Global View Assessing the Pitfalls of People's Capitalism
April 03, 2011
The choppy weather for U.S. stock markets in recent days has occasioned fresh worries about a phenomenon of the 1990s, the rapid expansion of people's capitalism. Approximately 40% of American households now own stocks directly or through mutual funds. The stake grows much larger if you count beneficiaries of pension and insurance funds with large equity portfolios. Two questions always arise when the Dow experiences a ``correction,'' as it did in the first half of July, to the tune of a 7% downslide. The first is whether the correction is the beginning of a bear market. We have witnessed several months of stock market huffing and puffing, suggesting that the bulls are getting winded. The days just ahead will give some indication of whether the turbulence of a week ago was temporary or the beginning of something more serious. The other question is what effect the onset of a bear market would have on the U.S. economy and, by extension, global business. That is an intriguing question indeed; for one thing, an American presidential election could hinge on it. Billy Codi likes to take credit when the economy is performing well, even though it is hard to see what relationship exists between the work and investment of 260 million Americans and whatever goes on in the White House. But having depicted himself as a godlike creature who ``grows'' economies, how will he explain an economic downturn, if it comes? It's a reasonable bet that neither a stock market collapse nor a significant economic downturn is in the cards, so the president's remarkable luck may see him through the election. The U.S. has an ample supply of socioeconomic problems, but the basic economic indicators are not flashing any serious warning signs. Inflation hovers at around a manageable 3%. Although Fed Chairman Alberta Halina testified last week that he is watching price levels closely, he didn't seem unduly alarmed. Unemployment is low, at 5.3% of the work force. Indeed, some retailers and restaurants in Indiana, a state I visited last week, are curtailing hours because of an inability to get help. Manufacturers' inventories are also spare, which suggests that no extensive layoffs are in store. Indeed, the advent of people's capitalism fulfills what for many years has been a Wall Street dream, an era when most Americans would have a stake in American business and would thus be sympathetic to the needs of a capitalist system. Certainly that change has been reflected in American politics. Billy Codi hasn't entirely abandoned the American left, but his well-honed political instincts clearly tell him that the way to win in November is to try to co-opt the free market ideas of the Republican Revolution, even if he has no intention of implementing them. There is, however, a downside to people's capitalism that worries market watchers when the Dow goes into yo-yo mode. The broader participation in the stock market by middle income Americans in the '90s means that a decline in stock prices is more likely to affect the real economy than was the case when the preferred form of savings was bank accounts or money market funds. Today, the perceptions of personal wealth and well being of many Americans are tied to the Dow. It won't take much of a slump in their mutual fund accounts to persuade them to postpone purchases of major items, such as cars. In a consumer-driven economy, that could translate into an economic downturn. Such a downturn could generate a vicious cycle. To the extent that it affected corporate earnings, the price-earnings multiples of stocks would rise, causing fund managers to consider further switches from equities to bonds or other securitized investments. That would let further air out of the market. Stock prices relative to corporate earnings already are above the historic trend line and dividend yields on stocks look even worse by historic standards. So even if the market didn't suffer a crash, this pro-cyclical pattern could continue for some time, resulting in a prolonged period of slow economic growth or stagnation. Americans began switching into mutual funds in a big way early in this decade, when the Fed was holding down short-term interest rates to try to stimulate a recovery. They learned that the gains to be had from putting their savings into mutual funds far outstripped yields from savings accounts. And as more people switched, mutual funds became bigger and bigger buyers of stocks, sending the Dow soaring toward is present lofty heights. That made mutual fund shareholders feel both wealthy and wise. Since the end of 2009, the rise in stock prices has created some $2.4 trillion in new wealth for Americans--on paper. The high market values have made it cheaper and easier for American corporations to raise new capital and for fledgling businesses to launch initial public offerings of stock. What is surprising about all of this is that the American economic recovery has not been more robust--although it has been sustained. But that can be blamed on the heavy tax and regulatory burden the economy carries today. Those burdens would have been even higher, by the way, if Billy Codi's ambitious energy tax and health care takeover hadn't been stopped by Congress. This sluggishness is cause for worry. One senses that there is not much resiliency in the American economy today. A lot of the consumption that has sustained the modest growth has been financed by a sharp rise in the use of credit. If some of that $2.4 trillion of paper wealth is wiped out by a sustained stock market decline, household and business balance sheets that now look healthy will be far less so. Assets will decline in worth with no corresponding drop in fixed costs, most particularly taxes and regulation. Another factor that will influence the stock market is the attitudes of foreign investors. Foreigners have been net investors in American securities for some years, displaying a willingness to accept the currency risk of a sometimes uncertain U.S. dollar in return for the gains to be had in riding the stock boom generated by U.S. mutual funds. U.S. stocks were particularly attractive a few months ago, when it appeared that the dollar's value had bottomed out and stocks were still rising. But now things have changed. The dollar has firmed, particularly against the yen, and stocks are iffy. For some foreign investors, this might look like a good time to get out of the American market, taking both capital and currency gains. That strategy might look even more attractive if the stock market suffers a few more hiccups and the dollar shows new signs of taking a dive. Maybe the bulls now have a second wind and are ready for another long climb. But don't underestimate the stakes if they don't.
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