The Wilshire 5000 Is Sending An Ugly Signal

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The Wilshire 5000 stock market index is an attempt to measure the performance of the broadest view of the stock universe. Dating back to the early 1970's, Wilshire has attempted to capture the rising tide of American capitalism as it flowed through every contour of the business end. Despite what the name implies, however, there have rarely been 5,000 companies in the index.

The number of stocks would obviously have to change with the ebbs and flows of listed companies given that the stated purpose of the index is to be comprehensive. The name "5,000" is more marketing than representative of anything truly significant. In 1979, there were only about 3,700 companies in the index as consumer inflation and a bad economic decade took its toll on American business. That flipped dramatically in the 1980's, as stock market riches lured companies to cash out and join the stock bull. By 1986, there were almost 6,000 stocks in the index.

That number exploded in the latter half of the 1990's, peaking in 1997 at just shy of 7,500. Unfortunately, so many of those companies that IPO'd just didn't make it, wasting so much resources in order to strike it rich in the mania of stock inflation. Entire businesses were floated on nothing more than a domain registration or a vague connection to something that sounded computer-related. It was a massive distortion in business, as companies favored the public option over remaining private and trying to raise funding via loans and debt.

During the dot-com bust, the number of stocks in the index dropped precipitously, back to about 5,000. In the years after the panic in 2008, we are back to 1979 levels with about 3,700 companies. That is a lot of shrinking in the listed exchanges, paring back the number of public companies available for stock investors. Curiously, it does not mirror the overall trend in companies, however, as the number of bigger firms (as measured by the number of employees) has actually grown.

In the 1992 Enterprise Statistics prepared and gathered by the Census Bureau, there were 6,492,072 firms with fewer than 500 employees. The number of companies with greater than 500 was 12,998. By the 2010 County Business Patterns survey, released in October of last year, there were 5,717,302 businesses with less than 500 employees and 17,236 with more. The number of "big" businesses, assuming number of employees is a decent proxy, grew by a third in those eighteen bubbly years. Small businesses declined by about 12%.

Defining these terms down even further, the segment containing firms with between 100 and 500 employees added 25.9% more companies, while between 20 and 100 the gain was 17.9%. That means the ranks of the truly small business, the real "mom and pop" shops, have shrunk considerably - the number of firms with fewer than 20 employees has fallen by 14.3%.

On average, this means that business in the US is skewing much larger in size as not only do the "mom and pops" decline, the growth rates are far larger at the upper ends of the size scale. In 1992, 47.2% of all employees worked at companies with greater than 500 employees. By 2010, the proportion was 50.9%.

There is a bit of arbitrariness going on here, since I picked 500 employees as the threshold between large and small. And like other more relative measures, perhaps that number should change with the population or some other anchor. In other words, it is not readily apparent what separates a big company from a small (or even if the number of companies tells us much at all, since there are self-employed persons and even "establishments" that are unincorporated).

Even the number of listed, public companies provides only narrow and basic information about the relative options for financing businesses. I don't think there is a whole lot to be said about the dramatic rise in public companies between 1980 and 1997; it was a bull market after all. The huge spike in the latter half of the 1990's corresponds with the artificial mania, meaning that companies go where the "money" is, as you would expect.

The decline of the "mom and pop" businesses does not offer a straightforward interpretation either. In a lot of cases the introduction of a larger competing business is actually very economically beneficial. The "mom and pop" are unable to compete with the larger-scale firm in terms of pricing, but that is a net positive for the economic system. This is essentially the "WalMart effect", as small, regional retailers have been pushed out of business by the giant, and shoppers are much better off in the aggregate - which is why they continue to patronize despite other social "pressure".

That is the nature of capitalism, as better competitors force laggards to exit. It is the brutal reality of competition, and the economic system thrives on it. But does that necessarily mean the upward shift in the size of business, assuming that is the correct interpretation, is a replication of the "WalMart effect" across multiple industries and sectors?

