This is Water

PDF Download (Paid Subscription Required):  This Is Water There are these t
Join the Pack: You have reached the maximum number of free, long-form articles for the month. Please click to join.

Paid Members can log in here.

To learn more about Epsilon Theory and be notified when we release new content sign up here. You’ll receive an email every week and your information will never be shared with anyone else.


  1. Avatar for Mav Mav says:

    This post reminded me of two oldies but goodies and how important it is to call things by their proper name (“The Name of the Rose”) and the problems that arise when words mean something different to different groups of people (“The Market of Babel”).

    The insidious effect of financialization has been that it has changed the Common Knowledge/Convention of words like earnings and capitalism, which I think is one of Ben’s points.

    Pre-GFC “earnings” does not mean the same thing as post-GFC “earnings” even though we use the same word to describe both.

    A millennial who only knows a world of easy money, record stock buybacks, and exorbitant CEO compensation will have a completely different meaning of capitalism than a Baby Boomer or Gen Xer.

    This difference in language creates a “problem of meaning” where the observed “facts” of the world actually mean something different particularly between generations.

    It’s why we are seeing a shift away from “capitalism” towards something else.

    It’s why we are experiencing a widening gyre.

    To recognize this change in language is to see with Clear Eyes.

  2. Avatar for faust faust says:

    This is a really interesting. “Financialisation” (sorry, UK spelling this time guys) is really where the gains of financial engineering outweigh the gains of real engineering, or to put it differently, the incremental gains on the bottom line of manipulating your capital structure is higher than the gains of actual investment in your core operations.

    The ever-declining interest rates are a key cause in this because higher cost of capital will necessarily force companies into productivity-enhancing investment. Zero cost of debt capital means that companies do not have such high costs of capital that they need to reinvest their profits. Even talking about “cost of capital” like it is a real thing other than what investors want as a return by applying some half-baked financial model is an example of where financialisation creeps into our subconscious so much that we can only express ideas using financial language.

    Financialisation though is reaching a point of over-engineering. Banks employ teams of high quality bankers who provide “credit rating advise” to their clients. That is, bankers literally approach clients pitching them to create a capital structure that “targets” credit ratings to improve their EPS or whatever metric management compensation is based upon. Targeting credit ratings is getting things arse-backwards: credit ratings should be the outcome of a process and not the end-goal in itself.

    This over-engineering of the corporate world only means one thing: central banks will increasingly get concerned that higher rates will tip everything over. I am not a natural pessimist but given one reason why the Fed did not increase interest rates is because of the amount of sub-investment grade debt out there, one can only wonder how long the tail can wag the dog…

  3. Ben-Great points as always! One would have thought that the Panic of 2008 represented the terminus of financial gaming and gimmickry, a welcomed death knell for what had become the complete “financialization” of the US economy, but noooo. Instead the Fed created conditions to double down on it. So, we have a economy that is even more hollowed-out drifting ever further toward the “7-11 Economy” I observed in Louisiana 30 years ago…now a Dunkin’ Donuts (empty, produce nothing entity on every corner…like 7-11s) economy.

    I’ll be curious which side/faction of the “Political Utility” crowd wins…the side that relies on an ever-rising/ebulent stock markets to paper over societal under-saving/over-spending and the side that is clamoring for ESG companies/investment. Notice how companies are tripping over themselves in their craven attempts to be “ESG Friendly” so that they can be included in ESG indices…and ESG ETFs by extension. Eventually, everyone will be “ESG”…putting everyone in the index. Both lines of Political Utility thinking (two side of same coin like chivalry and chauvinism, kinda sorta don’t get one without the other) are antithetical to growth/progress when other economies/countries are less constrained by “fairness” (a flavor of the same ESG ice cream). Phil Gramm nailed it in yesterday’s WSJ Opinion piece. Enjoy!

    Haul-ass, bypass, and re-gas!

  4. Avatar for nick nick says:

    The ESG cartoon has rapidly become my favorite cartoon.

    It is an incredible case study in how quickly Wall Street and the financial services industry more generally are able to take an abstract concept, identify the “value” to be harvested, and then quickly productize strategies for strip mining that value.

  5. Great article. I have been talking about this idea of financialization with not nearly as much clarity, finesse or the right verbage for awhile, but most people look at me like I am high. Like I don’t “get it”, particularly Wall Street. So I really appreciate how well you explain and address the subject.

  6. The real tragedy of ESG, in my opinion, is that retail investors have now been taught that buying stocks based on their own personal ESG passion will not only advance their cause but is also a “smart” investment. Seeing all these Robinhood accounts pile into TSLA on the basis of supporting a green business while institutions and the BoD sell like crazy makes me sick to my stomach.

  7. Avatar for nick nick says:

    Agree. This seems like a relatively obvious con. And yet.

  8. Avatar for DaHoj DaHoj says:

    Surely some of the post-GFC “earnings” growth is due to Labor’s declining share of income?

