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McCabe Lecture Series
October 28, 2020

Capitalist Risks and Miscues

By John J. McCabe '65

Capitalist Risks and Miscues

There is no question that the mature and cyclical United States consumer-dominated nation has earned its title as the planet's sole surviving superpower. The US has been blessed with an enormous stockpile of highly productive resources including land, labor, capital, management, and technology, and has nurtured them well. Moreover, US military prowess is second to none.

It is mind-wrenching that while home to just four and a half percent of the world's seven-plus billion inhabitants, the US accounts for twenty-four percent of world gross domestic product. To boot, while there are over two hundred nations ensconced on this planet, sixty of the world's one hundred largest corporations are headquartered in the United States.

The foundations of US prosperity remain sturdy. The United States leads the world in capacity to innovate, market flexibility, and the proficiency to attract global talent. Our capital markets are the most transparent and the quality of corporate know-how is superb. The availability of venture capital funding is widespread. On top of this, Uncle Sam leads the world in higher education and training and possesses the majority of all technology patents.

Unfortunately, however, it cannot be denied that our free market socioeconomic capitalist system is somewhat off-kilter. The ongoing protestations and urban violence centering on race and income inequity prove the point. Upward mobility has become a stumbling block for far too many Americans. The less skilled and under-educated are especially hard hit. There is no question that the foundations of American prosperity should be healthier and more robust than they are.

The fundamental aspiration of our free-market capitalist system is to generate sufficient wealth, capital, and employment so that each generation has the potential to achieve higher living standards than the previous one. Consumption drives productivity and is responsible for delivering over two-thirds of our nation's twenty-one trillion dollar GDP. The more dollars in consumer pockets, the more vigorous monetary velocity and the more expeditiously living standards rise.

First-year economic students discern that the most propitious time to generate improving living standards occurs during sustained periods of low inflation and that inflation stifles economic performance. Fortunately, the Federal Reserve broke the back of the stultifying profit draining and savings depleting runaway inflation that plagued the US from the middle nineteen-sixties up through the early nineteen eighties. The Fed did so by raising the price of money to such a costly level that a crippling fifteen-month long recession ensued. The prime rate of interest, for example, catapulted to twenty-one and a half percent and the residential mortgage rate topped eighteen percent.

The harsh medicine worked. It flushed the excess borrowing, speculation, and spending out of the economy. It also smashed corporate profits, jackknifed unemployment sky high, and sent the teetering Dow Jones Industrial Average's forward price-earnings multiple to below a horrendously bearish eight times earnings.

Satisfaction vs Dissatisfaction

The good news for consumers is that the inflation genie has remained quarantined in its bottle for over thirty-five years. During this prolonged time frame, the US economy initiated the strongest period of wealth generation, capital formation, and job building ever recorded. Even while enduring four recessions that include both the longest on record, the eighteen-month Great Recession, and the ongoing government induced COVID 19 dramatic downturn, the Dow Jones Industrial Average zoomed from a low of 777 in the summer of 1982 to an all time high of 29,551 in February of this year for a gain of 3,703%.

The bad news is that the stock market is not the economy and Wall Street is not Main Street. The DJIA and the S&P 500 are leading economic indicators that offer some inkling of where institutional and individual investors assume the economy and corporate profitability might be six months to a year down the road. Sadly, and more importantly, too few middle class and working class Americans have meaningful ownership positions in common equities. Many citizens hold no financial assets whatsoever and have not seen an uptick in living standards since the nineteen seventies. Only about half of all Americans possess a 401k.

Finance professors like to bellow that there are two types of people in this world. Those who work for their money and those who have their money working for them.

Common Stocks Best Long-Term Investment

Decade Long Bull Market Run
"March 9, 2009 – March 7, 2019"*
$1,000 Invested

U.S. Stocks $4,050
Vintage Cars $3,070
Fine Arts $2,300
San Francisco Home $2,180
Thorough Bred Horses $2,130
Fine Wine $1,480

*Bull Run Coinciding with Ending of Great Recession
Source: New York Times

Far too few consumers land in the second grouping. The typical home owner in the US retains about two hundred thirty-nine thousand dollars in household wealth and the average renting household just five thousand two hundred dollars.

