Stock Investors: Off to Work We Go

Heigh ho, Heigh ho

It’s off to work we go!

We keep on singing all day long

Heigh ho!

Got make your troubles go

Well, you keep on singing all day long

Heigh ho!

Seven Dwarfs Marching Song, Tom Waits

For some analysts the comparison of the S&P 500 Index with average wages for U.S. earners is a method of determining whether the U.S. equity market is overbought.  Dividing the S&P 500 Index price by the average hourly wage of all workers (salaried and hourly together) provides the number of hours the average person must work to buy a hypothetical stake in the U.S. stock market through the S&P 500 Index.  The measure might also shed some light on the economic dilemmas we face these days.  Call it the ‘equity purchasing power’ of the average wage earner.

 In 1975, the average bloke could work just 18.60 hours and buy a hypothetical share in the U.S. stock market through the S&P 500 Index.  In the last fifty years that is the greatest buying power wage earners have ever wielded in equity investing in the U.S.  Wages have been on a steady rise over the years, slipping only slightly in the immediate years following the burst of the dot.com bubble in 2002.  Despite the increases in wages over the years, now in mid-2017 U.S. workers must toil more than two weeks to generate earnings equal to the price the S&P 500 Index 93.15 hours to be exact.  The U.S. equity market has never been more expensive for the average person than it is today.

 The S&P 500 Index could very well be overbought.  However, the record number of hours it requires for the average person to take a stake in the stock market could shed light on more important economic questions.  It might also provide insight into political matters as well.

Financial analysts and economists like to explain individual participation in the stock market as related to risk profiles.  Expectations of the individual in terms of the equity risk premium  -  the compensation required to accept the added risk of investing in uncertain stock price outcomes  -  is widely regarded as the driving force behind stock market participation.  Information and transaction costs, even in the age of the Internet, are also thought to account for low stock market participation rates. 

Gallup completes an annual survey to determine the number of individuals who have money invested in the stock market in the form of individual stock ownership, a stock mutual fund or a self-directed retirement plan.   Gallup has been carrying out this survey every year since 1998.  The peak participation rate was 67% in 2002, when the dot.com prospects for outsized returns was still attracting many to the U.S. stock market.  At the same time the index price had faltered following the terrorist attacks on the World Trade Center in New York. 

In this interesting conflux of conditions in 2002, the equity purchasing power of the average earner was an impressive 64.46 hours. In fact, as the years rolled by the average wage earner enjoyed a steady rise in wages, and was able to take a stake in the stock market with fewer and fewer hours.  The individual enjoyed the most advantage in December 2008, when the financial crisis led to a sharp sell of in the S&P 500.  Wages were still climbing at that point but risk abounded  -  imagined and real.  It required only 37.64 hours of work to buy a hypothetical stake in the S&P 500 Index at the end of 2008. 

Unfortunately, with so much uncertainly in the world’s financial institutions, it was difficult to convince individuals to take advantage of the new found ‘buying power’.  Gallup completed another survey in April 2008, that found only 33% of respondents thought it would be a good idea to invest in the stock market.  The survey appears to uphold role of risk in determining whether individuals are game to buy stocks or not.

Perhaps this is not the only lesson to be taken from the ratio of the S&P 500 Index Price to Average Wages. 

Risk perceptions may have changed over the years.  By 2014, respondents to the Gallup survey were about split on the merits of investing in the stock market with about half saying it was a good idea and half saying it was a bad idea.  Willingness to invest in stock rebound from about a third to half of survey respondents.  However, individual participation in the stock market has failed to return to historic levels.  By April 2017, the Gallup survey found that 54% of respondents have money invested in the stock market, well off the peak rate of stock ownership of 67%.

It could be that the individuals simply cannot afford to invest in the stock market, even if risks are perceived to be manageable.  Individuals enjoyed purchasing advantage through the end of 2013, at least in terms of comparing the number of hours required to buy the S&P 500 to historic rates.  Just prior to the financial system crisis that led to the Great Recession of 2010-2012, the number of hours required to buy the S&P 500 Index had peaked in 2007 near 74.00 hours.  As recovery took hold and the U.S. stock market rebounded, the required number of hours sky rocketed to the current historic high at 93.15 hours.

Ouch!  Even the most risk tolerant investor has to think twice about investing in the U.S. equity market.   It is simply not affordable.  Normally, one would expect a correction of some sort that could bring equity valuation back into alignment.  The Fed Model compares stock compares stock yield to bond yield.  Otherwise known as the Bond Equity Earnings Yield Ratio or BEER, the computation is current earnings yield of the stock market divided by the benchmark bond yield of five or ten-year Treasury bonds.  The S&P 500 Index is popular for this measure as well.    

The BEER or Fed Model has been depicting the S&P 500 Index as undervalued since 2002, without interruption  -  at least in terms of bond prices and yields.  However, in the current depressed interest rate environment, the market mechanism might be malfunctioning.  The Federal Reserve has been an active participant in the U.S. bond market since 2001.  The Fed’s near-monopoly on a vast portion of the U.S. bond market cannot have been without influence on bond prices and hence on bond yields.  The divestiture of the Federal Reserve bond portfolio is an imminent issue for both bond and stock valuation.

While the finest economics minds in the country ponder these weighty topics, individual investors have an easier question to answer.  For  them, it is as the Seven Dwarfs sang as they went off to their mines,  Heigh Ho, Heigh Ho, it's off to work we go!

Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.