Perception of Scarcity and the Equity Shortage: Continued
The Hidden Equity Shortage
A Question Of Direction
The question is not so much whether government guidance of investment is advisable, but rather the direction of this guidance and the form it takes.
A useful discussion is not whether government should be involved in economic decisions, but rather how this involvement should occur and what goals should be set.
Adam Smith considered government essential for capitalist society.
Adam Smith recognized the importance of the role of government in economic development.
He believed that government should make investment in public works such as roads, bridges, canals, and harbors, and especially education.
He considered government essential for capitalist society and said,
'It is only under the shelter of the civil magistrate that the owner of that valuable property, which is acquired by the labor of many years, or perhaps of many successive generations, can sleep a single night in security.'
Smith did not believe that an 'invisible hand' would align economic activity with the best interests of mankind.
In fact, he had a rather dim view of business people. He wrote:
Another bad effect of commerce is that it sinks the courage of mankind, and tends to extinguish martial spirits. In all commercial countries the division of labor is infinite, and every one's thoughts are employed about one particular thing. The minds of men are contracted, and rendered incapable of elevation. Education is despised, or at least neglected, and heroic spirit is utterly extinguished.
Bacchanalian Economics
Nevertheless, by the millennium, commonsense lessons of the past had been quietly set aside for the heady, bacchanalian economic celebrations of the last hours of the Great Bubble.
Who could doubt that equity prices did not reflect real worth, rather than scarcity, now that the Cold War had been won and that economists had found the Virtuous Cycle in liberal democracy?
Irrationality was cloaked in abstruse mathematics and the prestige of Great Universities.
It seemed to be, as Francis Fukuyama noted, The End of History.
However, an imbalance in the supply and demand for equities was indeed the driving force in the Great Bubble, even though the scarcity of stocks was not perceived by investors and irrationality was cloaked in abstruse mathematics and the prestige of Great Universities.
The Importance of Perception
In capital flow analysis, we must try to understand investor motivation and strain to see things from the viewpoint of market players.
Their perception of value is the reality with which we must deal.
The Great Bubble would never have occurred if investors had perceived that there was a shortage of equities.
Without a perception of scarcity, the Bubble goes unpricked.
A normal reaction to a perceived shortage is to substitute something else for that which is over-priced.
During the 1990s, if investors had understood that stocks were too expensive for their retirement needs, they would have transferred their assets to bonds or real estate, ending the bull market at the usual high water mark of twenty times earnings.
Without a perception of scarcity and the sensation that prices are beyond one's budget, there is no substitution effect and the bubble goes unpricked.
Price Itself, Not Sirloin
Meat-eaters easily note when there is a shortage of steak, because the slice on their platter shrinks as prices rise.
Tight budgets eventually force them to switch to potatoes.
For Lesser Fools, price is the product.
With stocks, however, investors' appetites may be fed by price itself, rather than by more ounces of sirloin.
Rising prices satisfy the seekers of capital gains.
For Lesser Fools, price is the product.
Part of the explanation of the Great Bubble is that Lesser Fools, like fungus in a damp, dark cellar, prospered and multiplied, eventually taking over the economic environment, as Mr. Dividend faded into history.
The delusion of these Lesser Fools was fortified against a return of commonsense by steady and readily available inoculations of mathematical quackery, administered by doctors of economic science at the Great Universities, under the aegis of the Nobel gods.
After the 1970s, these anti-dividend heresies grew and flourished, promising to confound capital markets and the perception of equities for years to come.
Market Measures of Scarcity
It is impossible to determine with precision the extent of the shortage of equities in the U.S. market.
However, a ballpark estimate would be useful in trying to understand the extent of the problem.
This helps to establish whether the phenomenon is short-lived and possibly self-correcting, or endemic.
The supply of equities must be counted in terms of corporate profits.
While the supply of steel may be measured in metric tons, the supply of equity must be counted in terms of profits that back up tradable securities.
In the long-run, stock investors are buying a claim on future profits which is most likely, in some way, related to current profits.
As new investors come to the market, additional corporate profits are necessary to support the demand for a new supply of tradable stocks.
Over the last fifty years, the number of Americans investing in equities has increased ten-fold, due to strong marketing and tax incentives.
As new investors have entered the market, corporate profits should have expanded to fill the growing demand for investment value.
Three Measures Of The Market
We may estimate the apparent shortage of equities, relative to market prices, by using three numbers:
Current Size of the Equity Market. The Wilshire 5000 index shows the size of the U.S. equity market. This index measures the market capitalization of about 5,700 stocks traded on the NYSE, AMEX, and NASDAQ.
In June 2003, this calculation showed market capitalization of the equity supply to be $11.3 trillion.
The equity market was priced at about $11.4 trillion (2003)
The comparable figure from the Federal Reserve flow of funds accounts (Table L.213) was $11.4 trillion
(This does not include direct investments by foreigners, mutual fund shares, or stock of S-corporations, but does include privately-held companies, not part of the Wilshire 5000 index.)
The Federal Reserve notes to the flow of fund tables indicate that most of this equity figure refers to stock traded on the NYSE, AMEX, and NASDAQ.
