Leverage Has been Driving Stock Market Since 1980s

American has a golden period since the second world war from 1950s to 1960s. Entering 1970s, American struggled through a lost decade: oil crisis and record high inflation. It did not get ditched out until inflationed was dampened in early 1980s. Since 1980s, American companies' profitability have not increased a a whole. But the stock market has been keeping ticking higher for almost three decades. We know the stock market in the late 1990s were driven by irrational exuberance over technology bubble and stock market in the 2000s were driven by subprime mortgages. Behind the business cycles, some secular factors have been driving the economy and stock market: overleverage in consumers and companies, a cliche concept we have heard. Here, I add more color to the blame. First, as shown in the chart, American companies profitability relative to GDP have not surpassed the 1950s level. It has been centering around 8-10%. It implies that companies' profits growth has been in line with GDP growth, which has been been stable at 3-4% annually since 1980s. But companies still managed to boost stock evaluations significantly. First, American compainies have been increasing dividends payment. The dividend share in profits has doubled from ~30% in late 1970s to ~45-50% nowadays. Under DCF model, when a company's growth is certain, the increase of dividends can lead to higher company evaluation. It implies that stock index (DJ) was expected to increase ~70% from $850 to ~1300-1450. This evaluation might be justified only if companies can still maintain the same capital expense. But where was the money from if more profits have been paid out? from bond market! (of course, this estimate for DJ is not justified because more leverage should lead to higher discount rate for equity, dragging down stock evaluation. In my analysis, US market beta should increase from 1 to 1.3 in 2009 because debt/equity is up from 50% to 100%).

Second, American companies have been levering up its balance sheet to take adavantage of lower inflation and lower interest payment. Since 1980, the 10 year US Treasury has been plummeting from 15% to 4-5% even though inflation has been generally below 4%.

As shown in the third chart, both financial and nonfinancial companies have levered. In particular, financial companies leverage has increased at a frenzy pace. As demonstrated in the fourth chart, the bulk of financial leverage went to housing mortgages, Agency MBS and ABS (private label).

The source of high leverage in financial companies was high mortgage debt on consumers. But the fundamental cause was government policy. "The democratization of credit began decades ago. Federal legislation in the late 1970s required banks to avoid discriminatory lending and meet the needs of local communities, spawning a wave of home buying and entrepreneurship in lower-income neighborhoods. The rate of homeownership in families with incomes in the bottom two-fifths rose to nearly 49% by 2001 from below 44% in 1989, according to Fed data analyzed by Mr. Mann at Columbia."(http://online.wsj.com/article/SB125511860883676713.html?mod=WSJ_hpp_MIDDLETopStories)

Also, Bush's policy for increasing home ownership in the late 1990s further fuel consumers to take on mortgages, especially subprime mortgages.