The new economics of oil

Sheikhs v shale

The economics of oil have changed. Some businesses will go bust, but the market will be healthier

Dec 6th 2014

         



THE official charter of OPEC states that the group’s goal is “the stabilisation of prices in international oil markets”. It has not been doing a very good job. In June the price of a barrel of oil, then almost $115, began to slide; it now stands close to $70.

This near-40% plunge is thanks partly to the sluggish world economy, which is consuming less oil than markets had anticipated, and partly to OPEC itself, which has produced more than markets expected. But the main culprits are the oilmen of North Dakota and Texas. Over the past four years, as the price hovered around $110 a barrel, they have set about extracting oil from shale formations previously considered unviable. Their manic drilling—they have completed perhaps 20,000 new wells since 2010, more than ten times Saudi Arabia’s tally—has boosted America’s oil production by a third, to nearly 9m barrels a day (b/d). That is just 1m b/d short of Saudi Arabia’s output. The contest between the shalemen and the sheikhs has tipped the world from a shortage of oil to a surplus.

Fuel injection
 
Cheaper oil should act like a shot of adrenalin to global growth. A $40 price cut shifts some $1.3 trillion from producers to consumers. The typical American motorist, who spent $3,000 in 2013 at the pumps, might be $800 a year better off—equivalent to a 2% pay rise. Big importing countries such as the euro area, India, Japan and Turkey are enjoying especially big windfalls.

Since this money is likely to be spent rather than stashed in a sovereign-wealth fund, global GDP should rise. The falling oil price will reduce already-low inflation still further, and so may encourage central bankers towards looser monetary policy. The Federal Reserve will put off raising interest rates for longer; the European Central Bank will act more boldly to ward off deflation by buying sovereign bonds.

There will, of course, be losers. Oil-producing countries whose budgets depend on high prices are in particular trouble. The rouble tumbled this week as Russia’s prospects darkened further.

Nigeria has been forced to raise interest rates and devalue the naira. Venezuela looks ever closer to defaulting on its debt. The spectre of defaults and the speed and scale of the price plunge have unnerved financial markets. But the overall economic effect of cheaper oil is clearly positive.

Just how positive will depend on how long the price stays low. That is the subject of a continuing tussle between OPEC and the shale-drillers. Several members of the cartel want it to cut its output, in the hope of pushing the price back up again. But Saudi Arabia, in particular, seems mindful of the experience of the 1970s, when a big leap in the price prompted huge investments in new fields, leading to a decade-long glut. Instead, the Saudis seem to be pushing a different tactic: let the price fall and put high-cost producers out of business. That should soon crimp supply, causing prices to rise.

There are signs that such a shake-out is already under way. The share prices of firms that specialise in shale oil have been swooning. Many of them are up to their derricks in debt. Even before the oil price started falling, most were investing more in new wells than they were making from their existing ones. With their revenues now dropping fast, they will find themselves overstretched. A rash of bankruptcies is likely. That, in turn, would bespatter shale oil’s reputation among investors. Even survivors may find the markets closed for some time, forcing them to rein in their expenditure to match the cash they generate from selling oil. Since shale-oil wells are short-lived (output can fall by 60-70% in the first year), any slowdown in investment will quickly translate into falling production.

This shake-out will be painful. But in the long run the shale industry’s future seems assured.

Fracking, in which a mixture of water, sand and chemicals is injected into shale formations to release oil, is a relatively young technology, and it is still making big gains in efficiency. IHS, a research firm, reckons the cost of a typical project has fallen from $70 per barrel produced to $57 in the past year, as oilmen have learned how to drill wells faster and to extract more oil from each one.

The firms that weather the current storm will have masses more shale to exploit. Drilling is just beginning (and may now be cut back) in the Niobrara formation in Colorado, for example, and the Mississippian Lime along the border between Oklahoma and Kansas. Nor need shale oil be a uniquely American phenomenon: there is similar geology all around the world, from China to the Czech Republic. Although no other country has quite the same combination of eager investors, experienced oilmen and pliable bureaucrats, the riches on offer must eventually induce shale-oil exploration elsewhere.

Most important of all, investments in shale oil come in conveniently small increments. The big conventional oilfields that have not yet been tapped tend to be in inaccessible spots, deep below the ocean, high in the Arctic, or both. America’s Exxon Mobil and Russia’s Rosneft recently spent two months and $700m drilling a single well in the Kara Sea, north of Siberia. Although they found oil, developing it will take years and cost billions. By contrast, a shale-oil well can be drilled in as little as a week, at a cost of $1.5m. The shale firms know where the shale deposits are and it is pretty easy to hire new rigs; the only question is how many wells to drill. The whole business becomes a bit more like manufacturing drinks: whenever the world is thirsty, you crank up the bottling plant.

Sheikh out
 
So the economics of oil have changed. The market will still be subject to political shocks: war in the Middle East or the overdue implosion of Vladimir Putin’s kleptocracy would send the price soaring. But, absent such an event, the oil price should be less vulnerable to shocks or manipulation. Even if the 3m extra b/d that the United States now pumps out is a tiny fraction of the 90m the world consumes, America’s shale is a genuine rival to Saudi Arabia as the world’s marginal producer. That should reduce the volatility not just of the oil price but also of the world economy. Oil and finance have proved themselves the only two industries able to tip the world into recession. At least one of them should in future be a bit more stable.