  9. Only if you are my age (54), or older, do you remember a time when it was hard to raise money for an investment. I know, today you still have to work to convince investors to put money into your idea (fund, IPO, start-up, mom-and-pop biz, new building, etc.) - but you know the money is “out there” (it’s like water to the fish, you don’t even consider that it isn’t there / you don’t know a time when it wasn’t there).

    But there was a time when you simply couldn’t find capital for your great investment idea as it wasn’t there (there was no water). That imposed a discipline on how capital was spent because it was scarce and expensive. You couldn’t afford to lever-up your balance sheet - you needed to find a real idea to make real money (per Ben, by way of productivity improvement via new plant, equipment or technology).

    I would never have guessed, ahead of time, that cheap capital would defeat real investing (it always felt like there were more good ideas than money in those days). But as Ben illustrates, cheap capital (via the CBs) has led to the financialization of the economy making it easier and smarter to leverage your balance sheet and legally manipulate your earnings than risking capital on an unproven investment. That is not an intuitive idea to someone who grew up in an era of tight(er) money and investment ideas desperately fighting for scarce and expensive capital.

    And the other thing I remember - things failed, all the time. Many banks, businesses, factories failed / shutdown / closed. In the late '80s, when there was a Savings and Loan crisis (classic banking sector failure), the government stepped in and rescued all the S&Ls…oops, no it didn’t, it let most of them fail or merge (and sell off the bad assets). And, yes, that was painful, but it worked. It cleared out the bad ones - the pain was deep but short-lived - as the economy powered forward with less dead wood - without being zombified.

    It’s good to go back and read the classics - Hayek, Schumpeter, Smith, etc. - as it helps you cut through all of today’s “sophistication” so that you see things like this: creative-destruction is the heart and soul of actual capitalism. All of this CB manna and Wall Street prestidigitation (securitization, balance sheet “management,” etc.) has stomped on that heart. We don’t let things fail - so no destruction - and many of our companies don’t invest in real new things - so no creation (obviously, I’m exaggerating, but you get the point).

    Ben’s right - we don’t have capitalism anymore. And this is the really, really, really bad part - the enemies of capitalism claim anything that isn’t the government is capitalism. So all this CB liquidity, QE, balance-sheet machinations, crony capitalism (where the government is as crooked as the businesses it “regulates”), securitization (squared), and on and on, is cited by the advocates of government “solutions” as evidence of capitalism’s failure.

    Hence, privatization, deregulation, markets, business, money - all of it - is lumped in with the mischief of crony capitalism and CB manipulation as proof positive that socialism is the future and that capitalism has failed. Maybe I’m wrong, but I’d add that to Ben’s list of zeitgeist changes and, IMHO, that is the one that, if successful, destroys it all for a generation or more.

  10. Avatar for bhunt bhunt says:

    Good question, but it’s the other way around, I think, as Labor is calculated on national incomes and this is corporate data. In other words, I think that the declining share of household income for Labor is an effect of financialization, not a cause. If squeezing Labor was a cause of profit margin growth, you would (by definition) see increases in labor productivity. In fact, that’s why productivity numbers always spike when a recession hits … people get fired.

  11. This is an excellent compilation of at a lot of really important concepts. And goes far beyond the typical “compare central bank balances/shadow Fed rates etc. to equity markets”. Which does show correlation, but the causation is more complex. Ben I remember when you said that the narrative transmission loops are probably more substantial in creating the 3 body problem than the actual monetary policy. (I’m riffing, but it’s close). I suppose due to network effects, reflexivity and other things I can’t think off right now.

    If we start at the end result (or future result) and we talk about the inevitability of a return to inflation, a shift in the zeitgeist, then a number of topics arise:

    • Ben showing that without financialization, P/E ratios on the SPX would be closer to 28. This is from the normalization of earnings margins to more historic ratios. The rate of change of margin growth is probably very important to the market What will market reaction be if the rate of change of margin improvement slows over a medium to long term time frame (versus simply compressing)?

    • What is the catalyst for the reversal in earnings margins? Simple inflation?. The margin base effects (comps) are hard to beat, but I think it still requires inflation to really start creating 2nd derivative divergences and absolute margin compression over a reasonable time frame.

    • With financialization deflating earnings multiples, while other valuation metrics like Shiller CAPE or margin adjusted CAPE currently show a very expensive stock market. A zeitgeist shift toward inflation is going to make stocks at the far right x axis of a CAPE chart look dramatically more expensive. But they already do, and no one seems to care (well maybe John Hussman).

    • Given that the S&P has near historical and cycle high operating margins, with near full employment, does this spring load the inflation machine? Boards and management teams are trained to financialize, what happens when inflation rears its head, employment is still near full, and margins shrink? Do they react to the margin compression and slow down on the buybacks (are your chart variables causal within a feedback mechanism?) How much skill or propensity to invest in technology and labour productivity has been ‘lost’, and how slow will these companies be to make that pivot?

