Can The Stock Market Continue To Go Up When The Middle Class Is Suffering?

Includes: AAPL, HCSG
by: Martin Lowy

For most Americans, individual incomes hit a peak in real terms in 1999, and they have declined since then. Household incomes have fared somewhat better, but have stagnated for the period 2000-2007 and declined in the recessionary period that ensued, all as shown by the following table.

Table 1

Changes in Income by Quintile and for Top 5% 1970-2011

Income Group





Bottom 20%





Second 20%





Middle 20%





Fourth 20%





Top 20%





Top 5%





Data compiled by the author from Table H-3.

Delving deeper into the household numbers, one finds that two-earner households are getting ahead, while single-earner households are falling behind. Whereas in 1970, a two-earner household earned 147% of a single-earner household's earnings, by 2011, the two-earner household earned 172% of a single-earner household's earnings. (Data compiled by the author from Table H-12AR.) This trend probably reflects a gradual increase in the percentage of two-earner households at the top of the income distribution. At the same time, it appears that single-earner households gradually predominated in the lower quintiles. Thus, married couples have done significantly better than single people since 1970. The trend toward a greater proportion of households being headed by a single person therefore, has been an important factor in the appearance of increasing inequality between the top quintile and the lower quintiles.

SA contributor Doug Short showed this more graphically in a recent article on SA:

What is happening to the middle class has obvious importance for the stock market in that sales of products and services are driven by final demand, which consists primarily of purchases directly or indirectly by consumers. High earners are believed to spend a lower percentage of their income than middle or lower earners.

Nevertheless, I believe there is some reason for optimism about the economy in the next few years -- and for corporate profits as well. One of the reasons for optimism about corporate profits is the trend of a greater share of GDP going to capital as opposed to labor. The smaller labor share is reflected in the slippage of individual earnings. The flip side is that profits are more robust than they were historically. Can that continue? Or will it quickly revert to the mean?

The following graph from researchers at the Federal Reserve Bank of Cleveland shows how labor has suffered relative to capital in recent years. The Cleveland researchers found that the fall in labor's share of income was one of the causes of rising inequality.

The following graph of corporate profits to GDP shows the obverse side of the same coin. Corporate profits have been rising as a percentage of GDP since 2000. Because the top 1% of the nation in wealth owns such a large percentage of corporate securities, the trend toward profits comprising a larger share of GDP benefits the wealthy, but not the lower economic quintiles.

I see no indication that labor's share of GDP will quickly revert to the mean. The forces that have reduced labor's share of GDP -- mainly foreign competition that drives down wages and increased efficiency through the use of new technologies -- are abating. Therefore, I believe that corporate profits as a share of GDP are likely to remain high for some time.

On the other hand, many readers know the story (perhaps apocryphal) about the auto manufacturer who is showing his new robots to the union boss. The manufacturer asks the union boss how he is going to get the robots to pay union dues. The union boss responds by asking, "How are you going to get them to buy your cars?" Whether or not the exchange took place, it may reflect a truth about robotics. Although robots do increase efficiency and the return to capital at the expense of labor, the returns to capital in general may be self-limiting if jobs that pay well are not being created elsewhere in the economy. Eventually, that may indicate that labor's share of GDP may cease shrinking. The process simply may be self-limiting, as many processes are in nature.

I do take to heart Doug Short's recent cautions about the market being expensive by historical standards. If you missed his article, see it here. But as I view it, the market has been overpriced since sometime in 2010, yet it has continued to perform well through a very difficult economic period. If I am correct, that growth will continue to improve, though not dramatically -- see my article here -- then I think the demographic factors are likely to help rather than hinder the market. I say that because household formation, which has been pent up during the Great Recession and its aftermath, should begin to improve. And that would have a large positive impact on sales and profits of many businesses.

For these reasons, although the risks are undeniable, and although I do not expect the middle class quickly to flourish (on a relative basis) as it may have done a generation or so ago, I think exposure to equities remains prudent in an environment where debt that is highly rated earns very little.

But as an investor, I would like now to be shifting toward companies with very solid balance sheets and the ability to pay dividends through the cycle because dividends tend to prop up a stock, even in down markets. Apple (NASDAQ:AAPL) certainly is one of the stocks that I want to own now. Its stash of something like $137 billion of cash and its relatively low P/E when its cash is deducted from its market price make it an almost ideal holding at this time, despite its slowing growth and the prospect of margin compression, both of which have, I believe, been reflected in the market price.

I also like smaller companies with sound balance sheets that have little debt and sufficient cash to weather a storm. I mentioned Healthcare Services Group (NASDAQ:HCSG) a few months ago as an overpriced outperformer. It has a strong dividend of almost 3% (but based on a high payout), and a sound, growing business and sound balance sheet. It is the sort of company that can survive in adverse circumstances. I have owned it quite happily since 2004. I am sure there are many other good candidates, and I will be looking for them.

Disclosure: I am long AAPL, HCSG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.