The World’s Dumbest Idea

John Mauldin

Dec 04, 2014

 
In today’s Outside the Box the redoubtable James Montier of GMO lifts his lance to prick the underbelly of the Mighty SVM. (That’s Shareholder Value Maximization, for you newbies.) “The world’s dumbest idea” (among many candidates in the world of finance), says James, citing none other than “Neutron Jack” Welch in support.
 
After noting that taking on SVM “is a little like criticizing motherhood and apple pie,” James sets right to work, tracing the monster’s birth to an editorial by Milton Friedman in 1970, in which Saint Milton wrote, “There is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits...”
 
Our intrepid author then explains how in the 1970s the Gospel According to Milton translated into the challenge of how to get corporate executives to focus on maximizing the wealth of shareholders. The solution: pay them a s***load of money (but not just cash – stock and options now constitute about two-thirds of total CEO compensation).
 
But, alas, there is pretty good research to suggest that larger incentives actually translate to lower performance, for reasons that James runs down for us. To make matters worse, both the average tenure of a corporate CEO and the average lifetime of an S&P 500 company have plummeted since the 1970s.
 
Bottom line: SVM has pretty well laid the kingdom to waste. James focuses on three areas of damage: (1) declining and low rates of business investment, (2) rising inequality, and (3) a low labor share of GDP. James takes these outcomes on one at a time, in his usual convincing manner. (Other work by James and some of the brightest minds around can be found at www.gmo.com.)
 
Last night there was a small dinner/reception/fundraiser at Harland and Amy Korenvaes’ home for the foundation of Ayaan Hirsi Ali. Ayaan wrote the books Infidel and Nomad, detailing her journey from Somalia, where as a young girl she actually joined the Muslim Brotherhood.
 
(That’s what her family and all her friends did. When she started asking questions, it became a problem. She was told that girls simply did as they were told.) She ended up fleeing to Europe and went on to become a member of the Dutch parliament (one of the great political twists of all time) and an outspoken advocate of Islamic women’s rights. For those not familiar, she was integral (as in, provided the outline and ideas) for Theo van Gogh’s movie outlining the problems that some Islamic young women have in the parts of Muslim society that considers them property.
 
This past November was the 10th anniversary of the murder of van Gogh on the streets of Amsterdam by an Islamic radical, who considered the movie an affront to his religion, a transgression that called for the death of anyone involved. Ayaan has lived with death threats for over 20 years now. She is accompanied by serious security everywhere she goes. I’ve actually gotten to know some of her security detail over time. Talk with Ayaan and her husband, Niall Ferguson, about the constraints imposed upon them by the constant worry that at any moment she could be attacked, and you are introduced to another world.
 
Niall, too, is outspoken. But thankfully, being a forceful critic of neo-Keynesianism merely gets you vilified by Paul Krugman. I didn’t even need security when I went to Japan a few years ago and told them their debt problem was going to create a significant crisis and the yen was toast. (The yen was close to its all-time high at that point.)
 
The majority of the people around the dinner table last night were women, and the evening was designed to stimulate free-flowing conversation, so it was interesting to observe the kinds of questions people asked of Ayaan. While everyone in the room (other than your humble analyst) would’ve been in the upper reaches of the 1%, they came from varied backgrounds. Yet there was clearly somewhat of a struggle to understand the depth of oppression and desperation in the world Ayaan came from.
 
If you are a young girl in a very closed culture and are told certain facts by your parents and your religious authorities and all your neighbors, then what can you do if you see that those facts don’t square with actions? How can Islam be a religion of peace with ISIS and Boko Haram beheading people simply because they believe differently? Why would you, as a girl, not be allowed the same rights as your brothers? What is the true line between belief and practice?
 
There is a part of the world where honor killings, genital mutilation, beatings, forced marriages of girls under 15, and so on are common practice. That world was so far removed from our Dallas table, and yet Ayaan’s story moved everyone in the room.
 
Before I close, I want to mention that Jack Rivkin (CIO of Altregris) and I are going to be interviewing Ian Bremmer next Tuesday. We’ll be talking about the geopolitical situation all over the world and how it will affect our investments. I hope to steer the conversation to what is happening in Russia and the Middle East, with of course a nod to China; but we’ll see what Jack and Ian want to talk about.

Have a great week.
 
Your thinking the Christmas tree goes up this week analyst,
 

John Mauldin, Editor
Outside the Box
 

The World’s Dumbest Idea

By James Montier
GMO White Paper, Dec. 2104
 
 
When it comes to bad ideas, finance certainly offers up an embarrassment of riches – CAPM, Efficient Market Hypothesis, Beta, VaR, portfolio insurance, tail risk hedging, smart beta, leverage, structured finance products, benchmarks, hedge funds, risk premia, and risk parity to name but a few. Whilst I have expressed my ire at these concepts and poured scorn upon many of these ideas over the years, they aren’t the topic of this paper.
 

Rather in this essay I want to explore the problems that surround the concept of shareholder value and its maximization. I’m aware that expressing skepticism over this topic is a little like criticizing motherhood and apple pie. I grew up in the U.K. watching a wonderful comedian named Kenny Everett. Amongst his many comic creations was a U.S. Army general whose solution to those who “didn’t like Apple Pie on Sundays, and didn’t love their mothers” was “to round them up, put them in a field, and bomb the bastards,” so it is with no small amount of trepidation that I embark on this critique.
 

