This year has seen high after new high in US stock price indexes and this comes on top of a run that dates back to March, 2009. There was a time when rising stock prices with or without rising earnings would attract a crowd of eager investors wishing to join the momentum.
But today, like so much else in economics and finance it seems to be working upside down and backwards. As the WSJ recently put it, “Earnings drive latest (price) leg, but money has been flowing out of stock funds.” While, it’s hard to image rising prices if money is actually flowing out, but judging from today’s anecdotal comments, confidence is certainly flowing out.
So as Yogi Berra, the erstwhile New York Yankee catcher and the King of malapropisms would likely ask, what Déjà Vu All over Again are investors seeing?
Well today’s baby boomers, with the majority of investable wealth, have been around long enough to have lived through the tech boom and bust, the dot.com boom and bust, the oil boom and bust and don’t forget the housing boom and bust and that’s within the past twenty years. And there are more as there have been 11 post-WWII cyclical recoveries that end in the next recessionary induced dips in stock prices.
The signaling device they are employing seems to be stock price prosperity is followed by recessionary events and if not, surely falling equity prices. Stock market enthusiasm has become a signaling device to get out and historically there is some justification.
This mechanism has occurred many times as cyclical expansions ultimately become more expensive for producers to produce additional output and hence reduces profit margins and total profits. This would occur when labor becomes scarce and expensive while worker output at the margin declines when adding labor faster than machines. The implication of rising wages and poorer labor productivity at the tail-end of a cyclical expansion is an increase in the cost per unit produced hence depressing profit margins and total profit.
So cyclical tail-end expansions have been the breeding ground for stock market reversals and many stock market “veterans” of this phenomena are reliving the nasty experience.
But funny things are happening these days so this might not be typical at all. After the weak but lengthy cyclical expansion from the depths of the Great Recession, earnings are not declining for the leading and most highly weighted areas of the market. At least judging from the last two quarterly corporate earnings reports both profit margins and total profits are generally rising.
This is not the usual happening at this stage of the cyclical expansion and to boot we are not getting the usual late cycle inflation when producers try to pass along the higher costs of production to consumers in the form of higher prices.
Instead, inflation keeps going lower and lower.
So we have a mature cyclical expansion but yet rising profit margins along with declining inflation!
So how can that happen?
Well, let’s see…The backbone of the “typical” expansion is a demand driven uplift with relatively slow motion improvements in supply capability. Today we have the opposite. Supply capability is moving forward faster than demand so markets clear at lower prices. Such a condition would be more visible and recognizable if the supply capability were the result of some new and improved technology with a substantial viewable physical presence as it has been in other episodes of revolutionary economic change. These are often referred to as creative-destruction episodes which in today’s parlance is being called disruptors and the disrupted.
The leading historical examples of the creative episodes is perhaps the steam engines era of the 19th century. It was first applied to shipping, then to the “iron horse” locomotive and then to machinery driven production. Another great transformer to production and efficiency was electricity being the driving force of assembly-line production and yet another was the internal combustion engine that relegated the horse and carriage to the scrap heap of transportation.
A more recent example is the “tech boom” that started with the large mainframe computers and branched out decades later to the personal computer.
And now the creative-destruction process is flying under the radar screen via the now ubiquitous but unimposing handheld device most every consumer carries in their pocket and enables the user to search the globe for the best deald possible and have it shipped to them.
This is a bona fide reason for supply curves in so many industries to be shifted downward and outward generating lower market clearing prices along with higher profit margins. In this case the lower business costs are due to economies in marketing, distribution and payments.
The new tech that is reshaping businesses and business efficiency is perhaps best explained by what was describe to me as a joke. Well, you decide whether it is funny!
A pizza customer calls his favorite local pizza parlor and asks: “Is this Mike’s Pizza?
Pizza Operator: “No, sir, we are now Amazon Pizza. Do you want your usual”?
Customer: “How do you know my usual?”
Amazon Pizza: “Well sir, our records indicate you ordered pizza with pastrami and thick crust for your last seven orders. Do you want that?”
Customer: “Well, ok”
Amazon Pizza: “Sir, could I suggest you add some vegetables, this time”
Customer: “Why do you say that, I hate vegetables?”
Amazon Pizza: “Sir, by cross matching phone numbers we find that your medical records indicate you have a cholesterol problem.”
Customer: “I don’t need vegetables, I take anti-cholesterol medication”
Amazon Pizza: “But sir, we see that you have not reorder your medication in 4 months”
Customer: “To show you how much you know, I recently purchased over- the-counter cholesterol medication.”
Amazon Pizza: “But sir your credit card shows no such charge.”
Customer: “To show you how little you know, I paid in cash.”
Amazon Pizza: “But sir, your bank account shows no cash withdrawals in some time but our location finder on your IPhone indicates you are at the corner of 4th and Main and our drug distribution center is only a half a block down Main. Would you like me to order the medication to be ready for your arrival?
Customer: “This is too much. I am being hounded and spied on. Where is my privacy? I want to leave the country!”
Amazon Pizza: “Sir, I’m sorry to inform you, your passport expired five months ago, but if you go on our web site and click “Renew” we can have it processed and delivered to you within 5 days for only $50.”
This is marketing and distribution in revolution. Go on either Amazon or a search engine such as Google and do a search for a totally generic item, like aspirin.
Well the aspirin producers pay for being at the top of the list and this is not a revolution in production or product development but in marketing, distribution and payment, which are significant business expenses. The manufacturer cuts costs and increases profit margins and the third party online delivery service generates profit for performing these functions.
And recently, Amazon has applied in twelve states for wholesale drug distribution licenses and the Wall Street reports it is in talks to purchase a major drug retailer to drive the buying to their own outlet for another slice of the profit. It won’t stop at Whole Foods!
So your IPhone started out to be a revolutionary way to keep track of your kids but now it’s become the means by which your suppliers keep track of you and all your tastes and wants and payment means. This is called “big” data.
This is a marketing and distribution revolution. There will be survivors of the changes who will profit from them and there will be new devises (and their producers) such as driverless cars, lockers, and drones that will do the actual distribution.
Books, newspapers, music, golf lessons and education have already been impacted as content is delivered via your handheld device leaving many traditional purveyors out in the cold. And those left out are seen on the landscape as it includes traditional retail shops and the shopping malls they inhabited.
We are only at the beginning of sorting out who will be the successful disrupters and which of the disrupted face extinction in this new industrial revolution— but stock investors placed with disruptors will be the real winners here.
So who will those winners be? As the great Yogi Berra said, “It’s tough to make predictions, especially about the future.” But we know that the disruptors are adding to and redistributing profit at this late stage of the housing cyclical recovery and its generating fresh enthusiasm for the stock market outlook.