From the February 2013 issue of Research Magazine • Subscribe!

January 23, 2013

The Middle Class Is Leaving the (Stock) Market

Why the middle class is shunning equities.

Last year’s presidential election moved the subject of the sagging American middle class to the fore of national debate. During the post-World War II decades, the middle class was hailed as a backbone of political stability and economic prosperity, and the United States was thought blessed among the nations because its middle class was so large and solid. 

What causes concern now is not just stalled average incomes or rising costs of education and health care relative to those incomes, but the fact that so many previously middle class families are dropping out. They are jumping off the upward mobility ladder, leaving the ranks of savers and even shunning the labor force. Over the past decade, the labor force participation rate fell by three percentage points, to 63.6%. 

In the 1990s, it was a point of pride for economists to talk about the U.S. as a shareholding society, where stock ownership had become a national pastime. Investing into shares of U.S. companies, either directly or through various pension schemes and mutual funds, represented direct ownership of the U.S. economy and a vote of confidence in America’s future.

Plus, equity investing was an important complement to individual retirement savings; over the long run, stocks consistently outperformed all other financial instruments in terms of their returns, providing an additional layer of safety for retirees. 

But the situation began to change after 2002, when stock ownership reached a peak of 67% of U.S. households. Even as the U.S. economy recovered from the dot-com bust, and the Dow Jones industrial average, having reached a recessionary nadir in 2002-03, began to climb toward new all-time highs, the percentage of stock-holding households started to dwindle. It spiked briefly in 2007, but in the current Great Recession it has tumbled rapidly, reaching 54% in 2011—the lowest level since the late 1990s—according to the Gallup poll. 

Prof. Edward Wolff of New York University has found that stock holdings of the wealthiest 1% of the U.S. population jumped from a 33.5% share of all stocks to 38.3% between 2001 and 2007. Meanwhile, the next 19% of the income ladder saw their share of stocks decline by three percentage points, to 52.8%, and the bottom 80% went from a 10.7% share to 8.9%.

All such figures—stock ownership, the share of stocks owned and labor force participation rates—are moving in parallel and pointing the same way: toward a reduction in the number of middle class households and, worse, their disengagement from core economic processes in the U.S. This trend predates the 2008 global financial crisis. 

Curiously, it also occurred at a time when stock option-based remuneration for senior managements was supposed to have aligned their interests with those of shareholders. The result has been a rather strange situation: Corporate profits have increased substantially, and, despite a tepid recovery of the past five years, have set new records in nominal terms and in share of the nation’s GDP. Dividend payments also grew, while taxes on capital gains and dividend income declined. Yet, the average American investor has moved to the sidelines.

These trends undermine the view, held by some market analysts, that the steady decline in trading volumes on Wall Street is a function of various technical factors, such as the emergence of other platforms, where trading now takes place. The reason why volumes are declining is probably an old-fashioned one: With retail investors being beaten down, there are fewer market players. 

Much evidence supports that idea: continuing redemptions at actively traded stock mutual funds, as reported by the Investment Company Institute; falling viewership at CNBC, which once was on every screen at public gyms and airport lounges; and the dimming fortunes of stock analysts, who only recently were big stars with considerable name recognition and public following.

Still Attractive

And yet, compared to the boom years of the 1990s, today’s Wall Street is a more attractive place for retail investors, based on objective factors. The Sarbanes-Oxley Act of 2002 tightened regulatory oversight where it was most needed, in bolstering controls over the quality of information released by publicly traded companies. While critics continue to claim that such rules reduced the attraction of New York City as a financial center vis-à-vis foreign rivals, notably London and Hong Kong, SOX should have attracted more U.S. investors, not fewer.

Another major trend in “democratizing” the stock market has been the emergence of exchange-traded funds, which allow individual investors to reduce costs and minimize risk, while pinpointing their investment strategy at very precise themes. Coupled with the earlier appearance of online brokers charging negligible transaction fees, ETFs opened up the horizons of do-it-yourself investors and investment clubs.  

As the number, variety and types of ETFs increased, they began to attract money from traditional mutual funds. However, ETFs seem not to have attracted many new investors, and certainly their emergence has not broadened the investor base in the U.S. 

True, over the past decade and a half U.S. shareholders suffered two massive market declines, one triggered by the bursting of the dot-com bubble at the turn of the century and the other by the housing bubble in 2008. Although in both instances blue chips proved resilient, we increasingly hear about the past 10 years being “the lost decade” of stock investment. In the late 1990s, investors were promised a “40,000 Dow” and even “100,000 Dow,” but in truth the Dow has moved nowhere since then.

 Elitist Champions

The Nasdaq market, which once held out a promise to technically savvy young, hip investors to back new ideas, illustrates the problem. The Nasdaq composite index has been an underperformer. It finally climbed above 3,000 in late 2012, reaching the 60% mark of its March 2000 high. This is more in line with the movements of Japan’s sclerotic Nikkei average than of a premier index of global innovation, which contains many dynamic brand names that have emerged during the high-tech revolution. 

But a quick look at the market champions of the past decade may explain why ordinary investors are not interested in the stock market, while also illustrating U.S. companies’ cavalier attitude to the small investor. Google debuted on Nasdaq in 2004 at a highish price of $85 per share. Since then it increased nearly tenfold, in late 2012 trading above $700. Apple, which when the dot-com bubble deflated traded around $10 per share and was on the brink of extinction, also set a record above $700 in 2012. Buying just 100 shares of one of those companies sets investors back a sum equal to 1.5 times the median annual income of U.S. households. Even Amazon shares are priced at $250 each, putting them well out of reach of an ordinary investor. Splits are apparently no longer cool among hip tech companies. 

As a result, Apple, the world’s largest company by market capitalization and a key component of the Nasdaq composite index, is now best suited for day traders and speculators. It even has its own volatility index, an Apple VIX, which more than doubled between August and December 2012. That, too, may be a sign of the times.

Retail investors are often outliers, whereas investment professionals tend to adopt a corporate herd mentality. With fewer independent players engaged in stock investing, we see a less efficient market dominated by insiders, and less longer-term growth—which in turn further alienates retail investors. All this is happening at a time when the stock market should have been picking up the slack left by decreasing corporate pensions and imminent cuts in Social Security.

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