Saturday, August 13, 2011

Earnings Yield Divergence & Market Distortions

Felix Salmon asked a question of his readers today. He wanted help in trying to understand what's behind the spread blowing out between the 10-year treasury yield and the stock market's earnings' yield (which is earnings divided by stock price). Since the mid-1970s both yields have tracked each other very well, but recently they've begun to diverge. Prior to the mid-70s however, there was almost no correlation between the two (as Jake over at EconompicData points out) and so I've reproduced Jake's chart below.

There are two things to understand about Jake's chart. First of all, prior to the mid-70s Harry Markowitz and Modern Portfolio Theory had yet to make an impression on portfolio managers. Markowitz first published MPT in 1959, but it would take a decade for it to find traction, acceptance and assimilation with money managers. But once it found acceptance it was so widely implemented that the 10-year and E/P yields tracked each other nearly perfectly until 2003. But before I address the issues behind the divergence since 2003, let me first explain MPT.

MPT is a mathematical system that described the fundamentals of pricing and asset selection for a portfolio that most money managers take for granted today. MPT proved the benefits of diversification and, in a mathematical way, showed there was a direct, linear relationship between perceived risk and return (MPT says that an investor will require another 'unit' of return for taking on another 'unit' of perceived risk). And, as I mentioned, MPT became the bedrock foundation of portfolio management in the 1970s, and Jake's chart clearly shows that. But since 2003 those yields have blown out. Which means that either investors have roundly abandoned MPT and effective asset allocation, or something else is at work. First of all, here's a reproduction of Felix's chart showing the divergence from 2003 to now:

As I said, this chart shows a dramatic shift away from MPT starting in 2003 and Felix wonders why. Has MPT been discredited? Have investors and asset managers become increasingly more risk-averse? Do they perceive much higher risk in equities since the dot-com crash of 2000 and Black October of 2008?

I think not. And Gillian Tett has a better explanation for the divergence:
"The IMF quietly published a ground-breaking paper... around the "cash" that companies, asset managers and securities lenders hold on their balance sheets. Two decades ago, these cash pools were modest, totalling just $100 billion... but these pools have exploded in size, as the asset management sector has consolidated... and companies have centralised their treasury functions. Institutional cash managers now control between $2 trillion and $4 trillion globally... what is striking is where this "cash" has ended up... cash managers have started to avoid banks... the key factor is risk management, not yield... the FDIC only guaranteed $100,000 in any account... cash managers have... cash pools that are so large that effective diversification is impossible... the net result is a shortage of [Treasuries]... Hence the low yields."
The IMF research shows that MPT isn't used by huge, institutional cash managers. They're strictly buying treasuries for cash hoarding purposes. These managers aren't interested in MPT or risk and return, they're only interested in zero risk, absent any return. Tett's article doesn't mention sovereign purchases of Treasuries, yet countries like China have been gobbling up Treasuries for the last decade, which has only further depressed yields. And while that's important, that's not as sinister as the information in Tett's article.

China's purchases of US Treasuries is economically unsustainable and will eventually correct itself, but corporations have been consolidating and combining at record rates, and their consolidations are causing market distortions that probably won't correct. So the IMF research is only adding more proof to the fact that the US is not a small-business-focused country by any stretch, and hasn't been for a long time. Corporations dominate every facet of daily life, and their consolidated and swollen treasuries are now distorting bond yields (in addition to the raft of other facets of daily life they affect). But rather than addressing all of those issues, for now I'll just refer to Felix's great piece on Wall Street's Dead End from the New York Times to illustrate how giant corporations are also making the stock market irrelevant::
"The number of companies listed on the major domestic exchanges peaked in 1997 at more than 7,000, and it has been falling ever since. It's now down to about 4,000 companies, and given its steep downward trend will surely continue to shrink... What the market is not doing so well is its core public function: allocating capital efficiently."
I quoted that last sentence, because 'allocating capital efficiently' was never the goal of any of the corporate-friendly, market-inspired deregulations we've had since Reagan that allowed massive corporations to so rapidly consolidate. Rather, the singular policy goal of every faithful Reaganite conservative has always--and only ever--been the further concentration and consolidation of wealth into the hands of the few. The crash in bond yields, just like the rapid decrease in the number of companies listed on US stock markets, is no longer a symptom of a growing problem, but a testament to the overwhelming success these policies have had, are continuing to have, and will continue to have into the foreseeable future.

This post isn't the place for me to discuss all the ways that continued concentration of wealth degrades society and the economy, but suffice it to say that the two issues I've discussed in this post alone (depressed bond yields and an increasingly irrelevant stock market) have already had damaging effects on the daily lives of wide swaths of the population. 

No comments: