In the latest installment of his “Breaking Through the Jobless Recovery” series, economist William Lazonick exposes the financial engineering that's far more in style than good old fashioned products.
During the 1980s and 1990s, Americans fell in love with the stock market. The "go-go years" of the 1960s had produced decent stock yields. But households still viewed investment in corporate stocks as a risky business, as would be confirmed by the negative performance of the stock market in the stagflation of the 1970s (see the table below). Then 1982 to 2000 witnessed the longest "bull run" in US stock market history with double-digit average annual real stock yields.
The terrible performance of the stock market in the first decade of this century, however, made even the 1970s look good, especially since inflation could no longer take the blame for negative real stock yields. The financial crisis of 2008-2009 was, of course, a big part of that sorry story. In the recovery of 2010, it looked like the market might be back on track as the S&P 500 registered a real yield of 20.6% (or in other words, 20.2% price yield + 2.0% dividend yield - 1.6% rate of inflation). Indeed, the market was sailing along on an even keel during the first seven months of 2011 -- until, in the wake of the debt ceiling crisis, it tanked this month.
So going forward, what's the prognosis for the stock market's long-run performance? It has always resembled a legalized gambling casino. That's even true of "blue chip" stocks, issued by well-established companies that have long records of profitability and solid growth. The term "blue chip," which came into use during the stock market boom of the 1920s, was taken from the color of the highest value counter in a poker game. And, of course, in the stock market crash of 1929, many people learned that they could lose their shirts even with their portfolios heavily invested in blue chips.
Nevertheless, stock price movements are not the same as a lucky draw of the cards. Except in cases of outright fraud, publicly listed shares are issued by companies that employ people to come to work on a regular basis to produce goods and services to sell to people who might want to consume them. When a particular company figures out how to produce a good or service that is higher quality and lower cost than those of its competitors -- that is, when it learns how to innovate -- it can capture a significant share of the product market and generate substantial profits. Its stock price will eventually rise, not because of blind luck, but because it is an innovative enterprise that has experienced sustained growth. When innovation is the driver of the stock market, a company's stock price increase occurs after innovation, when the stock trading public has the evidence of success.
Innovation is, however, just one of three drivers of stock price movements. The second driver is speculation, with traders moving into and out of stocks in attempts to beat the market. These days, high-speed traders grab short-run speculative gains before ordinary traders even know that the gains are there. In the longer run, however, speculation typically occurs on the back of innovation. A company succeeds in the product market and then gets discovered by stock market traders, who start bidding up the price of its stock well beyond the level warranted by the company's innovative performance.
Take, for example, the case of Cisco Systems, the world's leading Internet equipment company. Largely on the basis of innovation, its stock price increased by about 200 times from its initial public offering in March 1990 to mid-1998 (see the chart below), during which time Cisco became the fastest growing company in US history. Yet in the very first sentence of a Stanford Business School case on Cisco published in October 1998, the author, Charles O'Reilly, could write: "Cisco Systems is a $6 billion high technology stealth company, largely unknown to the general public." Less than a year and a half later, Cisco had clearly emerged from stealth mode as speculators bid up its stock price to the point where in March 2000 it sported the highest market capitalization of any company in the world.
It is inherent in speculation that at some point the bubble will burst and a sky-high stock price will fall back to earth. So it was with Cisco Systems. From a high of $79.48 on March 27, 2000, its stock price fell 89% to a low of $8.54 on October 8, 2002. Yet in fiscal year 2002 (ending on July 27th) Cisco had recorded profits of $1.9 billion on $18.9 billion in sales, virtually identical to its revenues in the boom year of 2000.
With its stock price in free fall but with $6.9 billion in cash and short-term securities at the end of fiscal year 2001 and $12.7 billion at the end of fiscal year 2002, Cisco's executives turned to the third way of increasing a company's stock price -- manipulation. To boost its stock price, they began large-scale stock repurchases, rising from $1.9 billion in 2002 to $10.2 billion in 2005 and averaging $7.6 billion per year from 2006 to 2010. In all, during 2002-2010 Cisco poured $65 billion into buying back its own stock, equivalent to 129% of the company's earnings and 173% of its R&D expenditures.
Currently Cisco is terminating 6,500 employees to save perhaps $1.5 billion in costs. In April 2011, CEO John Chambers sent a memo to Cisco employees that the company had "lost some of the credibility that is foundational to Cisco's success." Yet the company spent $5.6 billion buying back its stock during the first nine months of fiscal year 2011. My research on Cisco suggests that its obsession with manipulating its stock price over the past decade is an important reason why the company has lost its way.
The transitions over the past two decades from innovation to speculation to manipulation as the main driver of Cisco's stock price are typical of many other leading American high-tech companies. Over the past decade, total stock repurchases have been $110 billion at Microsoft, $89 billion at IBM, $54 billion at Hewlett-Packard, and $48 billion at Intel. Apple, Inc. is a notable exception. For all the companies in the S&P 500 Index, which make up about 75% of the market capitalization of all US corporations, the amount spent on buybacks over the past decade was in excess of $2.5 trillion.
Market manipulation is the enemy of industrial innovation. In a well-known book, Stocks for the Long Run, Jeremy J. Siegel argues that historically US corporate stocks have been "clearly the asset of choice for investors seeking long-term growth." Yet even in the most recent edition, published in 2008, Siegel mentions stock buybacks only in passing, and with no hint of the massive manipulation of the stock market that they represent. Back in 1924, another student of financial markets, John Maynard Keynes, observed: "In the long run we are all dead." Unless something is done to bring the financialized corporation under control, a decade or two hence Keynes' quip may be a fitting epitaph for many of America's leading technology companies.
William Lazonick is director of the UMass Center for Industrial Competitiveness and president of The Academic-Industry Research Network. His book, Sustainable Prosperity in the New Economy? Business Organization and High-Tech Employment in the United States (Upjohn Institute 2009) was awarded the 2010 Schumpeter Prize.