Before you dismiss me as a raving “red under the bed,” you might be surprised to know that I am not alone in questioning the mantra of shareholder value maximization. Indeed the title of this essay is taken from a direct quotation from none other than that stalwart of the capitalist system, Jack Welch. In an interview in the Financial Times from March 2009, Welch said “Shareholder value is the dumbest idea in the world.”

A Brief History of a Bad Idea

Before we turn to exploring the evidence that shareholder value maximization (SVM) has been an unmitigated failure and contributed to some very undesirable economic outcomes, let’s spend a few minutes tracing the intellectual heritage of this bad idea.
 

From a theoretical perspective, SVM may well have its roots in the work of Arrow-Debreu (in the late 1950s/early 1960s). These authors demonstrated that in the presence of ubiquitous perfect competition and fully complete markets (neither of which assumption bears any resemblance to the real world, of course – break these assumptions and you break the link between SVM and social welfare; but trivial details like the critical realism of assumptions never seem to bother the average economist) a Pareto optimal outcome will result from situations where producers and all other economic actors pursue their own interests. Adam Smith’s invisible hand in mathematically obtuse fashion.
 

However, more often the SVM movement is traced to an editorial by Milton Friedman in 1970. Given Friedman’s loathing of all things Keynesian, there is a certain delicious irony that the corporate world is so perfectly illustrating Keynes’ warning of being a slave of a defunct economist! In the article Friedman argues that “There is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits...”
 

(It is quite staggering just how many bad ideas in economics appear to stem from Milton Friedman. Not only is he culpable in the development of SVM, but also for the promotion of that most facile theory of inflation known as the quantity theory of money. Most egregiously of all, he is the father of the doctrine of the “instrumentalist” view of economics, which includes the belief that a model should not be judged by its assumptions but by its predictions.)
 

Friedman argues that corporates are not “persons,” but the law would disagree: firms may not be people but they are “persons” in as much as they have a separate legal status (a point made forcefully by Lynn Stout in her book, The Shareholder Value Myth). He also assumes that shareholders want to maximize profits, and considers any act of corporate social responsibility an act of taxation without representation – these assumptions may or may not be true, but Friedman simply asserts them, and comes dangerously close to making his argument tautological.
 

Following on from Friedman’s efforts, along came Jensen and Meckling in 1976. They argued that the key challenge when it came to corporate governance was one of agency theory – effectively how to get executives (agents) to focus on maximizing the wealth of the shareholders (principals). This idea can be traced all the way back to Adam Smith in The Wealth of Nations (1776) where he wrote:
 
The directors of such [joint stock] companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master’s honour, and very easily give them a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.
 
Under an “efficient” market, the current share price is the best estimate of the expected future cash flows (intrinsic worth) of a company, so combining EMH with Jensen and Meckling led to the idea that agents could be considered to be maximizing the principals’ wealth if they maximized the stock Price.
 
This eventually led to the idea that in order to align managers with shareholders they need to be paid in a similar fashion. As Jensen and Murphy (1990) wrote, “On average, corporate America pays its most important leaders like bureaucrats.” They argued that “Monetary compensation and stock ownership remain the most effective tools for aligning executive and shareholder interests. Until directors recognize the importance of incentives and adopt compensation systems that truly link pay and performance, large companies and their shareholders will continue to suffer from poor performance.”

Widespread Adoption of the Bad Idea

So far we have traced only the rise of SVM amongst academics and, frankly, who cares what a bunch of academics think? Of considerably more concern is the evidence that the tenet of SVM has become conventional wisdom (an oxymoron if ever there was one) amongst those who inhabit the real world. For instance, take a look at the statements issued by the Business Roundtable (an association of CEOs of leading U.S. companies). In 1981 they stated, “Corporations have a responsibility, first of all, to make available to the public quality goods and services at fair prices, thereby earning a profit that attracts investment...provide jobs, and build the economy.”
 

By 1997, this concern for the role of the corporation at large had transmuted into a single-minded focus on SVM as represented by the following edict: “The principal objective of a business...is to generate economic returns to its owners...if the CEO and the directors are not focused on shareholder value, it may be less likely the corporation will realize that value.”
 

In many ways that bluest of blue chips, IBM, represents a perfect microcosm of the general pattern of obsession with SVM. Cast your eyes over Exhibit 1. It charts the total returns to an investor in IBM since 1973. In those early days, IBM’s mission statement was outlined by Tony Watson (the son of the founder) and was based on three principles (in descending order of importance): 1) respect for individual employees; 2) a commitment to customer service; and 3) achieving excellence.
 

By the early 1990s, IBM had pretty much been flat in total nominal return terms since the 1970s. Lou Gerstner arrived as CEO and stated, “Our primary measures of success are customer satisfaction and shareholder value.” In their Roadmap 2010, under Samuel Palmisano, the goal shifted to the primary aim of doubling earnings per share over the next five years!
 
 
One might be tempted to conclude that the evidence offered by IBM strongly supports the power of SVM. After all, after languishing for a prolonged period, when Gerstner and his focus on SVM arrived on the scene IBM enjoyed a significant revival. However, before you conclude I’ve shot myself in the foot by showing this example, take a look at Exhibit 2, which compares the SVM champion IBM with a company with an altogether different perspective, Johnson & Johnson.
 
