In his recent speech on economic modelling, Fed Governor Meyer poured some much-welcomed scorn on the New Paradigmers, expressing scepticism that employment could remain much below 5% without causing problems and voicing doubts that the trend in productivity really had entered a sustainable upward trajectory. He also raised the issue of whether the latter could help explain stock prices.
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While the first is a shackle of Keynesian thinking, his doubts on the latter points are certainly understandable.
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Productivity is measured using several varying methodologies, from counting actual units produced, to deflating dollar billings, to totting up electricity usage. Further, hours are calculated from surveys and via econometric techniques which also derive estimates of hours-at-work from hours of paid work. The scope for errors in this confection of direct and indirect estimates is therefore large.
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Moreover, the numbers are prone to the distortions inherent in all aggregate statistics. For example, the simple fact of the increased weighting given to computers and semi-conductors of late is having a major impact on these deflated output numbers, as we have seen recently from changes to both the BLS estimates of GDP and the Fed's upward revisions to Industrial Production.
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Leaving that aside, Meyer suggests that, although unconvinced himself, if we were to accept that this new higher path is a reality, it would reduce the over-valuation of equities. His argument is that this would allow for a higher sustainable rate of earnings growth, reduce economic risk and thus justify a higher price/earnings ratio or, equivalently, a lower equity risk premium.
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Here we have to take issue.
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Increasing productivity is, it is true, the only route to increasing real wealth in an economy through its effects in reducing the cost and effort involved in satisfying existing wants and thus in freeing up resources for further enhancements and innovations. This, in a nutshell, is the basic Austrian-school theory of 'lengthening the productive structure' and is, of course, to be welcomed, but profits, much less profit growth, do not come into the picture. In an economy in dynamic equilibrium, the 'evenly rotating' economy of von Mises, the state to which all free markets tend, though never attain, there is no room for the universal production of profit.
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True, entrepreneurs at an individual level strive to make returns over and above the cost of capital by attempting to gauge future wants more successfully than their fellow men and increasing one's own productivity vis-à-vis one's competitors is, temporarily at least, a way of enhancing the chances of success. However, only some entrepreneurs succeed and reap the rewards of their foresight, while others misjudge the market and fail. It is a matter of first principles, that not all businesses can outperform simultaneously and continuously in this manner. To believe so is to subscribe to the Deep Purple school of thought - after the seventies heavy rock band of that name where the lead singer asks at a sound check whether he can have 'everything louder than everything else!'
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As John Stuart Mill pointed out as far back as 1830, '..the calculations of producers and traders being of necessity imperfect, there are always some commodities which are more or less in excess, as there are always some which are in deficiency. If, therefore, the whole truth were known, there would always be some classes of producers contracting, not extending, their operations. If all are endeavouring to extend them, it is a certain proof that some general delusion is afoot..'
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As he went on to note, the most typical such delusion, of course, is our old friend the credit expansion, a theme which should need no further exposition here!
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The Internet Revolution may be slashing prices in the High Street, by effectively compressing the roles of retailers and wholesalers and extending the just-in-time inventory system down into the consumer sector, but even here there is no guarantee that this will lead to increased profits for any particular enterprise and there are definitively no grounds for believing that the Dot.Coms en masse will benefit.
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As the attached graph shows, profits in America in the last 40 years have averaged some 9% of GDP (pre- tax with inventory adjustment) and while this ratio has occasionally stretched to a little over 11%, this pool of income cannot grow at a faster pace than the economy as a whole over any length of time. True, in a globalized market, US businesses may eat into the profit share of other nations and the most recent numbers show some evidence this was occurring (though this may reflect M&A activity as much as anything), but they also showed domestically generated profits to be essentially stagnant. It should also be noted that most other major international stock markets are also at or near record highs so this simple case of robbing Pierre to pay Paul cannot really be the explanation here.
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That the Nasdaq composite, a universe of 4,756 stocks accounting for roughly $4.3 trillion in market cap - or around a sixth of an entire IFC world index itself at historically elevated levels compared to world GDP - can trade at a multiple 10 to 15 times the long term valuation attached to such aggregates defies all logic.
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This phenomenon can only be the result of a world awash in central bank-sanctioned liquidity. This is, naturally enough, encouraging real, tangible investment of course, from which some benefits will accrue even if the process will ultimately be revealed as wastefully sub-optimal, possibly disruptive, once the bubble bursts. As Greenspan put it in one of his increasingly rare moments of lucidity in the infamous Boca Raton speech, ' ..for capital investments to be made, the prospective rate of return on their implementation must exceed the cost of capital. That has clearly happened in the last five years. ' (Our italics).
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It is also, more directly, fuelling stock prices without regard to 'fundamentals' amid the ever more frenetic turnover. On this point, note that Nasdaq volume has averaged an incredible 1.2 billion shares a day since mid-October, with last week's total was a full 62% higher than a year ago, as prices have mapped out their vertiginous ascent.
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If you accept the above contention, the equity risk premium should be higher, not lower, since the credit cycle is the driver par excellence of economic fluctuations and if the events of the last four years have taught us anything, they should have taught us that the credit cycle is has gained enormously in amplitude and frequency this decade - to the point of uncontrollability.
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It is not the physical increase in goods-per-hour we should be concerned with, but the financial sector's greater efficiency in pumping out credit. This is the true structural change Governor Meyer should incorporate into his modelling. With the Fed still running the printing presses and selling hundreds of billions of liquidity options ahead of year-end, the short-term dynamic is clear. Quite when the music will stop is unclear, though the first few 2000 will be crucial to the Big Bull Market if the post-Y2k Fed finally begins to make credit less lavishly available and not just marginally more expensive.
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We may not know precisely when the piper will present his bill, but it is guaranteed to be a large one and he is unlikely to accept payment in stock options!