Sunday, July 15, 2012

What does the stock market tell us?

by Michael Roberts

We are now into what financial market commentators call the ‘earnings season’ when the major companies in the US and Europe announce their quarterly earnings figures for Q2 in 2012.  JP Morgan, America’s most successful bank, just did so and others are to follow this week.  JP Morgan announced a massive $5.8bn loss on the trading scam that its London derivatives office had been engaged in.  This loss is expected to grow to $7.5bn.  Remember these trades and losses took place after the financial collapse and during the recovery since.  It shows that the big banks have learnt nothing and the regulators have done nothing to stop ‘business as usual’, namely banks engaging in speculative investment trading to make profits rather than the basic banking job of taking deposits and making loans to the public (ironically, in its latest earnings results, for JPM, it was this basic business that did better!).

Just three months ago to the day of the latest earnings report, Jamie Dimon, head of JP Morgan (no relation to Bob Diamond of Barclays!) dismissed concerns about these derivatives trading losses and said that they were a “tempest in a teapot.”  Now he has had to eat his words.  Of course he has not resigned.  But even worse, it now appears that Dimon’s London traders, who had been supposedly making so much money for him and JP Morgan, were actually hiding their losses by faking their returns.  That’s fraud.  We’ll see if anybody gets charged with anything at all, however.  Don’t hold your breath.

Remember what former Fed Chairman Alan Greenspan said to the then head of the US Commodity Futures Trading Commission, Brooksley Born way back in 1996.  He told Born that he didn’t think regulators should even pay any attention to fraud and or that it was something that needed to be enforced or was something that regulators should worry about.  He said to Born: “you probably will always believe there should be laws against fraud; I don’t think there is any need for a law against fraud.  The market would take care of itself.” In the exclusive world of high finance, participants are above the law of the land.

But can the speculations and tricks of the financial sector and the stock market be just labelled as ‘criminal activity’?  Can they also help us to see the bigger picture about the capitalist economy?  Indeed, are the volatile movements in stock prices any sort of guide to what is happening in the economy?

A stock market crash or banking collapse does not always lead to a slump in the capitalist economy.  In 1987, there was a spectacular crash in stock prices around the world, but it did not last and the major capitalist economies grew faster up to 1990.  In 1998, the Long Term Capital Management, a hedge fund investment firm run by Nobel prize-winning economists, followed a very clever ‘risk model’ that avoided losses.  In 1998, it went bust after losing nearly $4.6bn (JPM has just topped that).  The fall of LTCM threatened other leading Wall Street firms like JPM and so they all rallied round to bail it out, with the encouragement of Alan Greenspan (‘the market took care of itself’, as he had said).  So an economic meltdown was avoided and the US economy went on and up for a while longer – and nobody went to jail.

As readers of my book, The Great Recession, will know, I’m greatly interested in cycles in the laws of motion of capitalism.  There is a lot to be said for the pioneering research of Nicolai Kondratiev back in the early 1900s in discerning a long cycle in the prices of production based on industrial raw materials, of about 40-50 years.  In my book, I argued that this K-cycle has now extended to 64-72 years, for various reasons.

Poor old Kondratiev got a lot of stick for his theory when he presented it, both from the pro-capitalist economists and Marxists.  He ended up in Stalin’s Gulag.  And there is still little support for the idea of cycles in capitalist economies among Marxists, even though Marx himself reckoned he could discern them in the development of the UK economy in the 19th century.

Marx often referred to “the multi-year cycle which had been a feature of industrial development ever since the consolidation of big industry” (02.03.58, CW40, 278).  In discussion with Engels, Marx commented: “The figure of 13 years corresponds closely enough to the theory, since it establishes a unit for one epoch of industrial reproduction which plus ou moins coincides with the period in which major crises recur; needless to say their course is also determined by factors of a quite different kind, depending on their period of reproduction. For me the important thing is to discover, in the immediate material postulates of big industry, one factor that determines cycles’ (05.03.58, CW40, 282).

