What’s good for tech stocks is bad for the economy
A capital-intensive economy like this produces less value for everybody
|Sep 24, 2020||1|
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Tech stocks deepened their recent skid this week, and the fear among market watchers right now is the bubble may have already burst. Investments that could do no wrong just last month now look somewhat suspicious.
What these observers don’t know is that things are actually much worse than they think. There is a deep and important connection between these high-flying tech investments and the crappy economy their shareholders hope to escape.
Drawing this out requires a big picture outlook, and connecting some dots in ways that Wall Street can’t.
How society works
Let’s start as big as we can: all human societies have to constantly reproduce themselves to survive. Our society reproduces itself through a system of market exchanges. Each completed purchase validates the good or service exchanged as necessary for the reproduction of our society.
Investors use their capital to command some portion of society’s existing resources to produce something new they think society also demands. If they’re right, then the product will sell and they’ll get a return on their investment. If the new product isn’t socially necessary -- i.e. valuable -- it won’t sell, and they lose their investment.
Where investors gain value, and where they don’t
These investors don’t gain any additional value from the inputs they buy for their products. Buying these inputs just validates their necessity. To create new value the investors need to combine the inputs together to create new, value-added products, and this requires human input -- labor.
Labor power is an exceptional input because the workers selling it can’t realize its value without the machinery, facilities, and other inputs owned by private businesses. This means those businesses get to buy labor power at a discount, and investors pocket the difference.
This has an important implication: each enterprise is some combination of produced inputs and labor power. If the enterprise sinks a larger share of its investment dollars into inputs rather than labor, then over time they should return less investment. This is why labor-intensive “emerging markets” can have such extraordinary rates of growth as compared to capital-intensive advanced economies.
Why investors love “operating leverage”
This is the level where this impact emerges -- in the aggregate, over time. At the level where equity markets operate -- individual firms and sectors over short terms -- a different perspective emerges.
There, “valuation” has everything to do with expected future cash flows. Operating income -- the money left over after paying out all the costs of production and overhead costs of the business -- is the name of the game. The more operating income a company expects, the more valuable its stock should be.
Every company delivers this cash flow differently. Companies with low variable costs (the labor and input costs of each unit produced) and high fixed costs (the administrative expenses necessary to keep the lights on) are said to have a high degree of “operating leverage.” These businesses are efficient at turning their revenue into operating income.
Why tech stocks look so hot
Tech companies tend to have high operating leverage. Each additional unit sold adds very little to their variable costs -- Facebook can sell thousands of ads before they have to add any hardware or staff, for example -- which means that for every percentage point of revenue growth, they get more than a point of cash flow growth.
So when the economy is growing -- the norm for capitalist economies -- rising sales mean growing revenue, which means even faster cash flow growth and equity value. Investment gets disproportionately drawn into high fixed-cost, low variable-cost firms.
But produced inputs don’t add value, remember, and yet these high fixed costs -- attractive to investors -- include only those inputs. Labor power does add value, but that’s covered in the variable costs they seek to minimize.
Bottom line: investments at the firm level favor a capital allocation that produces less value throughout the economy overall.
Where the zombies come from
And it gets worse: when sales drop, these companies’ high overhead costs put them at increased risk of default. Since they are also the ones with disproportionate levels of investment, leaders seek to bail them out, mainly in the form of interest rate suppression by central banks. The companies can borrow and issue bonds more easily, but this debt only adds to their fixed costs.
Soon you have an economy full of companies that make just enough to cover their debt service -- so-called “zombie” firms.
So now we can connect the dots: high levels of operating leverage made tech stocks sexy investments for years, but this contributed to a capital-intensive economy with lower aggregate returns on investment. When downturns came, central bank rescues only created more long-term deadweight, hence the slow, sleepy growth of the last “recovery.”
Now that the recent speculative boom has paused, we’re left with a terrifying question: what do we do with an economy founded on a basis that can’t perform for the future, especially in light of all the debt -- i.e. future earnings -- that we’ve accumulated to build it?
One thing is certain: the leaders that can’t deliver a relief package everybody wants definitely can’t figure this one out either. Watch out for your own bottom line while they try nonetheless.
Our only investment advice: Long Denver and Miami.