A new crop of corporations go public without making profits. This is a problem that presents a greater systemic risk to our stock market, and down the road to our financial and even monetary system, than anyone seems willing to recognize. As I explained the other day, this profit-free corporate phenomenon is not emerging in isolation, but must be placed in the context of a troubling trend in our sovereign-debt market.
Today we are going to tie these pieces together and see how the profit-free corporate culture actually, over time, forces unhealthy levels of credit monetization. Let us start with a simple schematic of risk associated with investment in any given stock. Behold equation 1:
- R is the income risk from holding the stock;
- A is the initial investment in the stock;
- Pt is the expected price of the stock at the future point in time t;
- t is the period of time over which the investor expects to keep the stock;
- E is the dividend per t; and
- L is the expected liquidity of the market at t.
If the sum of expected earnings, E, is equal to A, then the income risk with holding the stock is zero. If A is greater than the sum of expected earnings, the risk is greater than zero, but for any given period of time t (over which the investor expects to hold the stock), risk remains low so long as the investor expects Pt > A.
As illustrated by the exponent in equation 1 above, risk increases exponentially with t. This is natural: while time is linear, the interaction between risk-generating and risk-influencing variables multiplies in both time and space. This makes for an exponential increase in risk taking.
In a sense, this is all rather trivial. The stock market – like every free market – offers elaborate methods and techniques for managing and mitigating risk. However, the point here is not to discuss risk per se, but to place it in the context of the economic system, specifically with reference to how corporate profits and market speculation interact with our monetary policy.
We assume that E represents the profitability of the company, in other words that dividends are proportionate to corporate profits. If E is zero, then the investor depends entirely on Pt to get his money back at any given point in time. At any given t, an increase in Pt reduces risk; at any given Pt, an increase in t increases risk.
Here is where the profit-free phenomenon starts causing problems. Most investors do not have a firm date on when they plan to sell a stock, in other words t is a moving target. This means that t increases over time as the investor evaluates his portfolio. When E=0, the only way the investor can keep a lid on his risk is if the increase in Pt is faster than the increase in t: dPt > dt. In practical terms, this means that the stock value has to go up over time.
For this to happen, though, there has to be enough demand for the stock in order to keep its price going up. As we discussed in the first part of this article, the stock market has to be liquid, at least in terms of the stock of the profit-free corporation. If the level of liquidity, or L in equation 1, is constant, then the dynamic between Pt and t will be the sole determining factor in terms of income risk. However, if liquidity declines – for example because investor interest in profit-free corporate stock is in decline – then risk will rise at any given t and Pt.
A rapid increase in risk can quickly lead to divestment of a stock. If it spreads to similar stocks, such as from one profit-free corporation to another, it can affect the entire market. There are mechanisms in place on our stock markets to make sure this does not lead to catastrophic instability, but those mechanisms are only temporary. They work as cooling-off measures, but they do not lead to replenishment of market liquidity. For that to happen, the market needs an external source of liquidity.
The Federal Reserve.
Its role here would be to supply commercial banks with basically free cash (as it has already done), which in turn is then used to prop up stock-market investors. With more liquidity – cheap credit – available for investors, their income risk is reduced. In equation 1, L increases, causing the exponent to decline.
So what could possibly be wrong with this? Isn’t it the role of the central bank to keep our financial system sound and solid?
Yes, it is. We can have a debate another day over whether or not that should be its role, but for now, yes, it is. However, the central bank’s dual role as a guarantor of the financial system and the de facto owner and operator of our monetary system, actually leads to an amplification of the very problem that the central bank is trying to solve by raising L in equation 1. Its dual role, namely, affects investor portfolios at both ends of its risk spectrum.
Again schematically, an investor likes to balance higher risk against lower. Suppose the solid red line in Figure 1 represents the perfect risk balance of a given portfolio. The two dashed lines represent, respectively, more risk-prone and more risk-averse investors:
When the central bank intervenes to mitigate risk at the higher end, it effectively bends the risk curve downward:
The problem is that in order to reduce risk, the central bank has to supply liquidity – print money – enough to motivate the decline in risk, equal to the grey area in Figure 2. At least in theory, we could put a monetary value on the extra liquidity needed. This would give us a good idea of the broader consequences of this stock-market monetization.
One of those consequences is the erosion of earnings at the low end of the risk spectrum. Treasury bonds, which often serve as the risk anchor of investor portfolios, produce income only insofar as interest rates are greater than zero. The more money the Federal Reserve prints at any given level of GDP, the lower interest rates will fall. By means of equation 1, this means that the risk of losing income increases; while the risk-defining mechanisms are a bit different for Treasury bonds than for stocks, the theory behind the income-risk concept remains the same.
In short, when the income from low-risk assets declines, the risk profile of the portfolio is tilted, and not for the better:
The central bank, of course, cannot allow an increase in the income risk associated with Treasury bonds. To counter that, it now needs to increase the liquidity in that market as well (raise L in equation 1). We already know this phenomenon as Quantitative Easing, but the European Central Bank went even farther during the Great Recession. They issued a guarantee that they would buy any treasury bond, denoted in euros and issued by any euro-zone government, at a guaranteed price.
This, of course, forced them to print an inordinate amount of money, which tells us what will happen here in the United States when the current trend toward zero interest rates starts raising income risk for Treasury investors. Since we already have an over-monetized economy and our monetary velocity is below one, the Federal Reserve is already deeply involved where it should not be. If, in the near future, it will also be forced to supply liquidity to a stock market saturated with profit-free corporations, then our combined financial and monetary system could be in grave danger.
We are not there yet. Profit-free corporations do not yet represent a systemic threat to our stock market. However, the very fact that the market so casually gobs up new profit-free corporations is a troubling sign in itself. It means that an investor culture already exists that is impervious to the long-term risks associated with these stocks. If they also take the market supply of liquidity for granted, we have a systemic crisis in the making.
There is yet another aspect on this phenomenon, one that pertains to the very solidity of our capitalist economic system. However, we will have to save that one for a separate article.
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