Tuesday, February 7, 2012

Equity Valuation Based on GDP Growth 2.0

This is based on my post Equity Valuation Based on GDP Growth with a slight twist.

As I've outlined previously, over the long run equity valuation and earnings both grow at roughly the pace as nominal GDP. If earnings (for example) grew faster, then earnings would eventually become larger than the entire economy, which is not possible.

With that in mind, here goes...

The below chart shows:

This is an attempt to compare historical S&P 500 valuation (relative to the size of the US economy), relative to the current valuation level. For example... if the S&P 500 (blue) is below the nominal GDP line (yellow), then the S&P 500 was cheaper then (on this relative measure) than it is now. It also means when the lines cross, valuation levels were equal to today.

The relevance: The chart below shows the relative valuation for each year from 1929 through 2001 (in December 2011 terms), then shows the subsequent 10 year forward change in the S&P 500 (note this does not include dividends).

This chart shows that if this valuation metric can forecast the future (I am not saying it will, but it seems useful), then equity markets may be a decent buy here. At relative value zero (i.e. today's measure) the trend-line goes through 0% on the x-axis at roughly 7.5% annualized (before dividends).


  1. I love your charts. Do you mind telling me what program you are using, or is it a secret sauce of some sort?

  2. It's all Excel pasted into PowerPoint and saved as a .png file. I'll try to create a post outlining the process at some point in the near future.

  3. Jake, how do dividends factor into this? Yields were much higher in the past than today. Shouldn't that affect the valuation analysis?

  4. David- long story short... I think so, but I can make the pro (corporations are cheaper) and con (corporations are expensive) cases:

    Pro: corporations should be worth more because they aren't "shedding" market value to investors (i.e. corporate earnings on a market value less cash basis make them seem CHEAP)

    Con: by hanging on to dividends in the form of cash (vs paying out to investors to reallocate to firms that need capital), corporations may be slowing future economic output of the nation, which would slow their earnings and valuation growth.

    What are your thoughts?

  5. "then earnings would eventually become larger than the entire economy, which is not possible."

    That's not quite right, if you mean "US GDP" by "the entire economy". S&P earnings could theoretically exceed US GDP because they include foreign income, which US GDP does not. Gross National Product, which does include domestic-owned foreign income, might hence be a better benchmark for S&P earnings.

  6. Yes... it's in theory possible, but if growth outside the US is that much more robust, earnings will leave US entities and move to non-US entities (either because non-US corps take over or US corps move abroad). I'm extremely confident in saying US corporate earnings will never be bigger than overall economic activity of the US.

  7. Jake,

    Looking at your previous chart, trend earnings growth, shiller's data on long term earnings growth, as well as Arnott/Bernstein's, wouldn't it be more accurate to say that earnings growth trails growth in nominal GDP over the long term? I know that at recent peaks it is has drawn even over certain time frames, but in general that does not seem to be the case.

    If so, then two thoughts come to mind. Over time we should expect that fair value versus GDP should be lower and lower, and thus today's reasonable valuation for the S&P500 is a bit misleading. Second that the recent periods of earnings drawing even with GDP in your previous chart are based on profit margins that will mean revert over time. Thus the trend line your forecast is based upon is biased upward.

    Or, I am missing something simple and need correction.