"The Value of Nothing: Capital Versus Growth"

More thoughts on growth, this time from American Affairs Journal, June 21, 2021: 

Throughout 2021, U.S. stock market valuations have hovered near all‑time highs. In June, the unadjusted price-to-earnings (P/E) ratio of the S&P 500 index eclipsed the tech boom record of 2000.¹ Many other asset classes have attained, or nearly attained, record valuations as well.

Stratospheric valuations may be partially attributable to the unique circumstances surrounding Covid-19, as depressed trailing earnings combined with optimism about a rebound can inflate simple valuation metrics. But valuations were already high before Covid. The cyclically adjusted P/E ratio has remained above 1929 levels for much of the last few years and is also approaching the peak of 2000.² Indeed, with the exception of the immediate aftermath of the 2008–9 crash, valuations have remained at elevated levels since 2000 (relative to previous history), despite the fact that this period has been characterized by a financial crisis, weak productivity gains, and ongoing narratives of “secular stagnation.”

The conventional explanation for this prolonged period of high and rising valuations focuses on low interest rates and other accommodative measures taken by the Federal Reserve. Fed policy is undoubtedly a major factor contributing to high asset values, but intense debates over monetary policy have arguably overstated its importance. After all, Japan has implemented even more ambitious monetary policies in recent years, including negative interest rates, yield curve control, and central bank purchases of equities. Yet Japanese stock market valuations are relatively low. The European Central Bank has also maintained low rates, and many European sovereign yields are lower than U.S. Treasury yields, but European equity valuations are not as high.

A more comprehensive explanation would simply state that the U.S. economy is, to a unique extent, organized around maximizing asset values and returns on capital independently of growth—in terms of corporate behavior, financial market incentives, and government and central bank policy. This may seem obvious or even tautological: what is capitalism if not a system aimed at maximizing returns on capital? But the disconnect that has emerged between returns on U.S. financial assets and underlying economic performance—and even corporate profits—over the last few decades should raise deeper questions about basic economic policy assumptions and their theoretical foundations. Insofar as rising asset values are not linked with growth or productivity—and at the very least it is clear that they can diverge for meaningful lengths of time—then not only are different policy approaches required to achieve these distinct objectives, but the larger relationship between capitalism and development will need to be rethought.

Market Returns Inversely Correlated with Growth

Contrary to the conventional belief that stock market returns go hand in hand with economic growth, empirical studies have long shown otherwise. Analyzing data across sixteen countries, including the United States, Jay R. Ritter found that GDP growth and stock market performance were negatively correlated.³ Similarly, a recent National Bureau of Economics Research working paper concluded:

From 1989 to 2017, $34 trillion of real equity wealth (2017:Q4 dollars) was created by the U.S. corporate sector. We estimate that 44% of this increase was attributable to a reallocation of rewards to shareholders in a decelerating economy, primarily at the expense of labor compensation. Economic growth accounted for just 25%, followed by a lower risk price (18%), and lower interest rates (14%). The period 1952 to 1988 experienced less than one third of the growth in market equity, but economic growth accounted for more than 100% of it.⁴

In other words, the link between equity appreciation and economic growth has been weakened in two areas. First, labor’s declining share of profits means that corporations can grow earnings even in a “decelerating” economy. Second, changes in valuation multiples can have a large impact on equity returns independent of any changes in earnings or overall economic growth.⁵ As I will argue, firms’ strategies to maximize valuations contribute to the declines in labor’s share of profits as well.

Although the expansion of valuation multiples has attracted comparatively little attention outside monetary policy discussions,⁶ changes in valuations go beyond interest rates and are often inversely correlated with overall growth. For instance, when capital is being allocated to greenfield growth projects, less is available for share buybacks or other cash returns to shareholders, removing near-term support for valuations.⁷ Even if incomes are rising and credit is expanding, businesses and households may be liquidating tradable assets in order to invest in more speculative and less liquid projects, depressing multiples on average.

Conversely, a corporate sector dominated by institutional asset managers and executives whose compensation is based on near-term equity returns is highly incentivized to engage in activities intended to expand valuations even if there is no impact, or a negative impact, on earnings. Such strategies include spinoffs that aim to “unlock” value simply by isolating business units expected to trade at higher valuations, or other forms of financial engineering like stock buybacks. At Apple, America’s largest company by market capitalization, operating income has barely changed in the last six years, yet its stock price has more than quadrupled, in large part due to $337 billion in buybacks. At the extremes, such behavior can harm growth by eroding a company’s long-term potential to generate earnings.⁸ Monopolies, certainly a strong presence in America’s concentrated economy, also tend to attract high valuations while harming overall growth.

Furthermore, during the last few decades, the U.S. economy has experienced a larger shift away from capital-intensive business activities (e.g., manufacturing) toward capital-light sectors (e.g., software and other forms of intellectual property). Asset-light businesses generally command higher valuations even if earnings (or cash flows) do not increase because they avoid the high capital expenditures needed to maintain physical assets; because they can often expand without large incremental capital investments; and because they likely have more flexible cost structures in downturns.

The contrast between recent S&P 500 P/E ratios and free cash flow yields (a metric which includes capital expenditures and other items that do not appear in earnings) is revealing. Although free cash flow yields have dropped significantly in 2021—to levels indicative of historically high valuations—they remained relatively high for most of the period since the financial crisis. This unusual combination of high earnings multiples and high free cash flow yields is consistent with a shift of earnings to asset-light businesses as well as weak capital investment more broadly, which in fact has been observed throughout this period.⁹ It also suggests that, with growth prospects low and cash returns to shareholders growing in importance, most stocks are increasingly trading like bonds.

