This is Water

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There are these two young fish swimming along and they happen to meet an older fish swimming the other way, who nods at them and says “Morning, boys. How’s the water?” And the two young fish swim on for a bit, and then eventually one of them looks over at the other and goes “What the hell is water?”

David Foster Wallace (2005)

It’s the perfect description of a Zeitgeist … the water in which we swim.

We can’t see it. We can’t hear it. We can kinda sorta feel it, if we focus really hard, but only kinda sorta. All the same, because it’s part of a social system and not a physical system, WE create it. Not in a conscious fashion. We can’t set out to create a Zeitgeist.

But we can be nudged.

It’s like a stadium crowd holding up cards for the TV audience. They can’t see the picture they’re making … they have no idea what it looks like or what their role in its making might be. But they’re told/asked to do it. So they do.

THIS is a Zeitgeist.

What’s the matter, Ben? You got a problem holding this card up over your head? It’s for the troops. You support the troops, don’t you? Don’t you?

Yes, I support the troops. And yes, I have a problem with this.

Why? Because I don’t trust the State and the Oligarchy to use the common knowledge of “support for the troops” – the crowd watching the crowd express a public act of allegiance to the military, so that everyone knows that everyone knows that yes, it is right and proper to support the troops – for the right reasons.

Instead, I suspect that they will use my voluntary “support” (hey, no one forced you to hold up that card) to justify things like … oh, I dunno, a trillion dollars wasted and 2,000 kids dead to fight a war in freakin’ Afghanistan. Because, you know, otherwise “the terrorists win”. Otherwise we lose “credibility”. JFC.

It’s exactly the same thing with capitalism.

In exactly the same way that all of us sit in our citizenship stadium and get nudged to hold up a card creating a common knowledge display of “Yay, military!”, so do all of us sit in our investor stadium and get nudged to hold up a card creating a common knowledge display of “Yay, capitalism!”.

What’s the matter, Ben? You got a problem holding this card up over your head? It’s for capitalism. You support capitalism, don’t you? Don’t you?

Yes, I support capitalism.

AND I have a problem with holding up this card.

You should, too.

Because we can’t trust the State and the Oligarchy to use our support for the right reasons.

In You Are Here, I wrote that the investment Zeitgeist is changing in three ways.

  • Deflationary expectations, now 40+ years old, are becoming inflationary expectations.
  • Cooperative and multi-play games in both international politics and domestic politics, now 70+ years old, are becoming competitive and single-play games.
  • Modern capital markets, now 150+ years old, are becoming political utilities.

Time to add a fourth.

  • Capitalist productivity, now 200+ years old, is becoming capitalist financialization.

What is financialization?

Financialization is profit margin growth without labor productivity growth.

That sounds like a small thing, but I tell you it is EVERYTHING.

Financialization is squeezing more earnings from a dollar of sales without squeezing at all, but through tax arbitrage or balance sheet arbitrage.

Financialization is the zero-sum game aspect of capitalism, where profit margin growth is both pulled forward from future real growth and pulled away from current economic risk-taking.

Financialization is the smiley-face perversion of Smith’s invisible hand and Schumpeter’s creative destruction. It is a profoundly repressive political equilibrium that masks itself in the common knowledge of “Yay, capitalism!”.

Financialization is a global phenomenon. In China, it’s transmitted through the real estate market. In the US, it’s transmitted through the stock market.

Financialization is the zombiefication of an economy and the oligarchification of a society.

Here’s the foundational chart for these strong words.

source: Bloomberg

This is a 30-year chart of total S&P 500 earnings divided by total S&P 500 sales. It’s how many pennies of earnings S&P 500 companies get from a dollar of sales … earnings margin, essentially, at a high level of aggregation. So at the lows of 1991, $1 in sales generated a bit more than $0.03 in earnings for the S&P 500. Today in 2019, we are at an all-time high of a bit more than $0.11 in earnings from $1 in sales.

It’s a marvelously steady progression up and to the right, temporarily marred by a recession here and there, but really quite awe-inspiring in its consistency. Yay, capitalism!

It’s a foundational chart for this note because I believe that the WHY of earnings margin growth in the 1990s and early 2000s is fundamentally different than the WHY of earnings margin growth since then.

WHY do we get three times as much in earnings out of a dollar of sales today than we did 30 years ago, and twice as much than we did 10 years ago?

The common knowledge answer is technology!.

By which I mean that the common knowledge answer is the meme! of technology as opposed to any actual technology. By which I mean that we can’t exactly say why technology would improve earnings margins and efficiency over the past decade, but we believe it MUST be technology. Somehow. Of course it’s technology. Everyone knows that everyone knows that it’s technology that makes anything in the world more efficient. So we mumble something-something-technology whenever anyone asks a question like this. And yes, This Is Why We Can’t Have Nice Things.

Here, hold this card up over your head. It’s for technology and progress. You support technology and progress, don’t you? Don’t you?

I used to believe this, too. I used to believe that corporate management was getting better and smarter over time, that they were making constant process improvements and technology-based productivity enhancements to squeeze more and more profits out of the same sales dollar.

And I think this used to be true. I think that during the 1990s and early 2000s – the so-called Great Moderation of the Fed’s Golden Age – when we actually had significant advancements in labor productivity year after year after year, corporate management was, in fact, able to drive earnings margins higher for the right reasons. I think the driver of profit margin growth over this period was actual technology, as opposed to the meme of technology!.

But I don’t believe this is true anymore. I don’t believe that technology and productivity advancements have been responsible for earnings margin improvements for the past decade … for some years before the Great Financial Crisis, in fact.

Here, take a look for yourself.

See, the Fed was convinced that an easy money policy would lead to corporate management investing more in technology and plant and equipment … you know, all of those things you need to drive productivity. All of those things you need to drive a 1990s style recovery, with earnings margin accretion for the right reasons.

