When Views Differ: Wall Street Vs. Main Street

Posted by Brad McMillan, CFA, CAIA, MAI

This entry was posted on Jul 25, 2014 1:02:00 PM

and tagged Commentary

Leave a comment

Wall Street vs. Main StreetI was lucky enough to have lunch yesterday with the chief market strategist for a major Wall Street bank. In addition to being an experienced and intelligent observer of the financial markets and economy, he is also a great guy.

Our conversation was a great opportunity to compare two views of the world: Wall Street vs. Main Street. Now, I’m probably doing him a disservice by painting him into the “Wall Street” corner—and giving myself too much credit by claiming the “Main Street” moniker—but I think these characterizations are somewhat in line if you consider that I deal more with advisors who have regular, Average Joe clients, while he deals more heavily with international and institutional clients. (Disclaimer: What follows is my take, not his, on the broader Wall Street mindset.)

It was comforting to learn that we agree broadly on many topics, but in the areas where we disagree, there are some key issues that are worth thinking through. Our differences depend crucially on the answers to two main questions—which I’m presenting from both Wall Street and Main Street points of view. 

The Wall Street view
  1. Will current record profit margins revert to the mean (i.e., decline); if so, over what time period?
  2. Are the past 25 years a better indicator of where valuations will be in the future than the (lower) valuations of previous time periods? 
The Main Street view
  1. Will workers get a bigger slice of the pie in the future than they have over the past couple of years, which will increase wages but decrease profit margins?
  2. Given that the past 25 years have seen an incredible “financialization” of the economy, which has driven up stock prices, will that trend continue, or will we see less financial support of asset values—and therefore potentially lower valuation levels? 

With these questions in mind, let’s look at how the answers differ in terms of Wall Street vs. Main Street. 

Q&A #1

The arguments for the first question are based on trends over—you guessed it—the past 25 years. If you chart out average profit margins over that period, you see progressively higher levels, per this somewhat dated chart from zerohedge.com.

Profit Margins

So how does our perspective affect the answer?

The Wall Street argument: There are no signs of this trend changing, so current profit margins should at least remain stable—and quite possibly continue to increase.

The Main Street argument: These rising margins have largely come from subpar wage growth. Companies are keeping more money by paying workers less. Will this continue? I would argue that wage growth is actually rising, and it’s hitting a tipping point where it will accelerate and begin to force margins down.

Rising margins have also come in part from the fact that companies are not investing in the business, using cheap labor instead of buying more equipment. That, too, is changing, driven not only by higher wage costs, but also by the fact that existing plants and equipment are now being used intensively enough that new materials are needed. Rising capital expenditures should be good for the economy (i.e., Main Street), but bad for margins and potentially for stock prices (i.e., Wall Street). 

Q&A #2

The answer to the second question depends on whether the growth of the role of banks and the financial sector will continue at the same pace in the future.

The Wall Street argument: Look at all the benefits! Why not?

The Main Street argument: Although there have been many benefits over time, there have also been costs. More simply, look at how the financial sector in the U.S. economy has grown, as illustrated in this chart from Wikipedia.

GDP

The financial sector accounted for all of 6 percent of the economy in 1929, a peak it did not surpass until around 1990. What drove the most recent expansion? The deregulation of the Reagan years, the continued lowering of interest rates by the Federal Reserve from 1980s peaks, and other factors.

With the passing of Dodd-Frank and other recent laws, the era of financial deregulation is at an end, at least for a while. With interest rates near zero, they simply cannot fall any more—and they will have to rise at some point.

The other driving force behind the financialization of the economy has been the need for baby boomers to do something with their savings, much of which has gone into the financial markets. That tidal wave of cash is now slowing—and it will reverse in the near future. Main Street has enabled Wall Street for the past couple of decades, but the trends are shifting.

In summary

The Wall Street view: Current conditions—which have been wonderfully supportive of the financial markets and financial services industry—are good and not only will, but should, continue.

The Main Street view: Things have to change—in wage growth, in interest rates, in regulation of the financial sector—which will at least limit and probably reverse many of these favorable trends.

Getting back to my conversation with my Wall Street bank friend, the significant differential between us, as I see it, is that he considers the stock market reasonably valued, based on data from the past 25 years. I, on the other hand, neither consider that time period the best indicator, nor valuations reasonable.

Both of us agree on many things, not least of which is that the market is likely to continue rising in the short-term, and that the U.S. economy is in a sustained recovery. But our differing medium- to long-term views on the stock market make for a pretty big disagreement. 

I sincerely hope he is right; 20 years or so from now, no doubt he will be. But Wall Street and Main Street view time frame and downside exposure very differently. For people retiring today, long-term results may not matter if they get hit hard enough in the first couple years of retirement. For kids planning to head off to college, long-term results will not matter if they get hit the year before they start.

Where Wall Street looks at the upside risk, Main Street cares about the downside. This, at the core, is what people need to think of when they consider investing.

 

Upcoming Appearances

Tune in to CNBC's Squawk Box on Monday, November 27, at 6:15 A.M. ET to hear Brad talk about the markets. Check your local listings for availability.

5 Ways to Affiliate
Commonwealth Independent Advisor

Hot Topics

Have a Question?

New Call-to-action

Conversations

Subscribe via E-mail

Subscribe

Disclosure

The information on this website is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly into an index.

The MSCI EAFE Index (Europe, Australasia, Far East) is a free float‐adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.  

Third party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided at these websites. Information on such sites, including third party links contained within, should not be construed as an endorsement or adoption by Commonwealth of any kind. You should consult with a financial advisor regarding your specific situation.

Member FINRASIPC

Please review our Terms of Use

Commonwealth Financial Network®