Commentary: Is the stock market’s rise driven by mania or logic?
Although investors always fear a bubble, the rational explanation is even more alarming, says the Financial Times’ Robin Harding.
LONDON: Despite the deepest economic downturn since the Great Depression, the S&P 500 index is up 6.5 per cent this year.
Apple has a market capitalisation of US$2 trillion, Facebook is worth US$762 billion and Tesla is valued at US$394 billion.
Even Nikola, a maker of battery and hydrogen trucks that is yet to sell a vehicle, was briefly valued at US$34 billion.
Knowing the disaster about to hit the economy, few analysts would have forecast such a spectacular rally in the US stock market.
There are two ways to look at the market’s rise. Is it speculative, irrational, unsustainable or false in some way – fuelled by a mania for technology stocks, a wave of young investors trading on their mobile phones and the provision of central bank liquidity in response to COVID-19?
Or is it a rational, logical response to a severe economic shock and the resulting likelihood of low interest rates for a long time?
Although investors always fear a bubble, the rational explanation is even more alarming.
LOW INTEREST RATES, HIGH STOCK PRICES
Low interest rates can temporarily justify higher stock prices because they make the existing and future earnings of companies more valuable.
At an interest rate of 5 per cent, you need $20 million to earn $1 million a year, while at an interest rate of 1 per cent you need $100 million.
A million dollars a year in corporate earnings is correspondingly more precious when interest rates fall.
One worrying message of high stock prices, therefore, is that markets expect low growth and low interest rates for the foreseeable future.
But that is not the end of it. Falling interest rates may lead to a temporary rise in stock prices, but at least in theory they should also induce more investment.
For example, if a company built a factory for $20 million, but the stock market now values its earnings at $100 million, then it will make sense for either the company or its rivals to raise funds and build more factories.
Investment should continue until the excess return on corporate capital falls.
If investors place a higher value on these companies’ profits, however, it suggests they do not expect increased investment and competition to erode them. In other words, they see a company enjoying monopoly profits and expect them to continue.
That possibility links to a range of pre-COVID research by economists such as German Gutierrez and Thomas Philippon, who argue that increased concentration and reduced competition have led to higher corporate profits but lower investment in the US, or David Autor and his co-authors, who study how so-called superstar companies now dominate their markets.
For example, consider Facebook. Strip out its cash, marketable securities and goodwill, but capitalise its spending on research and development, and it is valued by the stock market at about 10 times the investment needed to reproduce its assets.
Nobody expects new entrants to challenge Facebook. Nor will it raise fresh capital to invest – the cost of adding extra Facebook users is negligible and the company struggles to use the gush of cash it already creates.
Its users want to be in the same virtual place as their friends so, as the dominant social network, Facebook earns a stream of what are effectively monopoly profits.
The increased value of those profits in a world of low interest rates has created a delightful rise in the share price for existing investors in Facebook and other technology companies.
But it makes a grim prospect for the future.
The market adjustment to lower interest rates should be a one-off – it does not mean the share price will keep rising.
Moreover, thanks to their monopoly position, these dominant companies will suppress investment overall. Suitable remedies are hard to find, but competition cases such as by the US Department of Justice against Google this week, which argues that it suppresses competition, make sense.
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There is evidence of mania as well as rationality in the US stock market. The bizarre behaviour of stock in companies such as Hertz this year – it briefly tried to sell US$1 billion in new stock despite declaring bankruptcy – attest to the enthusiasm of retail traders.
The high value placed on Nikola, before a short-seller alleged its technology was not what it claimed, was as ebullient as anything from the dotcom era.
But as long as a speculative boom involves equity, not debt, it can have positive effects for society. Consider Tesla, which is now valued even more richly than Facebook, at more than 30 times its shareholders’ equity.
Unlike Facebook, though, Tesla is contesting a highly competitive market, against rivals such as BMW, Mercedes and Toyota. Unlike Facebook, it does not make much money right now.
Also unlike Facebook, it will need a lot of capital to build new factories and finance inventories of cars, raising US$5 billion from the stock market in September.
Undoubtedly, many Tesla investors believe the company’s battery or self-driving technologies will allow them to earn monopoly profits in the future.
They may be wrong or they may be right. But competition regulators can worry about it when it happens.
In the meantime, investors are directing billions of dollars into chief executive Elon Musk’s effort to tackle greenhouse gas emissions via his electric cars. Be Tesla an investor triumph or a disaster, everyone else will be a winner from his efforts.
Sometimes it is semi-rational exuberance, not cold calculation, that moves the world forward.