This suggests that the volume of non-publicly-held corporate stock is relatively small (about $100 billion) and that there are dwindling sources of domestic equities to be brought to market.
Profits Currently Backing Up the Equity Market. On June 30, 2020, the price-earnings ratio of the Wilshire 5000 index was 23.6.
The U.S. equities had a claim on about $480 billion in profits.
This implies that the earnings of companies included in the index (almost all traded stocks) amounted to $478 billion dollars ($11.3 trillion divided by 23.6).
This is consistent with the Federal Reserve's estimate of after-tax corporate profits for 2003 of $484 billion (Flow-of-Funds Table F7, National Distribution of Income) because this larger amount includes profits of privately-held corporations.
The Long-Term, Equilibrium, Price-Earnings Ratio. For two hundred years, stocks on the American market have varied in price from ten-times-earnings to twenty-times-earnings.
The break from this pattern occurred in the mid-1990s, during the Great Bubble, when price-earnings ratios soared beyond thirty-times-earnings.
Professor Jeremy J. Siegel of the Wharton School of Business has calculated the long-term (1871-2001) average price-earnings ratio of stock in the U.S. market at 14.4 times earnings.
In 2003, corporate profits fell $282 billion short of the amount needed to justify the historic price-earnings ratio of fifteen.
Professor Siegel determined the average price-earnings ratio for the period 1946-2001 to be 15.3 times-earnings.
Since taxes and the quality of reported earnings have varied considerably over the decades, there is no point in being too precise and fussy in indicating a long-term, equilibrium, price-earnings benchmark to use when estimating the shortage of equities.
A price-earnings ratio of fifteen would be a reasonable benchmark.
(See: 'Equity Risk Premium Forum, November 8, 2020' , Historical Results I, Jeremy J. Siegel, Wharton School of Business, Philadelphia, Summary by Peter Williamson, Amos Tuck School of Business Administration, Dartmouth College. Published on the Internet in pdf format.)
If the $11.3 trillion in market capitalization of equities in mid-2003 were to be fairly valued, based on a long-term equilibrium price-earning ratio of fifteen, traded companies, as a group, would have to earn profits of $760 billion each year.
This is $282 billion more than all public issuers earned in 2003 and gives a measure of the shortage of equities relative to market prices.
Growing Out Of A Shortage
Professor Siegel showed that real corporate earnings grew about two percent annually during the last half of the twentieth century.
If the $478 billion dollars in profits that supported the 2003 stock market were to grow at this historical rate, compounded, for twenty-five years, i.e., until 2028, American issuers would then be producing the $760 billion, in real terms, needed to justify 2003 prices at fifteen-times-earnings.
This assumes that supply, demand, and prices remain steady for a quarter of a century.
In 2003, it was unlikely that corporate profits would grow fast enough to compensate for over-pricing of the Great Bubble any time soon.
In other words, it seems unlikely that corporate profits could, in a few years, grow fast enough to compensate for over-pricing of the Great Bubble.
By 2028, baby-boomers will be dumping stocks in their 401(k) and IRA plans to comply with tax laws and the need to pay retirement and medical bills.
Wall Street promoters are eager to convince investors of the validity of the Efficient Market Hypothesis, renouncing traditional values and rational ties between corporate profits and market prices.
If the fair value of equities is measured on the basis of long-term, benchmark, price-earnings ratios and reasonable expectations of earnings growth, brokerage firms will shrink for a generation and luxury houses in the Hamptons will go begging, as the nation reels with acute indigestion from a diet of over-priced stocks acquired during the Great Bubble of the 1990s.
Shortage Relative To Market Price
Another way to interpret the scarcity of stocks would be to suppose that new securities had been steadily offered throughout the last twenty years of the century, so that by mid-2003 the market capitalization of $11.3 trillion would be backed by companies earning $760 billion.
This would put stocks at a reasonable level in terms of the long-term, price-earnings benchmark.
The $282 billion dollars in extra profits, at fifteen times earnings, would have to be represented by a block of stock with market capitalization of $4.2 trillion.
Relative to 2003 prices, the shortage in equity supply was about $4.2 trillion.
This suggests that, with respect to mid-2003 prices, there was a $4.2 trillion dollar shortage in equity supply.
This way of measuring scarcity is relative to market price.
At the peak of the Great Bubble, the apparent shortage would have been even greater.
On the other hand, if prices were to fall 36% from mid-2003 levels, market capitalization would then be only $7.1 trillion dollars, low enough to merit a price-earnings ratio of fifteen.
The shortage would have disappeared, along with $4.2 trillion of investors' net worth.
Flow of Funds Deficits
There are other ways to address this question.
We may gauge the shortage of equities from the Federal Reserve flow of funds table F.213 (Corporate Equities) over the last quarter-century.
This table shows net annual changes in equity positions held by various institutional investors (mutual funds, closed-end funds, pension funds, banks, trusts and estates, and broker-dealers), along with changes in U.S. stock portfolios of foreign investors.
Institutional and foreign demand for U.S. equities exceeded new issues by $3 trillion (1975-2002).
