By Cali Money Man:

During the past decade, US equity markets have experienced structural changes with major macroeconomic implications, as policies of both companies and investors have evolved.

An unprecedented change in corporate financial policy.

Many corporate executives now not only channel their companies’ cash flow to shareholders, but leverage up to do so – often at the expense of capex, R&D, and employee compensation and training. This price-insensitive buying of stocks, mirroring the similarly price-insensitive buying by central banks, amounts to a “relentless bid.”

We’re now seeing the result in slowing growth of, or even falling, productivity and corporate revenue.

Andrew Lapthorne of SocGen has documented this in detail. Andrew Smithers has also written about this in his column at the FT website. Now the mainstream news media have noticed.

• “In corporations, it’s owner-take-all,” by Harold Meyerson, op-ed in the Washington Post, 26 August 2014
• “Why have U.S. companies become such skinflints?” Paul Roberts, op-ed in the LA Times, 27 August 2014

Soon the investment banks will begin writing about it.

Changed investors

Structural changes by investors also might have large macro effects, adding to those caused by the new corporate financial policies described above. The US equity market’s structure has changed from the fusion of fee-based management and passively managed asset allocation. That is, charging fees for “actively” managed portfolios with relatively fixed asset allocations.

Managers realized that generating long-term alpha is almost impossible for most of them, and so they gave up chasing it. Instead, investors now pay de facto for service and relationships (although they’re not told that).

From a business perspective, less attention to portfolio management frees up time to devote to sales. Hence the rise of brokers using this strategy with billions of assets under management.

This produces a second relentless bid for stocks, as investors’ savings flow into stocks irrespective of valuations and conditions. Send a dollar to your broker, 60% plus or minus goes into stocks (ignoring other potentially more useful asset allocation formulas). Stocks are bought for the long-term, so the allocations do not change. This contributes, along with closet indexing, to the long decline in equity turnover.

Both total volume and turnover rates are back to levels of about 1998. Some calculate that, excluding HFT and EFT-arbitrage, percent turnover might be back to levels of the late 1980s. Credit Suisse has some of the best research on this; the FT posted this August 2012 CS analysis. Since then, NYSE volume is down by half!

To see the scale of this change, the SEC has cautioned brokers that charging clients for asset management with too-little turnover is inappropriate and warrants regulatory action – a reverse of their long-standing concern about excessive trading (i.e., churning). For a sound look at this topic see “The Relentless Bid, Explained” by Joshua M. Brown at The Reformed Broker, 5 March 2014.

The ill consequences from this dominance of fixed asset allocation strategies had already been described by Bill Sharpe and Andre Perold in “Dynamic Strategies for Asset Allocation,” Financial Analysts Journal, Jan-Feb 1995:

… the more demand there is for one of these strategies … the less healthy it may be for markets generally. … {I}f growing numbers of investors switch to concave strategies, then the market may become too stable. Prices may be too slow to adjust to fair economic value.

Combining the two relentless bids

Have these flows created a Minsky-like cycle in equity markets – without leverage? If so, what will happen in the eventual Minsky Moment, when the corporate buying stops and investors sell? Rising rates will end this zaitech between corporate bond and equity earnings yields. As for investors, there are many possible catalysts: boomers turning to sellers (as they retire with small pensions and savings), the next recession, and geopolitical events.

The price decline might be magnified by illiquid markets – with low volume (ex-HFT and EFT trading), a smaller pool of trading capital (as both spreads and volatility has declined), and liberation of traders from many of the post-1928 regulations (especially the downtick rule).

“We run carelessly to the precipice after we have put up a façade to prevent ourselves from seeing it” – Blaise Pascal in Thoughts (published after his death in 1662). By Cali Money Man.

Selling strung-out American consumers something they can’t afford, can’t get financed elsewhere because they already bought things they couldn’t afford and ruined their credit in the process, and overcharging them for the privilege is one of the most irresistible money makers. But subprime giveth, and subprime taketh away. Read… Subprime Blows up on Retailer, CEO Warns on ALL Subprime, Hits Auto Sales

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