 
In contrast to IBM’s transient objectives, Johnson & Johnson has stuck with a mission statement written by its founder (Robert Wood Johnson) as part of its IPO documentation in 1943, which reads as follows: “We believe our first responsibility is to the doctors, nurses and patients, to mothers and fathers and all others who use our products...We are responsible to our employees...We are responsible to the communities in which we live and to the world community as well...Our final responsibility is to our stockholders...When we operate according to these principles, the stockholders should realize a fair return.”
 

The contrast between the two firms couldn’t be much greater. Whilst IBM targeted SVM, Johnson & Johnson thought shareholders should get a “fair return.” Yet, Johnson & Johnson has delivered considerably more return to shareholders than IBM has managed over the same time period.

Prima Facie Case Against SVM

To move from the micro to the macro, we can contrast the returns achieved by shareholders in the era of managerialism (defined here as 1940-90, although the results are robust to the exact sample chosen) with those achieved in the era of SVM (1990-2014). Exhibit 3 shows the results of this comparison in two different ways. The first pair of bars shows the total real returns (p.a.) in the two periods.
 
They are virtually identical (the era of managerialism actually produced slightly higher real returns). So much for the horror that was visited upon investors by this experience. 

The second set of bars adjusts the total real return data to account for shifts in valuation, which effectively have nothing to do with the underlying return generation of companies, but rather reflect the price that the market is willing to put upon those returns. As you can see, the adjustment barely impacts the returns achieved during the era of managerialism. However, a significant proportion of the returns achieved in the era of SVM actually came from the price investors were willing to pay. If we remove this element, then the underlying return generation of companies has fallen significantly under SVM.
 

What Went Wrong?

Given this data, the natural follow-on question is, of course, what went wrong? I think one of the most obvious candidates concerns the pay of CEOs. When one casts even a cursory glance over Exhibit 4 (CEO median pay) the increasing dominance of stock-related pay becomes obvious. During the era of managerialsim, the vast majority (i.e., over 90%) of the total compensation for CEOs came through salary and bonus. In the last two decades one can see the increasing dominance of stock-related pay. In the last decade some two-thirds of total CEO compensation has come through stock and options.
 
 
This has certainly aligned managers and shareholders à la Jensen and Murphy, but doesn’t seem to have generated the kind of impact that one might have expected. At least two reasons for this stand out. Firstly, as is now well known, options aren’t the same thing as stock. They give executives all of the upside and none of the downside of equity ownership. Effectively they create a heads I win, tails you lose situation. (The asymmetry of options and their excessive use in CEO remuneration have been pet peeves of mine (and many others for a long time). I recently came across a note I wrote in 2002 moaning about exactly this.)
 

In addition, incentives don’t always work in the way that one might expect (yet more evidence of the law of unintended consequences). Economists tend to have complete faith in the concept of incentives, driven by their obsession with a very specific definition of rationality. However, the evidence on the way incentives work may surprise you (and recently raises questions for many economists).
 

In 2005, Dan Ariely and coauthors set up some intriguing experiments to test the power of incentives. They journeyed to rural India to conduct their experiments because in this setting they could offer the participants meaningfully large incentives, in a way that just isn’t possible on tight research budgets when applied to first world countries. (In case you are wondering about the relevance of rural Indians to CEOs, Ariely et al. also tested their findings on the more orthodox cash-strapped U.S. student, and found similar patterns of behaviour.)
 

Participants were asked to play six games and were told that their pay would relate to their performance on the various tasks. In the low incentive version, participants received 4 rupees if they reached the “very good” level in a game, under the medium incentive version they got 40 rupees for reaching the same level, and under the high incentive version they received 400 rupees for attaining the “very good” level.
 

Now 400 rupees was close to the all-India average monthly per capita consumption. Thus, if players in the high incentive condition reached the “very good” standard in all six games they stood to win the equivalent of half a year’s consumption – not an insignificant amount.
 

Exhibit 5 shows the percentage of the maximum available earnings that were achieved by each of the groups. Those who faced the lowest incentives captured around 35% of the maximum possible. Under the medium incentive version, 37% of the maximum was attained. But under the high incentive only 19.5% of the maximum possible was reached.
 
 
From the collected evidence on the psychology of incentives, it appears that when incentives get too high people tend to obsess about them directly, rather than on the task in hand that leads to the payout. Effectively, high incentives divert attention away from where it should be.
 

One of the other features that stands out as having changed significantly between the era of managerialism and the era of SVM is the lifespan of a company and the tenure of the CEO. Both have shortened significantly.
 
 
In the 1970s, the average lifespan of a company in the S&P 500 was 27 years (already down massively from the 75 years seen in the 1920s!). In the latter half of the last decade, the lifespan of a corporate in the S&P 500 had declined still further to a paltry 15 years.
 

In parallel to this trend, the average tenure of a CEO has fallen sharply as well. In the 1970s, the average CEO held his position for almost 12 years. More recently this has almost halved to an average tenure of just six years. It is little wonder that CEOs may be incentivized to extract maximum rent in the minimum time possible given the shrinkage of their time horizons (not independent of the shrinkage in time horizons for investors perhaps).

SVM and the Damage Done*
*With apologies to Neil Young.

Let’s now turn to the broader implications and damage done by the single-minded focus on SVM. In many ways the essence of the economic backdrop we find ourselves facing today can be characterized by three stylized facts: 1) declining and low rates of business investment; 2) rising inequality; and 3) a low labour share of GDP (evidenced by Exhibits 7 through 9).
 