One trouble with discerning long-term cycles in the capitalist mode of production is that there are not many data points, especially for the K-cycle of 50-70 years.  So you cannot make a judgement with any degree of confidence.  There are more data points, however, for what I call the profit cycle, at least in the major economies.  And this is the most important cycle, to which others can be connected.
The closest connection is with the stock market for which there are again more data points.  Whatever the fluctuation in stock prices, eventually the value of a company must be judged by investors for its ability to make profits.  A company’s stock price can get way out of line with the accumulated value of its stock of real assets or its earnings, but  eventually the price will be dragged back into line.  Indeed, if we consider stock price indexes (ie an index of an aggregated group of individual stock prices) over the long term, they exhibit clear cycles, with up phases called bull markets and down phases called bear markets. And these bull and bear markets, at least in the US, match nicely the movement in the rate of profit (something I show in my book, chapter eight).

The share price of a company will always bear some relation to the profits made or the profits likely to be made over a period of time. Finance capitalists indeed measure the value of a company by the share price divided by annual profits. If you add up all the shares issued by a company and multiply it by the share price, you get the ‘market capitalisation’ of the company — in other words what the market thinks the company is worth.  This ‘market cap’ can be ten, 20, 30 or even more times annual earnings.  Another way of looking at it is to say that if a company’s market cap is 20 times earnings and you bought its shares, you would have to wait for 20 years of profits to double your investment.
If profits drive the share prices of companies, then we would expect that when the rate of profit in capitalism rises, so would stock prices. To measure that, we can get a sort of average price of all the company shares on a stock market by using a basket of share prices from a range of companies and index it. That gives us a stock market index.  So does the stock market price index move up and down with the rate of profit under capitalism? The answer is that it does, over the longer term — namely over the length of the profit cycle, although the stock market cycle does not coincide exactly with the profit cycle.

That close relationship can be established by measuring the market capitalisation of companies in an economy against the accumulated assets that all companies have. The latter measures the real value of the capitalist economy to its owners.  We can do this by using what is called Tobin’s Q. The leftist economist, James Tobin developed the measure. It takes the ‘market capitalisation’ of the companies in the stock market (in this case the top 500 companies in what is called the S&P-500 index) and divides that by the replacement value of tangible assets accumulated by those companies. The replacement value is the price that companies would have to pay to replace all the physical assets that they own (plant,equipment etc).

The graph above shows that in the US, there was a secular bull market from 1948 to 1968, followed by a bear market until 1981 and then another bull market until 1999. So the stock market cycle appears to be about 32 years in length, pretty much the same as the profit cycle, although slightly different in its turning points. Indeed, the stock market seems to peak in value a couple of years after the rate of profit does.
Another way of measuring this is to look at the stock price index of all the companies against their overall earnings.  This is called the price to earnings ratio (PE).  If we smooth out the movements in stock prices and earnings of the top 500 US companies on the US stock exchange, this is what we get with PEs.

This pretty much matches the results using Tobin’s Q.  When the rate of profit enters its downwave, the stock market soon follows, if with a short lag. And we now appear to be in a secular bear market that began in 2000 and could last until 2015-18, pretty similar to the profit downwave.

Looking at previous bear markets, as the graph above does, it seems that the PE ratio has to get down to below 10 before the bear market ends.  It is currently around 20.  That suggests there is another huge leg down to come.  If 1932 was the bottom of the first slump in the Great Depression, the next slump bottomed in 1938, six years later, taking the PE ratio back down to its previous low in 1932.  Successive slumps in a depression is a feature of the bear market and behind that, the down phase of the profit cycle.  The Long Depression in the UK and the US, starting in the mid-1870s, experienced a succession of slumps through the 1880s.  The Great Recession of 2008-9 could thus be followed by another slump around 2014-5?.  And the stock market will express that in another leg down.

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