US equities have outperformed other markets in recent years. Since December 2012 they have risen 70 per cent according to MSCI whereas global equities have risen only 45 per cent and UK stocks have fallen in dollar terms.
This is a new phenomenon. From 1969 (when MSCI’s data begin) the US outperformed the world index by only 0.1 percentage points per year in dollar terms. What, then, explains its surge recently?
It’s difficult to attribute it to cheap money simply because monetary policy has been easy around the world. There might be another reason. It’s that product market competition has weakened with the result that listed companies are less likely to see their profits competed away. More companies today have what Warren Buffett called “economic moats” – ways of fending off competition. This means high profits are more sustainable, which in turn means valuations are higher as investors anticipate years of high profits.
Three separate pieces of evidence tell us this:
◼︎ Jan De Loecker and Jan Eeckhout show that prices have risen relative to companies’ marginal costs since 1980. This, they say, is evidence that companies’ market power has risen – although Rohan Shah at the Adam Smith Institute says it might be due to a survivorship effect.
◼︎ Jason Furman and Peter Orszag find that “there has been a trend of increased dispersion of returns to capital across companies." This is a sign of weaker competition, as competition should tend to equalize profits.
◼︎ David Autor and colleagues document a rise of “superstar companies” with huge profits, such as Apple and Microsoft.
We’re talking here about a US phenomenon rather than worldwide one. The flat share of profits in GDP and relatively lacklustre stock market tell us these trends are not so evident in the UK.
Why then are we seeing them in the US? A lot of the answer lies with the rise of brand power and the digital economy.
To see how these matter, compare Tesco with Facebook. If you can sell groceries cheaper than Tesco, you’ll grab a slice of the market and force Tesco to cut prices. But if you set up a good social network site, you might well fail simply because people will prefer to stay on Facebook because that is where their contacts are.
Companies such as Facebook have two advantages. One is a high barrier to entry in the form of capital requirements. David Evans and Richard Schmalensee show that many new economy companies are like matchmakers in that they bring people together: think of Twitter, Facebook, Uber, Snapchat, Airbnb and so on. Setting up a successful matchmaking site, however, requires lots of capital. You must either spend a fortune on advertising or suffer years of cash burn before you reach a critical mass of having enough people to bring together.
A second advantage of such companies is that they benefit from network effects – the more people use them, the more valuable they are. Whereas old economy companies sometimes suffer from diseconomies of scale, the likes of Facebook and Snapchat enjoy economies of scale. They have near-zero marginal costs; an extra customer costs them almost nothing.
As Jonathan Haskel and Stian Westlake point out, this means such businesses are scalable. Once you have a strong brand, you can expand it into new cities at little cost. The likes of Starbucks and Uber have done just this – although Uber is yet to show a profit. Smaller, less well-known rivals don’t have this advantage.
High capital requirements and zero marginal cost give new economy businesses high monopoly power – a power further entrenched by strong intellectual property laws.
All this, though, might not be the whole story. Professors De Loecker and Eeckhout estimate that rising mark-ups aren’t confined to the new economy but have occurred in most industries.
Although they say these have risen steadily since the 1980s, they show that the increase accelerated after 2000 and 2008. This might be no accident as the market falls in those years might well have had a scarring effect. They taught us that the returns to entrepreneurship are precarious: they might be massive for one or two winners, but they are slim or negative for most. William Nordhaus has shown that the average profits to innovation are small, and Hendrick Bessembinder has shown that most quoted companies underperform cash over their lifetimes. As potential entrepreneurs have wised up to the facts about returns, the US’s 'can do' entrepreneurial spirit has waned. Which means competition has declined. Hence bigger and more sustainable profits for incumbents.
Can this continue? There are two reasons for doubt.
One is that we cannot foresee the pace and direction of technical change. History tells us that mighty companies with technical know-how can be wiped out by new technologies: think of Xerox, Polaroid or Kodak. In the long run, the same fate might befall today’s giants. Yes, it seems unlikely today, but Kodak thought the same in the 1970s.
Another danger, however, comes from politics. The rise of giant monopolies has been accompanied by increased inequality and stagnant incomes for millions, which in turn has fuelled political polarisation and populism. Even if big companies are secure against a backlash in the marketplace, they are not so secure against a political backlash. The recent fall in Amazon’s share price after a critical tweet by President Trump might just be a hint at the vulnerability of such giants. There’s a precedent here. In the late 19th century big companies dominated the US economy, but several (such as Standard Oil) were broken up by subsequent use of anti-trust laws.
The stock market might seem healthy. But a healthy stock market isn’t necessarily a sign of a healthy economy, still less of a healthy polity. And this brings into question the longer-term sustainability of high equity valuations.