 
I’m going to argue that SVM has played a role in each of these characteristics. That isn’t to say that SVM alone is responsible, rather it is part of broader set of policies that have magnified these effects, but these are beyond the scope of this paper.
 

(In my opinion, SVM is part of the quartet of neoliberal policies that have led to the current economic situation. The others include the abandonment of full employment and its replacement with inflation targeting, globalization, and drive towards so-called flexible labour markets. I intend to return to these other policies in future notes. It is important to realize that all of these are policy choices; in as much as they are behind what has been called “secular stagnation” I’d argue that the outcome is itself a policy choice.)
 

Let me now turn to describing how SVM has played a significant part in generating these stylized facts. We will start with low and declining rates of business investment.
 

Given the shortening lifespan of a corporate and the decreasing tenure of the CEO, the finding that many managers are willing to sacrifice long-term value for short-term gain probably shouldn’t be a surprise. Nonetheless, an insightful survey of chief financial officers (CFOs) was conducted by John Graham et al. in 2005. They asked CFOs the following question: “Your company’s cost of capital is 12%. Near the end of the quarter, a new opportunity arises that offers a 16% internal rate of return and the same risk as the firm. The analyst consensus EPS estimate is $1.90. What is the probability that your company will pursue this project in each of the following scenarios?” The scenarios were based on how far short of expectations taking the project would leave quarterly EPS. Exhibit 10 shows the results.
 
 
If they take the project and exceed the earnings estimate, 80% would willingly invest (which obviously leaves you wondering about the other 20%!) However, a miss of even 10c reduced this from 80% to 59%. By the time the miss was at 60c short of expectations, only approximately half of the CFOs would invest in the project.
 

More evidence of the pernicious impact of SVM can be found in a recent study conducted by Asker et al. (2013). They compared the investment rates of public (listed) and private (unlisted) companies. Asker et al. uncovered the startling fact that when one compares the two groups (controlling for size and stage of the life cycle) “the average investment rate among private firms is nearly twice as high as among public firms, at 6.8% versus 3.7% of total assets per year.”
 
 
This preference for low investment tragically “makes sense” given the “alignment” of executives and shareholders. We should expect SVM to lead to increased payouts as both the shareholders have increased power (inherent within SVM) and the managers will acquiesce as they are paid in a similar fashion. As Lazonick and Sullivan note, this led to a switch in modus operandi from “retain and reinvest” during the era of managerialism to “downsize and distribute” under SVM.

 
Evidence of the rising payout amongst nonfinancial firms can be found in Exhibit 12. As one would expect under SVM, we have witnessed a marked increase in payouts over time. In the era of managerialism, somewhere between 10% and 20% of cash flow was regularly returned to shareholders. Under the rule of SVM this has risen significantly, reaching 50% of cash flows just prior to the Global Financial Crisis.
 
 
This diversion of cash flows to shareholders has played a role in reducing investment. A little known fact is that almost all investment carried out by firms is financed by internal sources (i.e., retained earnings). Exhibit 13 shows the breakdown of the financing of gross investment by source in five-year blocks since the 1960s. The dominance of internal financing is clear to see (a fact first noted by Corbett and Jenkinson in 1997).
 

From the mid 1980s onwards, equity issuance has been net negative as firms have bought back an enormous amount of their own equity (and geared themselves by issuing debt – a massive debt for equity swap). One of the most common raison d’êtres for stock markets that gets offered up is that they are providing vital capital to the corporate sector – the evidence suggests that this is nothing more than a fairy tale. Far from providing capital to the corporate sector,8 shareholders have been extracting it from corporates.
 
 
Now, if one were feeling charitable, one might choose to suggest that there just weren’t many new investment opportunities, and thus this return of capital was a perfectly reasonable thing to do. If this were the case, one might hope that the buybacks were done at prices that were below intrinsic value (since this would have genuinely improved the lot of shareholders). However, as Exhibit 14 shows, this hasn’t been the case. When market valuations were high (prior to the financial crisis) a record number of buybacks were conducted. Conversely, at the market lows, firms were hardly doing any buybacks at all. As Warren Buffett said in his letter to shareholders back in 1999, “Buying dollar bills for $1.10 is not a good business for those who stick around.”
 
 
The obsession with returning cash to shareholders under the rubric of SVM has led to a squeeze on investment (and hence lower growth), and a potentially dangerous leveraging of the corporate sector.
 

To see how this is related to the rising inequality that we have seen it is only necessary to understand who benefits from a rising stock market (i.e., who gets the “benefits” of SVM and its buyback frenzy). The identity of this group is revealed in Exhibit 15. The top 1% own nearly 40% of the stock market, and the top 10% own 80% of the stock market. These are the beneficiaries of SVM.
 
 
Another reflection of the role of SVM in creating inequality can be seen by examining the ratio of CEO-to-worker compensation. Before you look at the evidence, ask yourself what you think that ratio is today and what you think is “fair.” A recent study by Kiatpongsan and Norton (2014) asked these exact questions. The average American thought the ratio was around 30x, and that “fair” would be around 7x.
 

The actual ratio is shown in Exhibit 16. It turns out the average American was off by an order to magnitude! If we measure CEO compensation including salary, bonus, restricted stock grants, options exercised, and long-term incentive payouts then the ratio has increased from 20x in 1965 to a peak of 383x in 2000, and today sits somewhere just short of 300x!
 