When the Forbes 400 list of the richest Americans was inaugurated in1982, fifteen billionaires were on board. Today, there is a waiting list. All 400 current residents are billionaires and another two hundred thirty-three did not make the list. So far this year, entrepreneur Elon Musk's Tesla's shares alone have sailed over fifty billion dollars in value. On paper, Musk is now the fourth wealthiest person in the land.

Trickle-down economics is an obvious failure and the upside rewards of free market capitalism are ascertained by an insufficient number of consumers. The wealth and income disparities between the "haves" and "have nots" continue to dangerously magnify. The top one percent of Americans for example, capture twenty percent of total income while the bottom fifty percent of the population glean just thirteen percent. Furthermore, the richest ten percent of the nation's one hundred twenty-nine million households own over eighty percent of all common stocks. Yet, a high quotient of citizens still live paycheck to paycheck, have little or no savings, would incur difficulty coming up with five hundred dollars for a family emergency, and cannot afford what they produce on the job.

Economic stress has worsened for many Americans due to the ravages of the Coronavirus. The pandemic has been particularly draining for workers that require on the job face to face interaction with the public and those in the lower paying sectors of the economy including retail, passenger transportation, hotel, restaurants, and live sporting events. The longer it takes to get back to normal life the more challenging the situation.

It took less than three months for the US unemployment rate to plunge from a near half century low of 3.6% to a ninety-year Depression Era crest of 14.7%. The virus also brought about an abrupt halt to the record-shattering 128 month-long economic upturn. Second quarter GDP's negative 31.4% gut punch was the worst ever posted and over ten million more workers were without jobs last month than in February of this year.

As with most economic tumbles, those at the very low end of the wage spectrum and small businesses incur the worst body blows. For those earning $40,000 annually or less, about thirty-nine percent lost their jobs. Only thirteen percent of employees taking home $100,000 or better were let go. It has been estimated that more than thirty percent of all small businesses employing five hundred or fewer employees may disappear. The federal minimum wage is still $7.25 an hour. When adjusted for inflation, it is about where it stood in the nineteen sixties.

Creative Destruction

The famed Austrian School laissez faire economist and Harvard professor, Joseph Schumpeter, was born in Triesch which is now part of the Czech Republic, in1882. At that time, Great Britain was the globe's dominant economy. He passed away in the United States, the world's most prominent industrial society in1953. The scholar was quite accomplished having been a lawyer, political scientist, sociologist, bank president, research fellow, and high government official. He also lost a fortune in Vienna's1924 stock market crash, served as President of the prestigious American Economic Association, and coined the term—Creative Destruction.

Schumpeter preached that "capitalism is by nature a form or method of economic change and not only never is but can never be stationary." He continually emphasized that financial and human capital should not be prevented from gravitating to their most effective uses because they perform best where they are welcomed, productive, and rewarded. The professor also espoused that in some respects, free market capitalism is a loser's game. Loser's game in the sense that if one cuts their losses, the momentum and dynamism of the system can still make them a winner.

Schumpeter hammered away that making existing products and services more efficient, cheaper, and plentiful was not sufficient enough to capture the full bounty of competitive capitalism. Entrepreneurship and technological innovation are also paramount to improving living standards. Bankruptcies and corporate failures play a constructive role as well.

During his lifetime, he studied the dramatic productivity enhancements and living standard improvements that accompanied the invention of the steam engine, the light bulb, the automobile, and the airplane. He also studied the human disruption, economic fallout, and overall disequilibrium that accompanied these societal altering innovations. He concluded that the undermining hemorrhages of innovation are beneficial to long term commercial success. Inventions and innovation free up labor and capital that can be redeployed to more productive utilization elsewhere and also serve as educational tutorials for burgeoning and experienced entrepreneurs.

