would be dangerously out of balance and another crisis.” will happen”.

It is an ambitious agenda with clear political challenges. Perhaps it will take another financial crisis for us to call Will to make the changes he is suggesting. Still, his work is giving us a clearer understanding of how the economy really works and how it can perform better. This is a good first step.

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