 
We can see this has been a driving force behind the rise of the 1% thanks to a study by Bakija, Cole, and Heim (2012). The rise in incomes of the top 1% has been driven largely by executives and those in finance. In fact, executives and those in finance accounted for some 58% of the expansion of the income for the top 1%, and 67% of the increase in incomes for the top 0.1% between 1979 and 2005. Thus, there can be little doubt that SVM has played a major role in the increased inequality that we have witnessed.
 
 
This makes the decline in the labour share even more dramatic for those outside of the top 1%. Exhibit 9 includes the top 1%, so if we were to exclude them the share of GDP going to the rest of labour would be even lower. In fact, if we look at the bottom 90% we would see their labour share of GDP going from around 42% in the late 1940s to approximately 27% today.
 

If one looks at the income gains during expansions as Pavlina Tcherneva (2014) has done, one will find that during the last two expansions the income gains have gone entirely (and most recently more than entirely) to the top 10%.
 
 
The problem with this (apart from being an affront to any sense of fairness) is that the 90% have a much higher propensity to consume than the top 10%. Thus as income (and wealth) is concentrated in the hands of fewer and fewer, growth is likely to slow significantly. A new study by Saez and Zucman (2014) provides us with the final exhibit in this essay. It shows that 90% have a savings rate of effectively 0%, whilst the top 1% have a savings rate of 40%.
 

The role of SVM in declining labour share should be obvious, because it is the flip-side of the profit share of GDP. If firms are trying to maximize profits, they will be squeezing labour at every turn (ultimately creating a fallacy of composition where they are undermining demand for their own products by destroying income).
 

 

Conclusions

So what is one to conclude from this tirade? Three things stand out to me, each addressing a different constituency:
 
Shareholder’s Lesson
 
Firstly, SVM has failed its namesakes: it has not delivered increased returns to shareholders in any meaningful way, and may actually have led to poorer corporate performance!
 

Corporate’s Lesson
 
Secondly, it suggests that management guru Peter Drucker was right back in 1973 when he suggested “The only valid purpose of a firm is to create a customer.”
Only by focusing on being a good business are you likely to end up delivering decent returns to shareholders.

Focusing on the latter as an objective can easily undermine the former. Concentrate on the former, and the latter will take care of itself. As Keynes once put it, “Achieve immortality by accident, if at all.”
 
Everyone’s Lesson
 
Thirdly, we need to think about the broader impact of policies like SVM on the economy overall. Shareholders are but one very narrow group of our broader economic landscape. Yet by allowing companies to focus on them alone, we have potentially unleashed a number of ills upon ourselves.

A broader perspective is called for. Customers, employees, and taxpayers should all be considered. Raising any one group to the exclusion of others is likely a path to disaster.

Anyone for stakeholder capitalism?
 
 
Mr. Montier is a member of GMO’s Asset Allocation team. Prior to joining GMO in 2009, he was co-head of Global Strategy at Société Générale. Mr. Montier is the author of several books including “Behavioural Investing: A Practitioner’s Guide to Applying Behavioural Finance; Value Investing: Tools and Techniques for Intelligent Investment”; and “The Little Book of Behavioural Investing.” Mr. Montier is a visiting fellow at the University of Durham and a fellow of the Royal Society of Arts. He holds a B.A. in Economics from Portsmouth University and an M.Sc. in Economics from Warwick University.

Full-Time Jobs Down 150K, Participation Rate Remains At 35 Year Lows, "No Job Market For Young Men"

by Tyler Durden

12/05/2014 09:10 -0500


While the seasonally-adjusted headline Establishment Survey payroll print reported by the BLS moments ago may be indicative of an economy which the Fed will soon have to temper in an attempt to cool down, a closer read of the November payrolls report shows several other things that were not quite as rosy. First, the Household Survey was nowhere close to confirming the Establishment Survey data, suggesting jobs rose only by 4K from 147,283K to 147,287K, and furthermore, the breakdown was skewed fully in favor of Part-Time jobs, which rose by 77K while Full-Time jobs declined by 150K.





And then for those keeping tabs on the composition of the labor force, the same adverse trends indicated over the past 4 years have continued, with the participation rate remaining flat at 62.8%, essentially the lowest print since 1978, driven by a 69K worker increase in people not in the labor force.





The ratio of Civilian employment to the total population, which plunged during the onset of the recession, has still barely budged higher as shown in the chart below:





Finally, anyone hoping that young people, those aged 16-24 are finally entering the workforce in droves, sadly that is not the case once again, with the employed ranks of Americans in that age group down by 169K in the past month. The good news: aged workers, those 55 and over, just rose to a new all time high of 32.814 milllion.



 

Interview

Why Beijing’s Troubles Could Get a Lot Worse

Bank rate cuts and anticorruption campaign are unlikely to stave off woes, says Anne Stevenson-Yang.

By Jonathan R. Laing

December 6, 2014

 

Few foreigners know China as intimately as Anne Stevenson-Yang does. She has spent the bulk of her professional life there since first arriving in 1985, working as a journalist, magazine publisher, and software executive, with stints in between heading up the U.S. Information Technology office and the China operations of the U.S.-China Business Council. She’s now research director of J Capital, an outfit that works for foreign investors in China doing fundamental research on local companies and tracking macroeconomic developments.
 