Schumpeter recognized that economics is a behavioral science as is psychology, sociology, cultural anthropology, and criminology. It is not a physical science and as such, emotion and intuition can trump logic when individual and group political and economic decisions are formulated. He was keenly aware that human beings are wanting animals and once a need is satisfied another takes its place. He was very much concerned that if democratic capitalism was not fulfilling the needs of a large quota of the citizenry for an extended time frame, it could self implode and be voted out of existence.

Self-inflicted Wounds

Recessions in the cyclical US economy do not nearly last as long as the prosperity periods. Since World War ll, for example, the country has endured twelve reversals. The typical downturn not including the current pullback has lasted a little over ten months. The most recent five reversals since1980 not counting this one, registered an average life of slightly more than twelve and a half months. The current reversal is deep but should be brief. It might last about two quarters.

Two troubling observations are noteworthy. One is that even though per capita personal income according to the US Bureau of Economic Analysis, rose from $12,553 in1980 to $56,663 last year, living standards adjusted for inflation, for a goodly number of Americans have hardly budged. The second according to Pew Research, is that the middle class has dropped from over sixty percent of the population in 1970 to about fifty-one percent today.

Median Household Income*

Year Upper Income Middle Income Lower Income
2018 $207,400 $86,600 $28,700
2000 $192,000 $81,700 $28,200
1970 $126,000 $58,000 $20,000

*In 2018 Dollars
Source: Pew Research

Capitalism performs its best magic when there is intense competition for workers and a wide swath of the population is becoming wealthy and ever more independent. Wealth renders a cushion to fall back on in bad times and allows for investment risk taking in prosperous times. It also a catalyst for upward mobility, productivity enhancements, and technological innovation. Without wealth, capitalism fails.

Karl Marx and other left-leaning nineteenth-century philosophers and social thinkers deduced that socialism was the heir apparent to free market capitalism. Capitalism would inevitably fail because the bourgeois would have too much dominance over the means of production and the nation's wealth would become ever more concentrated in the hands of the well-healed and well-connected. Workers are the true profit creators according to the left-leaners. Their needs, wants and desires would not be met because of the greed and selfishness on the part of industry titans. Over time, emerging monopolies and oligopolies would gain control over pricing and constrain new competitors from entering the market place. The proletariat would revolt and socialism would inevitably replace free market capitalism.

The left-leaners had one fair point. It is a glaring fact that in free market economies, the larger more resource abundant, and skill-heavy business enterprises can harbor a plethora of profit and cash flow advantages over the competition. If the situation gets out of hand, a political backlash is inevitable.

During economic reversals when marginal competitors fail, the behemoths capture additional market share. They are well positioned to take over struggling competitors at reasonable prices. They are also prime beneficiaries of central bank "long and low" interest rate monetary policies. Not to mention the bottom line benefits accruing to them from fiscal policy initiatives to jump start consumer demand and capital expenditure outlays. These industry chieftains also have the wherewithal to frame superior compensation packages to retain and attract top notch talent.

Throughout our country's exhausting inflation battle, the phrase "creating shareholder value" was hardly heard. Equity stock options were not a major part of senior executive compensation packages. Executives did not really push for them. During harsh inflationary times, interest rates rise and price earnings multiples fall. From 1963 until1981the DJIA only advanced thirty-three and a half percent. Most senior executives during this era lobbied for other perks. Cash bonuses along with life insurance, health, transportation, and travel incentives, for example, fit the bill.

The term shareholder value came into vogue when Boone Pickens and Carl Icahn appeared on the scene in the mid-nineteen eighties. These "Corporate Raiders" began to castigate senior executives for not having much skin in the game. They pounced on them for owning an insignificant amount of equity in their companies and not realizing how grossly undervalued the corporations they led were. They also howled that too many boards of directors were asleep at the switch and not serving in the best interests of shareholders.

