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Rekenthaler Report

The Prediction of a New Normal, Reviewed

It was correct about the economy, but not about shareholder motivations.

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Bad Moon Rising
The most-cited economic forecast of this millennium has been 2009’s “New Normal” prophecy, which posited that this time, for once, was indeed different. The economic future would differ sharply from that of the past. As many people seized upon the label, there was no single definition of the New Normal. However, a March 2009 missive from McKinsey lays out the main elements:

1) Sluggish growth in the United States and Europe.

As both companies and consumers deleveraged their balance sheets, by using their free cash to repay debt rather than to expand, gross domestic product growth would be sluggish. Both supply and demand would be affected. Corporations would have less money to invest, and consumers less for purchases.

2) More government intervention.

Just as the Great Depression spawned the Securities Act of 1933, and several other major financial bills, the 2008 financial crisis will lead to greater government involvement. At the least, governments will stiffen their regulations and enhance oversight; at the most, they will enact trade barriers.

3) The possibility of social unrest.

Torpid GDP growth, accompanied by stagnant wages, didn’t figure to please the masses. The McKinsey brief states, “The big unknown is whether the temptation to blame Western-style capitalism for current troubles will lead to backlash and self-destructive policies.”

Good on Economics
Kudos to the seers! Growth was, as predicted, disappointing. In the United States, the highest real calendar-year GDP growth rate was but 2.7% (in 2014), as opposed to above 5% during the previous expansion and almost 5% during the 1990s. The forecast for government activities was solid, too. Governments did get more involved, albeit more by strengthening their fiscal policies through quantitative easing than by creating new restrictions, and the feared trade conflicts have arrived. As, of course, has social unrest.

(I wonder: Did 2009’s political scientists anticipate the U.S./European revival of populist nationalism? Or was this an intuition that occurred only to economists? If you know the answer, I would be delighted to hear it.)

Bad on Stocks
None of this, unfortunately, directly helped stock investors. The prognosticators correctly foresaw the political and macroeconomic trends, but they failed to understand how those events would affect equities. Unsurprisingly, they expected tepid growth, great government involvement, and social turbulence to depress stock markets. But such was not the case. Equities soared, most notably in the U.S., but for the most part throughout the developed markets.

Stocks appreciated because corporate profits surged and inflation stayed quiet. At essence, equity prices depend upon the answers to two questions: 1) how much money a company earns, and 2) the rate at which those earnings are to be discounted, due to the time value of money. If those responses are sufficiently positive, other concerns pale. That is in fact what happened. The forecasters’ concerns came true, but they ultimately were set aside.

The New Normal’s map was broadly accurate, as far as it went. It accurately portrayed the general economic themes. Those versed in the New Normal understood why unemployment remained higher than in previous discoveries, and that government scrutiny was to be expected. They also were prepared for the political backdrop.

In short, those who crafted the New Normal template considered the actions of chief financial officers (in repaying debt), government officials, legislators, and even voters. But they missed a key constituency: institutional investors. Corporate executives don’t listen much to me, and probably not to you as well, but they do tend to pay attention to their largest shareholders. And the message they received from those parties has changed, dramatically. Corporate managements have been told to be conservative. They are under pressure to maximize current profits, rather than spend on projects for later.

For Example
A recent The New Yorker profile of Ron Shaich, founder of Panera Bread, addresses the issue. In 2007 and then again in 2015, activist investors accumulated shares and pressured Shaich to cut back on the company’s capital spending. At the time, the firm was spending heavily to develop “new technology for online and mobile ordering.” For Shaich, these costs were necessities, as Panera historically had benefited by being an early adopter of technology. The activists, though, wished for him to cease and desist those expenditures. When he did not, they pushed for his resignation.

As the article points out, the activists’ efforts reflect a long-term trend. Since the early 1970s, finance professors and Wall Street analysts have gradually come to agree that the sole task of corporate managements is to enhance “shareholder value,” by increasing the price of their company’s stock. In theory, there’s no reason why that approach wouldn’t lead to higher capital expenditures, because institutional investors could decide that organizations are best served by investing heavily into their businesses. In practice, while institutional owners permit that strategy from a few firms--for example,  Tesla (TSLA) and (AMZN)--they generally prefer parsimony to ambition.

(The New Yorker'sarticle takes a political angle, linking some of the activists’ beliefs to President Donald Trump. For purposes of this discussion, ignore that part. The relevant item is that corporate managers are measured differently today than they were in the past--and, as evidenced by the dates of Shaich’s complaints, this change in mindset far predates the current administration. It has many presidential parents.)

Improving the Forecasts
Such scolding had a meaningful effect on corporate profits. By training corporate managements to retain more of their profits, rather than plow them into ventures for the future, institutional shareholders helped to boost current earnings--which, in turn, has made for higher stock prices. How much companies’ higher profitability owes to restraining from capital expenditures and how much to other factors, is unclear. But there’s no doubt that institutional-investor behavior has affected equity prices, in a manner that the market forecasters failed to perceive.

Whether this stock-market boost is permanent, or as Shaich would have it, the product of a temporary “sugar high,” is an open question. It may be that institutional owners have corrected corporate management’s previous wasteful ways, or it may be that stock prices will lag down the line, because corporations have underinvested. Which is the case, I cannot say. I do know, however, that when formulating their projections, stock-market prognosticators need to start considering the motivations of institutional investors. They matter.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.