The employment figures I just quoted suggest that big business has been the engine of employment growth in the past two decades, at odds with conventional wisdom that small businesses play that economic role. You hear all the time that small business is the backbone of the economy, but so many figures and analysis demonstrates otherwise. This is not to diminish the importance of small business in any way, just to define the modality surrounding systemic advancement - the means through which innovation raises living standards.

There was a paper published back in 1994 by David Birch and James Medoff, titled "Gazelles," that laid out a theory of small business in much more defined terms. The primary driver of employment growth, in their estimation, was not the broader segment of small business, but rather a subset of small business made up of fast growing firms. In other words, these were companies that started out small and became larger in a relatively short time period. That rapid growth is where a lot of employment opportunities were born and nurtured; think Microsoft, Cisco, Apple, etc., before 1990.

These gazelles are the innovators that either begin with an innovative idea and seek to exploit it from the start, or become innovators due to some unforeseeable market conditions. In either case it is lightning in a bottle, and the economic system is advanced in large part due to this transformation. The "gazelle" proposition is certainly debatable as well, but to me it offers a very intuitive explanation for how the capitalist system actually transforms, particularly with regard to the introduction and importance of new innovation in the business cycle.

Studying the company spectrum, then, I suppose it is possible that these "gazelles" offer an explanation for the greater skew toward larger businesses. You would expect these innovators to get larger at some point, passing any arbitrary criteria based on size.

Inevitably, the gazelles are going to run into competition and larger, more mature firms entrenched ahead of them. This is not to say the advancement here is a zero sum game, far from it. But mature businesses respond to these opportunities much differently than the nimble gazelle. I may be over-generalizing here, but mature and large businesses are likelier to be more interested in protecting their turf than adopting and partnering with smaller firms, especially if that company can in any way compete.

Beginning in 1984, there was a sudden and significant surge in patent applications received at the US Patent and Trademark Office. Such a spike in applications was not particularly unusual, as that was the typical pattern seen throughout our nation's history. There was a massive rise in patent applications in the years just after World War II, for example. But what happened in 1984 was different. It marked the beginning of a sustained trend in patent activity that was unmatched in history outside of the earliest years of the Industrial Revolution. The apex of that sustained application surge was 1998.

I may be wrong, but in my experience of conventional wisdom the patent data would seem to corroborate much of what is believed about the computer and internet revolutions. It would stand to reason that such technology bearing fruit would lead to just such action. As new technologies were applied, it would seem to make sense that it would increase patent-related activity.

But the problem with that convention is that most of the technology that created the computer and internet revolutions was born decades earlier. I have written about the innovations that started the technology wave in recent months, and every one of the stories takes place largely in the 1950's and 1960's (with some spillover into the 1970's). I suppose it is possible that there were additional patents to be gained from the adoption of technological revolution as it was applied into the real economy of the 1980's and 1990's, but there is an alternate explanation here owing to how businesses and patents truly relate.

Contrary to popular belief, again assuming I am correct in interpreting it, patents are not about innovation at all. The rise in patent applications was not a proxy for a new wave of innovation, but an era of protectionism. A patent is a legal form of destroying competition. Ostensibly, that is assumed to be a cost to the system worth bearing because we largely believe that patents encourage innovation by giving the innovator some protection to reap the benefits of trying to innovate. But is that really the case? Would innovation suffer from competition at the earliest stages?

Markets develop because market demand exists, and I happen to believe that innovation would be better served with competition right from the start. But to the question at hand, the sharp rise in patent applications starting in the 1980's was likely far more related to reducing competition than signaling the continued advancement of technology revolution.

Anyone that has any experience with telecom patents, for example, can tell you that there is a "thicket" of patent navigation to be had in adopting even simple device advances. There is a patent for nearly every single component and subcomponent, and they exist for the benefit of restraining potential competition before it ever becomes real competition.

Even after the patent law changes that made "submarine patents" impractical, the management and navigation of the complex web of patented innovations in this age is exclusively the purview of attorneys. A small innovator is behind the curve in terms of resources to devote to legalisms and trade protection that is specifically designed to thwart just such processes. Even genuine innovation is endangered where existing firms with far more resources can claim otherwise with similar patent protection, tying it all up with court claims and attempts or threats to shake out royalties. Patent litigation has become a huge growth business for the lawyer class, flush with cash from industry behemoths protecting their turf (as they see it).

