The stock market shouldn't fear Janet Yellen. It's Joe Sixpack who is the real danger.
Ms. Yellen, chair of the Federal Reserve, is universally expected to bump up the United States' key interest rate on Wednesday and continue hiking it for the foreseeable future. If so, some analysts fear that higher payouts on bonds and savings accounts could undermine Wall Street's long-running bull market by offering savers a more attractive alternative for their money.
But investors who are fretting about the potential danger to stocks may want to think again. Rates are rising precisely because the U.S. economy is looking stronger than it has in years.
"We don't think that tighter monetary policy will be the undoing of the U.S. stock market," says John Higgins of Capital Economics, who notes that historically there has been only a weak relationship between the stance of Fed policy and the value of U.S. stocks.
For now anyway, the real danger for investors isn't higher rates but a more insidious and unexpected threat – higher wages.
Earnings growth tumbled after the Great Recession. For a long while, paycheques struggled to stay ahead of inflation. Now, finally, the picture is improving.
The jobless rate has fallen below 5 per cent and most economists agree that the U.S. economy is at or near full employment. The Federal Reserve Bank of Atlanta's wage growth tracker shows an unmistakable upward trend in employee compensation over the past year.
For Joe Sixpack and every other working American who has suffered through a lousy decade, this is great news. For investors, though, rising wages are no reason to smile. Bigger salaries threaten one of the key underpinnings of this bull market – the unusually large slice of the economic pie that has been going to corporate profits.
In recent years, after-tax corporate profits have reached some of their highest levels since the 1970s when calculated as a percentage of the overall economy. Measured on the same basis, employee compensation has slumped to some of its lowest levels in the past half century.
If employees begin grabbing a greater share of the goodies, companies will be left with less. Corporate earnings will suffer. So will stock prices, since shares ultimately reflect how much companies are able to generate in profits.
Think of the situation this way: Over the past eight years, the stock market has done exceptionally well despite a lacklustre economy. The next few years could reverse that relationship. Stock prices could sputter despite an improving economy.
That, to be sure, would be highly unusual. But then these are unusual times.
One glaring oddity is the discrepancy between what businesses are earning and what those same businesses are paying out to shareholders. Over the past two years, companies in the S&P 500 lavished more cash on investors through dividends and share buybacks than they generated in profits, according to Aswath Damodaran, a professor of finance at New York University.
The discrepancy between payouts and earnings is a remarkable state of affairs. It's also unsustainable. At some point, the amount that companies are paying to equity investors must fall back into line with what the companies actually earn.
Chances are that this will happen. Mr. Higgins of Capital Economics believes higher wages and a stronger greenback will squeeze corporate earnings but he foresees a relatively smooth adjustment, with the S&P 500 ending the year at 2,300, only slightly below where it is right now.
However, it's easy to sketch a scenario where surging salaries suddenly leave companies with less money to shower on their shareholders at exactly the same time as higher interest rates on bonds and savings accounts begin to tempt investors away from stocks. If all that were to happen, today's love affair with equities could end abruptly.