Stock Market Short-Termism’s Impact

Mark J. Roe is the David Berg Professor of Law at Harvard Law School. This post is based on a recent paper by Professor Roe, available here.

Related research from the Program on Corporate Governance includes Corporate Short-Termism—In the Boardroom and in the Courtroom by Mark Roe (discussed on the Forum here); The Myth that Insulating Boards Serves Long-Term Value by Lucian Bebchuk (discussed on the Forum here); and Can We Do Better by Ordinary Investors? A Pragmatic Reaction to the Dueling Ideological Mythologists of Corporate Law by Leo E. Strine (discussed on the Forum here).

Stock-market driven short-termism is crippling the American economy, according to legal, judicial, and media analyses. Firms are forgoing the R&D they need, sharply cutting capital expenditures, and buying back their own stock so feverishly that they starve themselves of cash. The stock market is the primary cause: corporate directors and senior executives cannot manage for the long-term when their shareholders furiously trade their company’s stock, they cannot make long-term investments when stockholders demand to see profits on this quarter’s financial statements, they cannot even strategize about the long-term when shareholder activists demand immediate results, and they cannot keep the cash to invest in their future when stock market pressure drains away that cash in stock buybacks.

This doomsday version of the stock-market-driven short-termism argument embeds economy-wide predictions that have not been well-examined and that could tell us how severe these problems are: if the scenario is correct and strong, we should first see sharp increases in stock trading in recent decades and more frequent activist interventions, and these increases should be accompanied by (1) economy-wide R&D spending declining, (2) cash bleeding out from the corporate sector, and (3) sharply declining investment spending in the U.S., where large firms depend on stock markets and where activists are important, as compared with advanced economies that do not depend as much on stock markets. These baseline predictions flow directly from the short-termist critique of stock markets and corporate America. They are the central negative consequences of stock-market driven short-termism and they justify corporate law policies that seek to prevent these outcomes.

But none of these predicted outcomes can be found in the data. Corporate R&D is not declining, corporate cash is not bleeding out, and the developed nations with neither American-style quarterly-oriented stock markets nor aggressive activist investors are not investing any more in capital equipment than the U.S. More specifically, spending on corporate R&D is rising whether scaled by GDP overall, limited to the S&P 500, or scaled to earnings. Buybacks are up during the past decade, but so is long-term borrowing, with two approximately netting out. Some cash is flowing out of the S&P 500, but as much or more cash is flowing in to the smaller firms outside the S&P 500, which is what one should expect in a healthy economy. The decline in capital expenditures, which is a phenomenon of the developed world not just the nations dependent on stock markets, became most acute in the U.S. after the 2008-2009 recession when usage of capital already in place declined dramatically; it has recovered only recently. These two facts—low U.S. capacity utilization in the past decade and similar capital spending declines all around the developed world—point to better explanations for declining capital investment than stock-market-driven short-termism. Not all of these explanations are positive ones; cures though depend on diagnosing the problem correctly.

Hence, the stock-market-driven short-termist argument needs to be reconsidered, recalibrated, and, quite plausibly, rejected.

I then indicate why even if some firms suffer from short-termism, the economy as an ecosystem does not seem to. Lastly I address the broadest question: why has a view that lacks evidentiary support in the economy-wide data, and one that suffers from facing considerable disconfirming evidence, become one of the few corporate governance issues that attracts attention from the media, senators and other political and policymaking leaders, and the public. I suggest in this paper’s final part why that is so and why some of the underlying problems will not go away even when and if the facts are correctly perceived.

The complete paper is available here.

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