    Thanks Ben, I loved this note.

  12. Thanks for the article. I tend to not like labelling the DC lobby loop as a distinct network effect to be purchased the way one would buy a RAM upgrade. The idea of a that a lobby circuit as a component of the larger network effects in play particularly among multinationals and mega cap tech is more appealing to me. To get the DC lobbyist benefitsyou already have to have escape velocity as a corporate/political entity (ie network effects). Think Google 10-15 years ago. I have a hard time with an empirical statement that consumers always suffer from this (maybe it’s not meant to be empirical, in which cases, my apologies), if polled I’d suggest most people feel they have benefitted from Google’s products. (Skynet concerns abated). On the other hand, there are definitely cases where the public was worse off like the GFC or private prisons among others your article discusses. The misallocation of capital (public spending not being reflected in conditions other than GDP etc.) is a major unintended consequence of the process, absolutely. Fiscal policy is welded directly into the unintended consequence machine also and is highly related to what happens in DC on pay to play (public private games).

    Is this also always deflationary? I don’t think it is. Flashback to Ben’s point on labour productivity weakness, decapitating the argument that post GFC it was purely tech that blanketed inflation. Are there societal level negatives from pay to play? Yup. The bloating of the military industrial complex creates lots of negative outcomes. Health care and drug costs bias to inflation (not deflated) under the lobby story. And then we have to consider the moral hazard consequences, as well as the opportunity costs on fiscal policy ‘investment’. It’s a hugely complicated topic!

  13. Avatar for AMack AMack says:

    A couple of things I’m unsure of:

    Yes, firms have used lower borrowing costs (ZIRP) to re-jig their balance sheets but there’s no reason why we should be upset about that in and of itself. We can be upset because we aren’t seeing the investment and productivity growth that we’d like, but from the above, I’m still not sure why we’re not seeing the investment.

    • At a company level, when interest rates go down, why do corporations not do more real world investment as well as financialisation. what’s stopping the coefficient being positive?
    • And at a system level, corporations engaging in share buybacks/buying revenue are giving the money to investors that have the option to invest (directly or indirectly) in the real world. Why don’t they?
      I feel as though the argument needs another step. E.g. Corporate balance sheets hit some kind of leverage constraint through financialisaition, making real-world investment impossible/ the marginal cost of capital and the hurdle rate for real investment don’t move together/ investment should be viewed as an accelerator model, but relying on expectations of future growth, which have remained weak?

    Second, (& picking up on a comment below) labour share of income looks very like a mean reverting series (Annex B in and there seem to be reasonable reasons to believe that it should be: non-labour income is often unequally distributed and viewed as unearned. If there’s only so far you can push non-labour’s share of income without political blowback then betting on financialisation continuing is also a bet on there being no political pressure, no mean reversion in labour share?

  14. Avatar for Trey Trey says:

    I was having a discussion today about SC under performance vs LC. It occurred to me that some of the gap could be attributable to the inability of SC to financialize their earnings.

  15. Profit margin is a temptation few corporations can resist, but ultimately they will destroy themselves with it. Here is one example:

    I take my kids to a couple baseball games a year. Parking costs inch higher. $5 here, $5 there. Ok. Ticket costs inch higher. Ok. A cup of beer for $10… fine, if I’m drinking with a client I’ll expense it, and I’ll consider it an investment. It’s a hot day and my kids need a bottle of water. $8 for each of us, a party of four. Another $32, and finally, my breaking point.

    The next year we only go to one game. And the year after we go bowling instead.

    MLB execs scratching their heads trying to figure out why revenues stopped increasing. And a generation of fans that won’t be taking their own kids to games as a tradition in ten years.

Continue the discussion at the Epsilon Theory Forum


The Latest From Epsilon Theory


This commentary is being provided to you as general information only and should not be taken as investment advice. The opinions expressed in these materials represent the personal views of the author(s). It is not investment research or a research recommendation, as it does not constitute substantive research or analysis. Any action that you take as a result of information contained in this document is ultimately your responsibility. Epsilon Theory will not accept liability for any loss or damage, including without limitation to any loss of profit, which may arise directly or indirectly from use of or reliance on such information. Consult your investment advisor before making any investment decisions. It must be noted, that no one can accurately predict the future of the market with certainty or guarantee future investment performance. Past performance is not a guarantee of future results.

Statements in this communication are forward-looking statements. The forward-looking statements and other views expressed herein are as of the date of this publication. Actual future results or occurrences may differ significantly from those anticipated in any forward-looking statements, and there is no guarantee that any predictions will come to pass. The views expressed herein are subject to change at any time, due to numerous market and other factors. Epsilon Theory disclaims any obligation to update publicly or revise any forward-looking statements or views expressed herein. This information is neither an offer to sell nor a solicitation of any offer to buy any securities. This commentary has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. Epsilon Theory recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial advisor. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.