Inside the crash of ’18: What went wrong

 

The market has taken a few hard knocks in 2018, and unlike in previous years, it hasn’t bounced back quickly. Rather, it’s been staggering to its feet looking dazed and wobbly-kneed. The problem is, there’s no standing eight count in this game, so it keeps getting pummeled, again and again. The market is now down 9% from its high, and based on valuations, stocks are still priced at the very high end of acceptability. To put things in context, the market only fell as dramatically as it did because it had spiked so high, and it is only down 3% year-to-date. That’s worrying in another way, however. Bull markets almost always end in a euphoric blowout, the likes of which we saw in January.

As for the valuation problem, we already know relief is on the way. The huge Trump tax cuts are about to start hitting corporate profits, and that’s what it’s all about. For this, and various other reasons, I don’t think the party is over just yet, but I do believe the end is coming, and there’s very little chance of a soft landing. Income equality continues to increase, and along with crippling debt and the higher interest rates they bring, that will have a serious detrimental effect on spending and throttle the economy as it always has in the past.

What went wrong? I think you know.

The super-rich apparently gained 82% of the wealth created in 2017. Many people want to know how and why this happened. Wall Street didn’t give the news much play, but investors should have been among the most concerned.

Net income of S&P-500 companies has been rising rapidly. It is now around $289 billion annually, having first risen above $200 billion just 12 years ago. Despite this, real unemployment has remained high and the jobs the economy is creating don’t pay nearly as well as the jobs that were shed in the great recession. It follows, beyond doubt, that in the past fifteen years or so, S&P-500 companies have been wildly successful at holding down labor costs. That’s because they have been spending some of their record profits on automation and computer technology. Robots eliminate the need for blue collar workers, and ever-more efficient information systems eliminate the need for white collar workers.

Also, S&P-500 companies are making so much money, that they are now using a full half of all their profits on share buybacks. Share buybacks are not dishonest, but at their current, historic levels, they are problematic. Every dollar poured into share buybacks is a dollar that is not returned to the consumer in the form of wages, not spent on R&D, not spent on expansion of facilities, not even spent on acquisition. True, there have always been dividends, but they are antiquated relics of a time when ordinary workers—the sort who might find a little extra money useful—owned stock.

The percentage of Americans who now own stock is far lower than it was 20 years ago, and 10% of investors own 84% of the stock, (warning: the source for this information, Time.com, has not been officially approved by the 10% of Americans who own 84% of the stock). These people don’t want a check in the mail, especially not one that’s taxable. Taxes go toward the maintenance and betterment of society, and sharing money with society would defeat the whole point of siphoning money away from society for the maintenance and betterment of themselves. They want all their money to expand, tax free, into a lot more money, and with share buybacks, that’s what they get. At the end of the day, it’s the one way a company can spend its money that has absolutely no positive collateral economic effects—the owners of the company receive 100% of the benefit.

Now ask yourself, all other things being equal, what will higher corporate profits do in this situation?

First, they will probably increase corporate spending on automation and technology, which are probably negative (neutral at the very best) for jobs and wages. Second, they will most definitely increase spending on share buybacks, pushing stocks higher and making the super-rich even richer, on paper. Why just on paper? Because if record profits weren’t making their way to the consumer, record profits plus ten percent won’t reach the worker either, and the worker is also the consumer. Rising profits appear, but they aren’t coming from spending (unless it’s on credit), because consumers don’t have the additional cash to spend. Earnings per share are going up, but because they are being jiggered up by buybacks and tax cuts, which lead to more buybacks. In other words, it’s window dressing. It’s fake. The last time we created such gobs of fake wealth in this country was back in the late 1920s. As you may recall, that ended badly.

And yet, we have decided to spend trillions of dollars more on the thing we can clearly see isn’t helping—corporate profits. That’s all we’re going to get for mortgaging our future. It’s hard to say what we might have more advisedly done with that money, since the debt itself is almost certainly not advisable or even sane. If we had a Bush in the White House, we could have used the cash to fight the Iraq war, or some equally fulfilling war, four more times.

We could also have spent it to pay every dime for the health insurance of the 50 million neediest Americans for the next 20 years. (Private amount spent on healthcare by individuals = $4K. Multiplied by 50 million people = 200 billion. Four trillion divided by 200 billion = 20.) Such spending would have, incidentally, added to corporate profits and driven up the stock market. It would have made the super-rich richer, as almost everything does, but it would also have kept alive or greatly improved the lives of 50 million people, and that seems to be where it becomes unacceptable. Instead, all this money (minus a few hundred billion for Lockheed Martin and pals) will be spent directly on corporate profits. It will be spent purely, mostly through tax cuts, with no intervening or collateral benefits to any person, to any group, or even to the economy.

But surely it’s a good thing that the stock market is going up, right? The rich spend money just like everybody else, right? Wrong. The higher on the economic food chain that money is created, the less economic activity it produces. Give a hungry man five dollars and he’ll spend it within five minutes, creating an economic cascade, but give five-hundred-million dollars to a guy with more money than he can spend, and it may not go anywhere for a long time. The variable here is called the “velocity” of money, and simple rule of thumb is that amount of money times velocity of money equals economic activity. It’s because of its low velocity that the huge amount of money spent earlier this decade on bond buybacks didn’t have much effect on the economy. When there’s nothing left to buy, you don’t buy anything—you just horde. On paper, it looks like the super-rich have become even richer compared to the poor, middle class, and the minor-rich, but that’s not much of a win for them, since after a certain point, they are really only competing against the other super-rich anyway.

What’s more problematic by far is that our country just massively increased its already enormous debt in such a way that the spending has no real chance of benefiting any Americans other than the richest techno-financial-industrialists. As for them… it’s hard to figure out why they would even want this. It should be obvious that a paper-wealth boom today leads to a paper-wealth bust tomorrow. As for the rest of us… it’s hard—very hard—for me to understand why we have now chosen, apparently without reference to any previously held liberal, neutral, or conservative economic theory, to give them their selfish, ill-considered, and potentially ruinous way.

Julian Close

Julian Close

Julian Close became a stockbroker in 1995. In his 20 years of market experience, he has seen all market conditions and written about every aspect of investing. Julian has also written extensively on corporate best practices and even written reports for the United Nations. He graduated from Davidson College in 1993 and received a Master of Arts in Teaching from Mary Baldwin College in 2011. You can see closing trades for all Julian's long and short positions and track his long term performance via twitter: @JulianClose_MIC.

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