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The monopoly threat

High US share prices reflect the fact that the stock market is dominated by monopolies
May 6, 2020

US bonds and equities seem to be telling different stories. On the one hand, the S&P 500 has recouped many of the losses it suffered in March and now stands only 10 per cent down so far this year – which is remarkable resilience in the face of what will be record-breaking falls in economic activity. And the cyclically adjusted earnings yield on the S&P 500 is still well below its long-term average, which tells us that investors are optimistic about future growth.

On the other hand, though, 10-year Treasury bonds are still near a record low at 0.6 per cent, and are negative in real terms. These are signs that investors are nervous and expect weak economic growth.

You might think there are simple explanations for this apparent contradiction. The Fed is flooding the economy with cheap money: it plans to buy over $700bn of Treasury and mortgage bonds in the next few months. This is pushing bond yields down and share prices up. And low bond yields should mean that future profits are discounted only a little, which should naturally cause high share prices.

Both these explanations run into an obvious problem, however. If they are right, we’d also expect to see high share prices in the UK and eurozone because monetary policy is loose here and bond yields are low. But we don’t. Since the end of 2013 shares have fallen in US dollar terms in the UK and eurozone, but they have risen almost 50 per cent in the US. This tells us that there is something uniquely American about the coexistence of high bond and equity prices.

It might be, of course, that one market is hugely overvalued. Such a view is too hasty. We should not impose our opinion onto the world before trying to explain it. Instead, we should ask: what are the markets telling us? And they could be saying something alarming about American capitalism.

Let’s start from an underappreciated fact. The stock market is not a representative sample of US companies. As Rene Stulz at Ohio State University and Kathleen Kahle at the University of Arizona have shown, quoted companies are older, larger and more cash-rich than they used to be – and the larger ones are more profitable. This helps explain the paradox that share prices are high while the profits of US companies in aggregate are weak. It’s because listed companies are larger and hence more monopolistic than the typical company – and if, like Tesla (US:TSLA), they are not profitable now investors expect them to enjoy monopoly profits in future.

In fact, just five companies – Facebook (US:FB), Microsoft (US:MSFT), Apple (US:AAPL), Amazon (US:AMZN) and Alphabet (US:GOOGL) – now account for over one-fifth of the value of the entire S&P 500. That’s a record high – and a sign that the US economy is increasingly dominated by a few monopolies.

And here’s the problem. Monopoly causes economic stagnation. Expecting high monopoly profits for a few companies is therefore consistent with expecting aggregate growth to be weak. High share prices therefore can exist alongside low bond yields.

Standard economics gives us one reason for this. Monopolies charge higher prices than competitor companies. That reduces people’s real incomes (relative to what we’d see in a competitive economy), which means weaker demand for other companies’ products.

But the costs of monopoly go further than that. Harvard University’s Michael Kremer shows that monopolies are sometimes less likely to innovate. This is exacerbated by the fact that potential rivals to the monopolist are loath to innovate or enter the market for fear the monopolist will undercut them and so drive them out of business.

Yet another cost of monopoly has been described in a recent book by Brink Lindsey and Steven Teles. They show how big companies successfully lobby the government for regulations that entrench their power and reduce competition – for example, implicit subsidies to banks or copyright and patent laws that protect the monopolies of software and pharmaceutical companies. Such rent-seeking deals, they say, “make our economy less dynamic and innovative”. In the same spirit, Anne Case and Angus Deaton describe in their book Deaths of Despair how high healthcare costs – the result of intense lobbying by the industry – push up the price of health insurance and so make companies reluctant to hire less skilled workers.  

And then there’s a cultural impact of large companies. Back in 1942 Joseph Schumpeter warned in Capitalism, Socialism and Democracy that monopolistic companies would replace entrepreneurs with “rationalist and unheroic” bureaucrats. This, he warned would slow down growth and also weaken support for free market capitalism. The facts of low bond yields (which signal low future growth) and the popularity of anti-market or anti-capitalist politicians such as Donald Trump or Bernie Sanders are consistent with this.

There is, however, another old idea that has become relevant again. Back in 1966 Paul Baran and Paul Sweezy argued that monopolies caused stagnation because they could not create the demand for all the goods and services they were potentially capable of producing. Fearing such a lack of demand, they would rein back production.

For a long time, this idea was out of favour because (whether by accident or design) the economy did find ways of sustaining demand – be it the looser fiscal policy of the 1970s or easy credit after 1980. But it might now be relevant again.

All these problems might well get worse. One effect of the current recession will be to drive to the wall smaller companies – especially those with weaker balance sheets than their larger rivals or less of a web presence. The result will be to intensify the trend towards increased monopoly power and the stagnation it leads to. The high valuations on listed US companies are a sign not that investors expect good economic growth generally, but that they instead expect more monopoly profits for the minority of American companies that are on the market.

All this suggests that the combination of low bond yields and high equity valuations need not mean that one market is mispriced. Instead, it is just what we would see if monopolistic companies are holding back growth while generating high profits for themselves. A strong stock market is not a sign of the health of corporate America, but rather of its dysfunctionality. In this sense, we should worry not that US shares are overpriced, but rather that they are not.