There is a growing disconnect between the real economy and equity valuations that, if sustained, will result in slower growth and increased regulation of the investment industry. And that, in turn, will further undermine the legitimate underpinnings of capitalism.
The link between the two is broken because of a changing market structure, a concentration of wealth and powerful network effects that feed into the winner-take-all economy.
If equity markets continue to defy gravity without a meaningful recovery on Main Street, the legitimacy of capitalism itself will come under scrutiny.
While there is nothing wrong with traders and investors profiting from timely and smart speculative activity, the growing disconnect between the economy and equity markets is going to cause increased social tensions.
Not only is there a significant risk of another market crash, but if equity markets continue to defy gravity without a meaningful recovery on Main Street, the legitimacy of the market and capitalism itself will come under further scrutiny. The result would be an extended period of over-regulation that dampens both markets and the economy.
One of the primary explanations for rising equity valuations amid the damage wrought by the pandemic is the narrowing of listed firms. The number of publicly listed firms peaked at 8,100 in 1997 and declined to 4,397 in 2018, according to World Bank data. And a recent New York Times analysis indicated that the number has declined further, to roughly 3,600 in 2020.
That narrowing leaves a greater number of investors with a large quantity of cash chasing the returns of fewer firms; the result is a winner-take-all system that intensifies the concentration of wealth in fewer hands and leads to greater economic inequality.
Negative feedback loop
The winner-take-all nature of an economy distorted by mispriced valuations only fosters powerful network effects that distort competition. This in turn, creates significant barriers to entry and imperfect market conditions that lead to monopsony or monopoly pricing in many parts of the economy.
That concentration of wealth introduces a negative feedback loop into the economy resulting in a misallocation of resources away from the most productive and profitable firms.
If the well-being of those in the real economy does not improve, market participants will have far more to worry about than rising government spending.
The distortion of that signaling mechanism results in lower productivity, weak job creation and wage growth and reduced overall economic activity. That should sound familiar for those who have been paying attention during the past decade or so of unequal growth in the domestic economy.
Equity sales people and strategists would counter that this is a natural function of capitalism and policies put in place over the past decade. Equity markets are simply the beneficiary of the $3 trillion expansion of the Federal Reserve’s balance sheet and a global flight of capital into domestic markets caused by the coronavirus crisis.
Slick market pundits would also point out that the heavy weighting of technology and bio-pharma firms in the S&P 500 and the Dow Jones Industrial Average has also contributed to rising valuations during a time of mass unemployment. After all, COVID-19 is not going to stop the rollout of 5G, and in fact it may cause an accelerated integration of advanced technology into the production of goods and provision of services.
But that does not negate the fact that the S&P 500 employs only about 10% of the total domestic workforce, which vividly illustrates the disconnect between equity markets and the economy.
Following the unexpected increase of 2.5 million jobs in the May employment report released Friday, many declared that the market, with its rising valuations, was correct and that a V-shaped economic recovery is just over the horizon.
Maybe not. With the savings rate at 33% and personal income excluding government transfers collapsing at a 6.3% rate, that V-shaped recovery and rising equity valuations both look quite suspect.
The cost of the disconnect
One gets the sense that the more market pricing diverges from fundamental economic and commercial conditions, the greater the risk that there will be a significant upset across financial markets followed by a large overreaction by the policy sector and an extended period of over-regulation.
Of course, the optics of Wall Street prospering while Main Street flails will only enhance the idea — unfounded in my estimation — that the financial economy is fixed and favors those that can pay for access, inside information and influence.
Should the long-term well-being of those who live and breathe inside the real economy not improve in what will most likely be an elongated and frustratingly slow recovery, market participants will have far more to be worried about than rising government spending.
When one looks at an economic landscape of 21 million unemployed, an underemployment rate of 21.2%, 110,000 dead because of the pandemic and civil unrest in 350 of the 390 major metropolitan areas of the United States, one gets the sense of an American condition that is disconnected from the euphoria that is sweeping the narrow corner of the country that describes the investing class.
For more information on how the coronavirus is affecting midsize businesses, please visit the RSM Coronavirus Resource Center.