Among other things, J Capital conducts trips for hedge fund managers, U.S. corporate executives, and bankers all over the Middle Kingdom, relying on Stevenson-Yang’s roster of government officials, Communist Party leaders, financiers, small- business operators, and ordinary citizens to take the pulse of economic and political developments.
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“Every spasm of new stimulus seems less and less effective in boosting the economy.” —Anne Stevenson-Yang Photo: James Wasserman for Barron’s

 
An American, Stevenson-Yang, 56, is fluent in Mandarin, although her husband, a former People’s Liberation Army intelligence officer, and their two adult children sometimes mock her accent. For Stevenson-Yang, who toted Chairman Mao Zedong’s Little Red Book in high school, her years in China have given her a skeptical view of the nation’s miraculous growth. Her disenchantment arises from the stark inequality of wealth and opportunity, the thuggishness of the Communist elite, and the amount of chicanery and accounting fraud engaged in by Chinese companies and government organs.

Read on to find out why she thinks that China has entered the early stages of slowing expansion, severe credit problems, and potential instability.
 
Barron’s: Investors seem far more concerned about Europe’s sinking into economic despond than slowing growth in China. Are they whistling past the graveyard?
 
 
Stevenson-Yang: I think so. China, for all its talk about economic reform, is in big trouble. The old model of relying on export growth and heavy investment to power the economy isn’t working anymore.
 
Sure, the nation has been hugely successful over recent decades in providing its people with literacy, a decent life, basic health care, shelter, and safe cities. But starting in 2008, China sought to counter global recession with huge amounts of ill-advised investment in redundant industrial capacity and vanity infrastructure projects—you know, airports with no commercial flights, highways to nowhere, and stadiums with no teams. The country is now submerged by the tsunami of bad debt that begets further unhealthy credit growth to service this debt. The recent lowering of benchmark deposit rates by the People’s Bank of China won’t accomplish much because it won’t offer more income to households. It also gave China’s biggest banks the discretion to raise their deposit rates back up to old levels, which would give them a competitive advantage
 
How bad can the situation be when the Chinese economy grew by 7.3% in the latest quarter?
 
 
People are crazy if they believe any government statistics, which, of course, are largely fabricated. In China, the Heisenberg uncertainty principle of physics holds sway, whereby the mere observation of economic numbers changes their behavior. For a time we started to look at numbers like electric-power production and freight traffic to get a line on actual economic growth because no one believed the gross- domestic-product figures. It didn’t take long for Beijing to figure this out and start doctoring those numbers, too.
 
I put much stock in estimates by various economists, including some at the Conference Board, that actual Chinese GDP is probably a third lower than is officially reported. And as for the recent International Monetary Fund report calling China the world’s biggest economy on a purchasing-power-parity basis, how silly was that? China is a cheap place to live if one is willing to eat rice, cabbage, and pork, but it’s expensive as all get out once you factor in the cost of decent housing, a car, and health care.
 
I’d be shocked if China is currently growing at a rate above, say, 4%, and any growth at all is coming from financial services, which ultimately depend on sustained growth in the rest of the economy. Think about it:
 
Property sales are in decline, steel production is falling, commercial long-and short-haul vehicle sales are continuing to implode, and much of the growth in GDP is coming from huge rises in inventories across the economy. We track the 400 Chinese consumer companies listed on the Shanghai and Shenzhen stock markets, and in the third quarter, their gross revenues fell 4% from a year ago. This is hardly a vibrant economy.
 
How bad do you see things getting?
 
 
I hate to wear sackcloth, since in late 2011 I became quite bearish and yet a sharp dose of government stimulus managed to steady the economy. By our calculations, since June the central government directly and indirectly has added more than $400 billion of stimulus and relaxed lending terms for housing purchases. Yet, every spasm of new stimulus seems less and less effective in boosting the economy.
 
So most likely, China is sinking into a deflationary recession that’s increasing in speed and may take some time to run its course. Investors have lost faith in the property market, which alone comprises about 20% of GDP, when taking into account the entire supply chain, from iron-ore production to construction to related financial services and appliance sales. Employment and wage compensation will suffer. Consumption will continue to suffer. There’s even an outside possibility that China’s economic miracle could end up in a fiery crash landing, if a surge in banking-system loan defaults outruns government regulators’ attempt to contain such a credit crisis and restore financial confidence.
 
What are some of the other signs of economic malaise?
 
 
A big one is increasing capital flight from China on the part of wealthy Chinese, and corporations using phony trade invoicing and other ploys to get around the country’s capital controls. This trend so far has been masked by the influx of hot money into China to take advantage of its higher money-market rates, strong foreign direct investment, and, of course, China’s positive trade balance.
 
But something curious is happening. In the third quarter, China’s vaunted foreign-currency reserve balance actually declined by $100 billion, to $3.89 trillion. Sales of luxury foreign brands are faltering. Clearly, a lot of wealthy Chinese are rushing to cut back on in-country assets and get money offshore. If one has the ability to own a house in Sydney over an apartment in suburban Shenzhen, the choice is obvious.
 
Rampant capital flight could turn into a rout given the ridiculous concentration of wealth in China, cutting the seemingly impregnable foreign reserves dramatically.
 
Any other worries?
 