Fluctuating demand for equities is compared with supply: the net issuance of stock by domestic and foreign corporations.
The difference between institutional demand and issuer supply is assigned to an account called Households – individuals holding stock directly.
The net flows over the 28-year period, 1975-2002, may be summarized as follows:
Net Stock Offered by Issuers (1975-2002) Net Institutional Investor Purchases Net Foreign Investor Purchases The difference between investor demand for stock and the negative amount issued (net buybacks of $146.5 billion) was $3,029.6 billion.
This shortfall is registered as net sales by individual U.S. investors (Households).
Since the price-earnings ratios of stocks tripled during this period, from ten to thirty times earnings, it is clear that demand from institutions, foreigners, and corporate buybacks far exceeded the supply of existing shares that individuals were willing to sell.
Furthermore, individuals were the force behind institutional demand, since most of the increased holdings of mutual funds and pension plans represented new, tax-deferred savings from IRAs, 401(k) and Keogh plans, and variable annuities.
Buybacks and Bogus Patriotism
The breakdown of net equity issues, between foreign and domestic companies, indicates the impact of buyback programs over a quarter of a century:
U.S. Domestic Buybacks (Net) Foreign New Issues (Net) Net Stock Issues (1975-2002) This table exposes the bogus patriotism of Wall Street brokers who argue that not buying equities on the NYSE would be to 'sell America short'.
On balance, during the last quarter century, these brokers have engineered net redemptions of over one trillion dollars in American equity, while raising well over eight hundred billion dollars (net) to create employment in foreign countries.
Households Sold Stock
Flow of funds table F.213 (Corporate Equities) shows that U.S. households sold, on balance, $3,029.6 billion from 1975 to 2002.
Individuals took $1.1 trillion out of the stock market (1975-2002)
However, all of this money was not taken out of equities; some was reapplied through institutional investors.
From flow of funds table F.100 (Households) we find net reinvestment of individuals in equities through institutions to be $1,906.2 billion, broken down as:
Mutual Funds Life Insurance Pension Funds Bank Personal Trusts If households sold $3,029.6 billion in direct holdings of equities over the years 1975-2002 and reinvested $1,906.2 billion indirectly through institutions, this implies that individuals took a net $1,123.4 billion out of the stock market for other purposes (purchase of real estate, bonds, personal spending, and so forth).
Tracing Indirect Investment
The amount reinvested in stock is found by tracing the amounts that households invested in each type of institution and then, from other flow of fund tables, finding the amounts that these institutions invested in equities:
Mutual Funds Life Insurance Pension Funds Bank Personal Trusts From this we can see that deferred investment programs marketed by mutual funds and life insurance companies constituted the principal demand for equities during the last quarter of a century.
Much of this money was on automatic pilot, representing investment through payroll deductions in 401(k) plans.
Smarter Investors Sold Stock
The above table shows that pension funds and personal trusts managed by banks were neutral or net sellers of stocks over the period 1975-2002.
This implies that smarter investment managers, reporting directly to beneficial owners, were put off by the price of equities.
Private pension funds reduced their positions in equities by $328 billion from 1975 to 2002.
In fact, data on investment in equities by pension funds shows that, if it were not for pension plans of state and local government employees, pension funds as a class would also have been net sellers.
Private pension plans sold, on balance, $328.8 billion in equities during the years 1975-2002.
This explains why the withdrawal of government pension funds from equities in the first half of 2000 signaled the impending crash in equity prices.
The increase in foreign issues together with the withdrawal of government pension plans from the equity market tipped the balance and sent prices downwards.
Observers watching only mutual fund sales or stock buybacks would have failed to see this critical aspect of the big picture. (See also: Case Study: USA 2000 )
Equity Flows: The Big Picture
The following diagram charts the major forces that drove U.S. stock prices during the period 1975-2002.
The two-trillion-dollar demand for equity from institutions was not matched by an equivalent value in new equities from issuers.
The demand was met by the transfer of equities at inflated prices from private investors, allowing individuals to take over one trillion in cash out of the market, while U.S. issuers were buying back and canceling one trillion dollars in capital stock.
Buying stock from individuals does not supply capital to new enterprises that produce additional profits.
The rise in price-earnings ratios shows that the remaining stock simply did not earn enough to satisfy the increase in demand from long-term savers.
Buying stock from individuals does not supply capital to new enterprises that produce additional profits.
We have seen that by using a long-term price-earnings ratio of fifteen as a benchmark, the incremental supply of equities needed to justify prices in mid-2003 was about four trillion dollars.
From the flow of fund accounts over the years 1975-2002, we find that the unmatched institutional demand for equities was on the order of two trillion dollars.
A shortage of about $3 trillion in equities drove the Great Bubble.
It is not possible to determine exactly the shortage of equities that drove the Great Bubble, but from these two ways of looking at the problem, we can estimate that an amount of around three trillion dollars, give or take a trillion, would reasonably represent the shortage of equities.
The amount is so great that it is unlikely that American companies will be able to earn their way out of the hole in a short time.
Essay: continued >
