The Bear’s Lair: The economics of self-delusion

Moody’s Analytics Survey of Business Confidence is currently hovering near record highs and “expectations have never been stronger in this history of the survey.” What’s more, while the survey is a worldwide one, optimism is greatest among U.S. businesses. Indeed the National Association of Homebuilders Housing Market Index at 59 is the highest since November 2005, at the height of the housing bubble. Yet U.S. economic growth was negative in the first quarter of 2015 and doesn’t look to be shaping up much better in the second quarter. Corporations and, from the state of the market, investors, are therefore deluding themselves, with dire economic implications.

Self-delusion is common but not universal in bull market bubbles. In 1929, investors were entirely deluded on the stability of the various pyramid investment trust schemes devised by Wall Street. On the other hand, investing in RCA, the hot stock of the era, was perfectly rational; its stock price never got above a valuation of 28 times earnings, which in this era of Facebook would be considered a stone cold bargain. The myth perpetrated by J.K. Galbraith in the 1950s that the 1920s stock market was uniquely irrational is in general just that: a myth.

Novelty tends to be overpriced as does incomprehensibility. In 1929 RCA’s technological novelty was readily understandable to anyone with decent high-school science, while the financial engineering behind the Goldman Sachs Trading Corporation (name sound familiar?) was completely incomprehensible even to those on Wall Street. In the event, the Great Depression put paid to GSTC, which issued shares at $104 in December 1928 which rose above $300 in 1929 as GSTC spun off two subsidiaries Shenandoah Corporation and Blue Ridge Corporation before trading at $1.75 in 1932. GSTC had one unexpected old-fashioned virtue, however; since its originator Goldman Sachs was not in 1929 a bank and had no access to cheap debt, it avoided bankruptcy by virtue of being unleveraged in terms of debt (although the pyramid holding company structure made shareholder returns leveraged even without debt.).

Once again the moral is clear; in the case of both RCA and GSTC, the financial markets of 1929 ran on much sounder principles than those prevailing today!

Perhaps the strongest evidence of the self-deluding nature of today’s economy is in productivity. Revised data is now available for the first quarter of 2015, showing that U.S. labor productivity fell at a 3.1% annual rate, after a 2.1% annualized decline in the fourth quarter of 2014. In addition, productivity has since 2011 been rising more slowly than at any comparable period since statistics began after World War II. In the UK, likewise, productivity has performed appallingly badly in this economic recovery, and remains lower than at the height of the boom in 2007.

There’s the delusion: corporate bosses are reflecting record levels of confidence, yet the efficiency of the corporations they are running is performing unprecedentedly badly. Without adequate productivity growth, the U.S. and global economies are condemned to stagnation in the long term. Thus the productivity deficit should be concerning corporate heads and investors as a matter of first priority. If the U.S. really is condemned to a no-growth future then the risk of debt is much higher than people believe and the future expected return from equity is much lower.

Real estate is also an area of delusion, as it generally is in bubbles. The total value of world property markets hit a record $13.6 trillion in 2014, according to the FT. That was up only 4% on the year, but with the dollar having been very strong the increase in any other unit of denomination was considerably greater. Yields in prime cities are back to where they were in 2007, but because of record low interest rates they still appear attractive.

This is another illustration of the distortions caused by monetary policy so far out of the mainstream: it causes traditional valuation metrics to be abandoned. Markets, whether in real estate or stocks, get used to valuation levels far above those likely to prevail in the long run, capital is committed at the wrong level and the distortions increase ad infinitum.

The delusion also extends to corporate strategy. With interest rates so low, companies in general have decided it is financially advantageous to repurchase shares, borrowing the money to do so and decapitalizing the overall business. Certainly it fattens up the stock option returns of top management. But as no less a luminary than Senator Elizabeth Warren (D.-MA) has observed, it destabilizes the stock market, creating a “sugar high” in corporate stock prices, it siphons money into the pockets of top management and it tends to suppress corporate investment.

To which I would add that it is a rip-off on individual shareholders, who see corporate cash being siphoned off to the institutions and top management, and who suffer when (as inevitably happens) corporate management gets the timing hopelessly wrong, buying like madmen at the top of the market and having to undertake emergency rights issues in the next downturn. Warren wants to remove the 1982 SEC rule that permits such buybacks, holding them to be manipulative. I am surprised at finding myself in agreement with her, but in this case, while neglecting the interests of ordinary shareholders, she is at least right on the main issue.

The distortions in corporate strategy caused by “funny money” can also be illustrated by United Technologies’ (NYSE:UTX) decision to sell Sikorsky Helicopter, part of the company since 1929. Sikorsky is a perfectly satisfactory part of the company, making some $500 million per annum in profits, and its sale will probably leave UTX with a very substantial tax liability, since it would be sold at a price far above book value. But UTX is itself trading at 3.7 times book value, with a return on equity of a bloated 22% through stock repurchases’ shrinkage of its capital base, which have reduced its tangible net worth to minus $12 billion.

The distortion here is of course partly that from the accountants, who have forced UTX to write down its assets to a level wholly unrepresentative of its operations – its property, plant and equipment is only $9.2 billion compared with goodwill and other intangibles of $43.4 billion. Like most financial statements subjected to modern accounting principles, UTX’s balance sheet is neither representative of its business nor a useful clue to its value. The company’s top management has clearly been seduced by its distortions to engage in a “financial engineering” sale of one of the company’s core operations.

Sikorsky Helicopter may well be better off independent; it’s not clear that 86 years’ ownership by a conglomerate has benefited it much, although in its early days it must have increased the availability of research funds. However the decision to sell it appears driven entirely by the distorted valuation metrics in today’s market and not by any rational consideration of its long-term attractiveness as a business or its fit with UTX’s other operations.

Self-delusion is of course greatest in the tech sector. We learned this week that Uber’s drivers in California were to be considered employees of the company, not independent contractors. At this point it is unclear what value Uber has beyond its clever software (surely a wasting asset) and its base of operations as a taxi service in a number of cities. It is however abundantly clear that the value of a taxi service, even a worldwide taxi service (a business in which there are no economies of scale whatever) cannot possibly be anything like Uber’s valuation of around $50 billion.

The “unicorn” phenomenon, of tech companies with valuations above $1 billion, easily large enough to make a public offering viable, which remain private, selling shares to a small coterie of inside venture capitalists, looks increasingly like self-delusion elevated into a business strategy. Like Goldman Sachs Trading Corporation, it is mostly unleveraged, avoiding the self-delusion that infests most of the rest of the U.S. economy. Also like GSTC, it is unlikely to survive the next downturn.

Self-delusion is not universal in the U.S. economy; it is notably absent in the mining and energy sectors, for example, where values have been beaten down recently by new supplies and the peculiar absence of inflation (the consumer price index ticked up by 0.4% this month, but inflationists have been burned too often to take that as a leading indicator.) Nevertheless, whereas South Sea Bubble levels of self-delusion were confined in 1999 to the tech sector, and in 2005-07 to the home mortgage business, it has spread today to most of the economy, in particular to the commanding heights of the stock market and the real estate market. Its collapse, and replacement by irrational despair, is thus likely to be correspondingly painful.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)