An additional consideration is international capital flows. America’s trade deficit (which is not unrelated to its offshoring of capital- and labor-intensive sectors) must be offset by foreign capital inflows. These inflows add further support to asset valuations.

In sum, there are many factors that can cause asset valuations and economic growth to diverge. These factors appear in varying degrees around the world but seem especially potent in the United States, where their maximization has been systematically embraced as a business strategy.

Shareholder Value versus Profits: The Inadequacy of Economic Theory

The separation of asset valuations from underlying economic performance is perhaps the most conspicuous feature of the U.S. economy in recent decades, yet most economists and policymakers have failed to appreciate its significance. They refuse to ask a simple question: what if—instead of asset valuations and growth necessarily moving together—firms are being managed to maximize asset valuations separately from, or even at the expense of, growth, productivity, and other socially beneficial objectives?

Academic and policy discourse, in particular, tends to assume that the growth of asset values is straightforwardly driven by the growth of revenues and profits. This way of thinking is at least as old as Adam Smith’s description of the invisible hand:

As every individual, therefore, endeavours as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. . . . by directing that industry in such a manner as its produce may be of the greatest value he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.¹⁰

Today, however, any discussion of maximizing the value of production and the annual revenue of society sounds almost as quaint as capitalists naturally preferring to support domestic industry. Corporations instead seek to maximize returns to shareholders (which in practice usually means maximizing the value of the firm’s equity¹¹) and increasing profits is at best a means to that end. While deploying capital to grow revenues and profits may be the most intuitive way to increase equity values, it is hardly the only one. Rather than take the risks involved in expanding operations or developing a new product, it is often far easier for firms to simply reposition or financially reengineer themselves to realize a higher valuation.

Consider, for example, the case of IBM, which plans to spin off its IT infrastructure division this year in order to “focus on high-margin cloud computing.”¹² The move is being cheered on Wall Street because it is believed that the two businesses will be worth more as separate entities than as one. In particular, the remaining IBM cloud business should command a higher multiple once freed from lower-margin, slower-growing divisions.

IBM has followed this same playbook for years: “We divested networking back in the ’90s, we divested PCs back in the 2000s, we divested semiconductors about five years ago . . . ,” said IBM’s CEO, explaining the spin-off. As a result of this strategy, IBM’s revenues and net earnings are lower today than they were in 1998. But its stock price and P/E ratio are higher.¹³ (Notably, the company has also spent far more on stock repurchases than on any investment in its ever-shifting “core businesses” during this period, undercutting the stated rationale for these divestments.)

The point here is not that all divestments are bad or that all integrated businesses are good. The case of IBM does demonstrate, however, that shareholder value maximization (whether in a single firm or the whole economy) does not operate in the simplistic ways theorists usually imagine. Today’s shareholder-driven corporations are not necessarily—or even primarily—motivated to engage in the traditional methods of “growing a business.” Companies are often highly incentivized to pursue financial engineering and valuation multiple expansion, rather than investing to increase earnings. Eliminating profit streams can actually increase shareholder returns when the remaining company trades at a higher valuation—especially if share buybacks or other cash returns feature in the process.

Like Adam Smith, most of the neoliberal economists who promoted shareholder primacy and financialization took for granted that maximizing shareholder value meant maximizing profits and growth the old-fashioned way. Milton Friedman’s famous essay in support of shareholder primacy is titled “The Social Responsibility of Business Is to Increase Its Profits.” Friedman here did not even consider the possibility that firms might prefer financial engineering strategies to increase shareholder value, strategies that avoid the inherent risks and difficulties of growing profits.¹⁴ The business school professor Michael C. Jensen was far more sophisticated than the economist Friedman, and he understood shareholder primacy in the more precise terms of maximizing “total firm value.” But Jensen still equated firm value with the “long-term market value” of the firm’s “stream of profits”; he largely ignored the implications of the fact that markets value some streams of profits more highly than others.¹⁵

These issues are even more significant, if somewhat less visible, in firms’ internal capital allocation decisions. In theory, firms should invest in a new project whenever the expected returns on the investment exceed the firm’s cost of capital. In practice, however, firms have maintained “hurdle rates” considerably above their cost of capital; multiple studies have shown that hurdle rates typically exceed firm cost of capital by up to 7.5 percent.¹⁶ Moreover, hurdle rates have largely remained constant at around 15 percent for decades despite falling interest rates (and thus lowered cost of capital) in recent years.¹⁷

From the standpoint of economic theory, this represents an irrational refusal to maximize profits. But with regard to maximizing equity value, it is an eminently rational strategy. Lowering hurdle rates would mean investing in projects that might increase earnings, but which would likely degrade earnings quality. In other words, metrics like return on assets would deteriorate and valuation multiples would probably fall. Avoiding such investments—and instead returning cash to shareholders to further prop up valuations—becomes a preferable approach to maximizing shareholder value even if it forgoes substantial profit opportunities. But if the link between shareholder value and profits is severed, then the justifications for shareholder primacy—and much else in economic theory—collapse.¹⁸....

....MUCH MORE

Earlier:
"How Dematerialization Is Changing the World...."