During the present thirty-eight-year bull run various companies while espousing to be proponents of long term shareholder value creation began concentrating on short term quarterly earnings performance. They wanted to please Wall Street and did not wish to risk seeing their stock fall out of favor. Some entities whole heartily commenced substituting technology for human effort here at home and began exporting manufacturing and other jobs that could be performed more cheaply to Asia. Frequently, their stocks got a boost because of reduced operating expenses. Sadly, however, very little job training to upgrade employee skill levels were offered to departing workers. No one will ever know what the "opportunity costs" were of not making long term wealth building capital investments.

If Joseph Schumpeter were alive today, he would be flabbergasted by another capitalist miscue. The number of "zombie" companies still standing. Zombie companies are highly leveraged enterprises that are barely cash flow positive. They can meet their interest expense payments but cannot pay off the principal on the debt. GnS Economics calculates that approximately fourteen percent of the S&P 1500 Composite Index companies fall into this grouping. These teetering entities stifle human and financial capital from being more productively redistributed elsewhere. Moreover, the zombies are not increasing headcount nor are they spawning much wealth.

To the dismay of the individual investor who has a 401k or an IRA and despite a growing economy and a rising population, the number of listed public corporations has been declining for over twenty years. Mergers and acquisitions along with leveraged buyouts are three prime causes for the shrinkage. There has also been a reduction in the number of initial public offerings.

During the Dot Com boom, the number of listed public companies topped out in the late nineteen nineties at over 8600. Today, there are less than half as many listed companies. Traditionally, private companies go public to tap the large pool of available individual and institutional capital, share risk with public investors, and establish a market value for the company. Presently, there are other sources of capital available at a lower cost. They also come with less regulatory and compliance burdens than an IPO.

With the advent of the internet and other technological advancements, private equity companies have come into their own. There were about one hundred private equity firms in 2000. Today, there are over four thousand. These firms had less than a trillion dollars under management in 2000 and presently, it is over four trillion dollars. A sum that exceeds Europe's largest economy, Germany's GDP. Their target investor audience consists primarily of high net worth individuals, college endowments, eleemosynary institutions, pension plans, and the like. Minimum portfolio management fees start at about two hundred fifty thousand dollars and can top one million dollars or more. Not a place for the small investor.

Private equity firms have become more popular just as some of the luster of becoming a public company has diminished. The hassle and cost of going public coupled with the pressure on reporting requirements post the 2002 Sarbanes-Oxley legislation has caused many emerging companies to look elsewhere for funding. With over eighty percent of the trading volume emanating from institutions, many of which are chasing short term performance adds to unwelcome share price volatility. Corporate activists taking equity positions in all sorts of companies including cyclical, recession-resistant, and growth companies have caused some emerging companies to look elsewhere for funding.

In a period of ultra cheap money, companies are also staying private longer. At one time it would typically take less than four years for an emerging company to launch an IPO. Presently, it could take ten or more years. Some firms now decide that rather than going public, they should sell themselves to a larger public industry leader.

Shutting the small investor out of opportunities to invest in emerging companies is a major issue for the country. Jay Clayton, Chairman of the Securities and Exchange Commission, confirmed that it is a "serious issue for the markets and the country." Nasdaq's CEO Adena Friedman proclaims "job creation and economic growth suffer and income inequality could suffer as average investors become increasingly shut out of the most attractive offerings."

Obviously, the more public corporations the better it is for those who have their money working for them and for our competitive free market economy. Credit goes to the New York Stock Exchange for appealing to the SEC to allow for Direct Listings. This is a cheaper way for companies to go public without incurring the costs of an IPO. In a direct listing, corporations do not have to incur the costs of investment bankers and other intermediaries. The SEC approved the NYSE proposal earlier this year for direct listing and recently passed on a similar plan introduced by NASDAQ.

What our free market competitive capitalist economy does not wish to incur, is an ever-diminishing number of public corporations. Hopefully, the nation will never be put in a position where there are more investment dollars in 401k's, IRA's, and other portfolios than there are top quality public corporations to invest in. If taken to an extreme, more and more political and economic treatises will be written on the emerging monopolization of the US economy.

It would be a heartfelt tragedy if our nation lost its status as the world's only superpower due to unforced errors.

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