The tech boom gazelles are no longer as such, having become mature businesses with all the features that entails. In so many cases, including so many tech "darlings" that have been combined with others, they now spend more resources (again, generalizing) on marketing and legal to defend their aging technology than to create and adopt new innovation. They fight with each other over the smallest possibly defined changes or arrangements, and then get together in trade groups to pool resources in order to defend their collective cartelling.

But this skew in favor of larger businesses is not just innovators growing into mature companies, however. Far more often than not, big business gets bigger through the outright purchase of competitors. It is estimated that about 2,000 companies that dropped out of the Wilshire 5000 since 1997 did so as a result of a buyout or combination. Mergers and acquisitions on an industrial scale are a post-1980 phenomena. It began with the junk bond kings and LBO's of the mid-80's, but it has scarcely paused in the decades since. Perhaps it is just coincidence that the M&A fever coincides with the patent surge, but to my mind they are very much related by purpose.

Mergers, strategic or not, are typically carried out to restrain competition in one way or another. The monetary age has unleashed untold resources for larger firms to gobble their smaller competitors before they are ever truly threatening. That includes, I presume, baby gazelles. Unlike the African savannah where lions feed on the weakest, it is exactly these business gazelles that attract the hostile gaze. They are exactly the targets because they offer the greatest threat; big businesses spend inordinate amounts of resources identifying and tracking threats to their domain.

For the innovators that actually make it to the first stages of being a gazelle, you really do not have to wonder too much about why they would succumb to the buyout offer. Given the ease at which larger firms can secure debt financing, the utter cheapness of it gets translated directly into premiums (often very hefty) on these deals. From the perspective of the gazelle, it is an enticing offer to take the buyout in front of you, the guaranteed payday, rather than continue the fight, navigating the cronyism and patent web of the larger competitors. In finance terms, the probabilities are stacked against future value in remaining an independent entity.

One need only go back to Verizon's recent record bond/stock offering to see why. Not that Verizon Wireless, the purchase target, was an innovator threatening the existing telecom order, but Verizon put together $130 billion in a very short order to pay like it. It was an impressive display of drastically overpaying for corporate resources, demonstrating exactly the kind of raw financial power that is, in this day and age, targeted so often against innovation and competition. As much as the CEO and executives will sell the "market" on its "strategic purpose", the merger was simply an exercise in turf protection.

And Verizon paid an outrageous sum to get it. The chief weapon for the M&A practitioner is goodwill. Every piece of newly issued debt that gets tacked onto the price of the deal goes into the accounting notion of goodwill. Such intangibles are the exclusive realm of the mega-company - no bank or bond market would finance this kind of intangible (mostly worthless) asset skew in a smaller, "riskier" firm. The purchase does nothing for the macro economy except create a burden of overvaluation where it did not previously exist.

Unfortunately, this entire strand of thought is not something that is going to be settled by empirical "reality". The numbers do not prove one thing or another; they can only frame the debate and give some hopefully relevant context. My own sense of this business and of finance in general, particularly of the past two decades, is exactly what I describe above. The big businesses are winning the strategic game because they can simply buy their way to protection, whereas in the past, pre-monetarism, they had to compete more honestly. If a mature business wanted to buy a gazelle, there would be little goodwill at its disposal, only real capital created through successful and sustained enterprise - and that was valued at a jealously guarded premium rather than the appeal to intangibles and debt.

As I mentioned above, the computer and internet revolutions began in the 1950's and 1960's. There has been nothing close to that in the decades since. Some very astute observers have postulated that all the low hanging fruit has been plucked, in three successive technology bursts stretched well over a century, and we are simply "reverting to the mean". I have far more faith in American ingenuity, and look for answers instead in the artificial. To me, the suppression of competition is a much better explanation, even in part, for the dearth of true revolution in the past few decades. This case is bolstered by the sheer volume of imagination and resourcefulness directed, so unfortunately, toward finance and "money". Had it been unleashed more productively, we might be awash in gazelles rather than QE.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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