 
The giant government economic-stimulus programs since 2008 are rapidly losing their effectiveness. The reason is simple. Much of the money has been squandered in money-losing industrial projects and vanity infrastructure spending that make no economic sense beyond supplying temporary bump-ups in GDP growth. China is riding an involuntary credit treadmill where much new money has to be hosed into the economy just to sustain ever-mounting bad-debt totals. Capital efficiency, or the amount of capital it takes to generate a unit of GDP growth, has soared as a result.
 
And what about the much-predicted popping of the Chinese real estate bubble?
 
 
It is already under way, though in seeming slow motion. Government price data, such as its 70-city report, aren’t all that helpful since the numbers are cherry-picked and manipulated. But we do know that sales volume has been dropping this year.
 
The Chinese home real estate market, mostly units in high-rise buildings, is truly bizarre. Many Chinese regard apartments as capital-gains machines rather than sources of shelter. In fact, there are 50 million units in China that are owned but vacant. The owners won’t rent them because used apartments suffer an immediate haircut in value.
 
It’s as if the government created a new asset class that no one lives in. This fact gives lie to the commonly held myth that the buildout of all these empty towers and ghost cities is a Chinese urbanization play. The only city folk who don’t own housing are the millions of migrant laborers continuously flocking to Chinese cities. Yet, they can’t afford the new housing.
 
What would be the impact of a significant drop in Chinese housing prices?
 
 
We’ve talked about housing’s immense weight in national GDP. Likewise, a huge proportion of financial assets in China both in the banking and shadow-banking system are exposed to the real-estate market. All of China’s major corporations are speculating on residential real estate with either cash reserves or borrowed money. Who wants to build, say, a shipbuilding plant when a company thinks it can make a lot more speculating in the housing market?
 
Families have more than half of their wealth in housing, including the less affluent in recent years who have taken to buying fractional shares in luxury apartments and town houses. Local governments, which rely on land sales to developers and real estate transfer taxes for something like 35% of their revenue, would be in a bad way in a housing-price bust. The psychology bolstering the housing market is changing despite all the efforts of the government to control prices. People are starting to realize that housing isn’t a one-way street to future wealth, and selling pressures are starting to build.
 
Conventional wisdom holds that China has plenty of levers it can pull to stave off severe economic contraction and any debt crisis. Do you agree?
 
 
Not really. Take, for example, the $3.9 trillion foreign-currency reserves that we discussed. Many people regard it as a giant piggy bank that can be tapped at will to rectify any financial problem. But the reserve is only good for defending the yuan and is a lot less liquid than many people realize. And as we pointed out, capital flight could dramatically diminish the size of the reserve.
 
Interestingly, liquidity seems to be a growing problem in China. Chinese corporations have taken on $1.5 trillion in foreign debt in the past year or so, where previously they had none. A lot of it is short term. If defaults start to cascade through the economy, it will be more difficult for China to hide its debt problems now that foreign investors are involved. It’s here that a credit crisis could start.
 
Bad debt in China never seems to get written down. The huge pile of nonperforming bank loans that Beijing assumed earlier in the millennium in order to be able to take its major banks public still sits on the balance sheets of various asset-management companies.
 
All that the government can do is hose down economic problems with more and more cash. Certainly, such investment has proved a powerful tool, but you shouldn’t mistake wanton money creation with omnipotence.
 
You don’t put much stock in the rhetoric of President Xi Jinping’s administration about economic reform, giving wider sway to free-market principles, and bolstering Chinese consumer spending.
 
 
I see such moves as unlikely to occur anytime soon. [Beijing] will be hampered in carrying out such policies by special-interest groups and the Xi patronage network’s desire to maximize their slice of what may well be a diminishing pie. China has to invest more and more at falling rates of return just to keep growth going. Thus, by necessity, consumption has to decline as a proportion of GDP.
 
Can you expand on your feelings on Xi Jinping and his first two years in power? He has captivated the foreign press with his seemingly unassuming manner, glamorous entertainer wife, and the wide diplomatic swath he cut at the Asia-Pacific Economic Cooperation summit in Beijing.
 
 
In my opinion, the press is somewhat guilty of willing suspension of disbelief on developments in China. Xi’s agenda of Confucian [moral] purification has nothing to do with opening up the economy or social reform. He wants to bolster the power of the Communist Party and tamp down the cynicism about the system that is increasing in China. This explains in large part his bellicosity in the South China Sea, quashing of dissent on the Internet and elsewhere, and heavy-handed attacks on non-Han populations like the Uighurs. He openly disdains Western democratic values.
 
Of the same piece is China’s attacks on foreign companies and brands on the grounds of claimed antimonopoly practices, discriminatory pricing, corruption, and inadequate product quality. Chinese state-owned companies and firms in which party members are invested, however, are largely exempt from such scrutiny. In a state economy like China’s, the playing field is increasingly tilted so ultimate gains go to Chinese companies.
 
As for Xi’s much-ballyhooed anticorruption campaign inside China, it offends me that international media depict it as a good-governance effort. What’s really going on is an old-style party purge reminiscent of the 1950s and 1960s with quota-driven arrests, summary trials, mysterious disappearances, and suicides, which has already entrapped, by our calculations, 100,000 party operatives and others. The intent is not moral purification by the Xi administration but instead the elimination of political enemies and other claimants to the economy’s spoils.
 
 
OK, Anne, on that happy note, let’s conclude.