Instead, corporate management followed the Zeitgeist.

They always do. It’s the smart move.

This is a chart of Labor Productivity growth in the US for the past 30 years. It’s how much more stuff we make or services we provide from a unit of labor. It’s how much we’re growing for the right reasons, by applying capital investment in plant and equipment and technology to work smarter and more efficiently. It’s how we generated earnings efficiency and margin growth for the right reasons in the 1990s and early 2000s. It’s how we’ve been reduced to squeezing tax policy and ZIRP-supported balance sheets for earnings efficiency ever since.

This chart IS the failure of monetary policy for the past decade.

This chart IS the zombiefication and oligarchification of the US economy.

Why do I rail at the Fed? THIS.

Trillions of dollars in QE, and all we got for it was this lousy t-shirt. Yes, I’m going to get this productivity chart put on a t-shirt.

The reason companies aren’t investing more aggressively in plant and equipment and technology is BECAUSE we have the most accommodative monetary policy in the history of the world, with the easiest money to borrow that corporations have ever seen. Why in the world would management take the risk — and it’s definitely a risk — of investing for real growth when they are so awash in easy money that they can beat their earnings guidance with a risk-free stock buyback? Why in the world would management take the risk — and it’s definitely a risk — of investing for GAAP earnings when they are so awash in easy money that they can hit their pro forma narrative guidance by simply buying profitless revenue? Why in the world would companies take any risk at all when the Fed has eliminated any and all negative consequences for playing it safe?

That’s from Gradually and Then Suddenly, written in July 2017. It’s worth your time.

What’s changed since I wrote that note is that the barge of monetary policy, both in the US and everywhere else in the world, has done a 180 and is now chugging back down the easing river. No central bank in the developed world is looking to tighten today, and if anything we’re on the cusp of fiscal policies like MMT, or at least trillion dollar deficits forever and ever amen, to accelerate the shift in the modern Zeitgeist towards fiat EVERYTHING.

This is not a mean-reverting phenomenon.

This doesn’t get better going forward. It gets worse.

But wait, there’s more …

source: Bloomberg

This is a chart of the S&P 500 price-to-earnings ratio in yellow, the belle of the narrative ball, together with its forgotten cousin, the price-to-sales ratio in blue.

When we grow profits through productivity growth – when our “supply” of earnings is directly connected to the same operations that generate sales – P/E and P/Sales multiples go up and down together. When we extract excess earnings through financialization – when our “supply” of earnings increases for no operational reason connected with sales – the P/E multiple becomes depressed relative to the P/Sales multiple. As the kids say, it’s just math.

Why is this important? Because a P/E multiple deflated by financialization doesn’t mean what you think it means.

How many times in the past ten years have you heard that the market is not expensive on a valuation basis? And what you’ve heard is right, as far as it goes.

Because the market narrative of valuation is completely dominated by the vocabulary of earnings, not the vocabulary of sales.

Sure, the S&P 500 P/Sales ratio is near an all-time high, but who cares about that? The S&P 500 P/E ratio today is right at 19 … neither crazy low nor crazy high … and we ALL care about that. But here’s the thing:

Without financialization, my guess is that the S&P 500 P/E ratio today would be 28.

Good luck selling that to a value investor, Wall Street.

Here, hold this card up over your head. It’s for value and a reasonable earnings multiple. You support value and a reasonable earnings multiple, don’t you? Don’t you?

But wait, still more …

source: Bloomberg

This is a chart of S&P 500 buybacks per share (in blue) imposed over the ratio of S&P 500 earnings-to-sales in green. You’ll see that share buybacks spike after profit margins spike. You’ll see that share buybacks spike before and during recessions.

When do stock buybacks accelerate dramatically?

In 2006 and 2007, when management is rolling in record profits and profit margins, despite meager productivity growth.

In 2018 and 2019, when management is rolling in record profits and profit margins, despite meager productivity growth.

This is not an accident.

Here’s the past five years so you can see the temporal relationship more clearly.

source: Bloomberg

Stock buybacks are what you DO with the excess earnings you’ve made from financialization.

Why? Because stock buybacks are part and parcel of the financialization Zeitgeist. They’re part and parcel of the tax-advantaged issuance of stock to management, which is then converted into tax-advantaged income for management through stock buybacks.

Here, hold this card up over your head. It’s for alignment of interests between management and investors. You support alignment of interests between management and investors, don’t you? Don’t you?

What does Wall Street get out of financialization? A valuation story to sell.

What does management get out of financialization? Stock-based compensation.

What does the Fed get out of financialization? A (very) grateful Wall Street.

What does the White House get out of financialization? Re-election.

What do YOU get out of financialization?

You get to hold up a card that says “Yay, capitalism!”.

So what do we DO about this?

I’ve got three answers, one for your life as an investor, one for your life as a citizen, and one for your life as a human being.

As an investor, my answer is this: Adapt.

How? First read this.

And then take this to heart.

What are the Narratives I am being told?

What are the Abstractions presented to me?

What are the Metagames I am playing?

What are the Estimations shaping my outcomes?

Am I acting to promote Reciprocity?

Am I acting in a way that reflects my Identity?

Why? Because Clear Eyes, Full Hearts, Can’t Lose.

As a citizen, my answer is this: Resist.

How? First read this.

And then take this to heart.

Take back your vote.

Take back your distance.

Take back your data.

As a human being, my answer is this: Find your pack.

We’re all little fish.

We’re all swimming in the same smiley-face authoritarian waters of “Yay, military!” and “Yay, capitalism!”.

I tell you, brothers and sisters, we’re all we’ve got.

But I also tell you, we are all we need.

Yours in service to the pack. – Ben

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  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.

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