Getting Rich: Stock Valuations
February 2005
By: ChartingTheEconomy.Com
Stock valuations seem to be a topic of almost endless debate and there are always plenty of bulls and bears. This
report gives a view of stock valuations based on long term economic fundamentals. It starts with an analysis of U.S.
gross domestic product (GDP) which serves as the foundation for this report. Then the relationship between GDP
and corporate profits is discussed. Finally, the direct correlation between corporate profits and stock valuations is
analyzed. Through this analysis a clear conclusion is established that stock valuations are rich. It is also concluded
that on a short term basis the relationship between GDP, corporate profits and stock valuations is very volatile.
Accordingly, it is difficult to time the direction of the stock market with any precision in the short term. However, by
establishing the close long term relationship between GDP, corporate profits, and stock valuations it is clear that
stocks are set for a period of under performance.
Gross Domestic Product and Its Four Major Components
To better understand current stock valuations, we first need to examine gross domestic product and how it is
measured. GDP is the most commonly used measure of the overall size of the U.S. economy and can be defined as
the amount of goods and services produced during a specific period. The easiest way to think of GDP is as follows:
GDP = Consumption + investment + exports - imports
Chart #1 shows the major components that comprise the U.S. GDP and their relative size. Each component is also
discussed in following sections.
GDP - Personal Consumption
Chart #1 (above) shows that personal consumption is the primary driver of the U.S. economy. The fact is that
personal consumption in 2004 accounted for more than 70% of total GDP. Over the past couple of decades personal
consumption has steadily grown in its portion of the U.S. economy. In 1981 it represented about 62% of GDP. Why is
personal consumption making up so much more of the U.S. economy than ever before? Simple, Americans are
spending almost all of their income each year and saving almost nothing. Chart #2 shows how the personal savings
rate in the U.S. has declined in recent years.1
As personal savings declined over the past couple of decades, we have been spending an increasing amount of our
disposable income on personal consumption expenditures. Chart #3 shows how consumption expenditures have
increased much faster than disposable income since 1980.
The significance here is as follows. First, personal consumption expenditures are by far the most important part of
GDP. Second, the growth in personal consumption expenditures has boosted GDP growth over the past couple of
decades. Third, the growth in personal consumption expenditures cannot continue to outpace growth in personal
income indefinitely. The fact is that personal savings is now at one percent (1%) of disposable income. Therefore,
the best case is that consumption will grow at the same pace as income in coming years. What this means is that the
component that makes up over 70% of GDP is likely to see slower growth in coming years, all else being equal. Of
course, if savings go negative or income begins to rise more quickly, then personal consumption may continue to
increase at the current rate. Suffice it to say that negative savings and income inflation have other consequences
that can negatively affect markets. At this point we will assume that neither happens.
GDP – Government Expenditures and Investment
The second largest component of U.S. GDP is government expenditures and investment. This part of the U.S.
economy has been fueled largely by deficit spending by the Federal Government and many state governments. To
turn the tide on government deficits, we are likely to see tighter controls on government spending over the next
several years. In fact, the Bush Administration’s 2006 budget proposal is a step in this direction. What this means to
the U.S. economy is slower GDP growth in the near term as government expenditures increase at a slower pace than
in prior years.
GDP - Trade
Unlike personal consumption and government spending, the U.S. trade imbalance has been a major drag on U.S.
GDP growth over the past decade as it has ballooned from $94 billon in 1994 to over $600 billion in 2004. The trade
imbalance effectively lowered U.S. GDP in 2004 by 5%. Economists appear split on whether the imbalance will grow or
decline over the next several years. The decline in the U.S. dollar should slow or even stop the growth of the trade
imbalance. However, until now it has done little to reverse it. If the trade imbalance is maintained or reversed, it could
produce a positive affect on U.S. GDP. However, to the degree that the imbalance represents a small share of overall
GDP (when compared to consumption), any positive affect is unlikely to produce substantially higher GDP growth.
GDP – Private Domestic Investment
This leaves private domestic investment to carry the day on GDP. The rate of growth in private domestic investment
may increase over the next several years, especially, if overcapacity in certain industries begins to dry up. However,
private domestic investment, like trade, represents a small portion of overall GDP so an increase in its rate of growth
has a moderate affect on overall GDP.
The point in discussing GDP is not to debate each component, but to show what has been contributing to its growth
recently. Once this is understood it is clear that GDP growth will likely slow over the next several years. The slow
down in GDP growth occurs primarily because it will become increasingly difficult for the U.S. consumer to increase
spending relative to income as the savings rate approaches zero. Given that consumer expenditures make up over
70% of GDP this will slow GDP growth.
Gross Domestic Product and Corporate Profits
So what is the significance of a slow down in GDP growth in coming years? The significance is that GDP growth has a
direct impact on growth in corporate profits in the long term. So as it becomes increasingly difficult to maintain current
GDP growth rates, it also becomes increasingly difficult to maintain growth rates for corporate profits.
To get a full picture on the relationship between GDP and corporate profits let’s take a look at each on an annual
basis and long term basis. First, on an annual basis there is little direct correlation between GDP and corporate
profits as Chart #4 shows.
Chart #5 shows GDP and corporate profits growth over the same period on a cumulative basis. From this chart it is
clear that corporate profits are more volatile than GDP; however, their long term cumulative performance is very
similar.
The point here is that corporate profits will likely slow over the coming years as the rate of growth in GDP slows. Of
course, corporate profits will fluctuate greatly on an annual basis, but in the best case scenario expectations should
be for more moderate growth over the next decade.
Corporate Profits and Stock Prices
All of this leads us to the equity markets. Simply put, corporate profits are the single most important fundamental that
drive the valuation of stocks. When it comes down to it, other items such as growth, taxes, productivity, and interest
rates affect stocks mostly by influencing corporate profits. Interest rates do have the added affect of influencing the
attractiveness of alternative investments such as bonds which deserves some mention.
In the short run, stocks are not likely to follow corporate profits because stocks are influenced by a variety of other
factors. Depending on the effect of the other factors, stocks will either under-perform or outperform corporate
profits. Another way to look at this is that investors at any given time are willing to pay a specific price for a dollar of
corporate profits. The price investors are willing to pay may vary because factors like interest rates, growth rates,
taxes, debt, currency rates, and emotion cause investors to make different valuation assessments. In the short term,
you would expect stocks and corporate profits to vary based on the amount of external influences on investment
decisions.
In the long term, however, unless there is a shift in fundamentals that causes stocks to become less or more valuable,
stocks should follow corporate profits. Two examples that could make stocks more valuable would be higher growth
rates in the future, or that other investment alternatives are not expected to be attractive for an extended period.
Given the above discussion on GDP there is little reason to believe that growth rates should accelerate in coming
years. In fact there are plenty of reasons to think that long term growth rates may slow. Also, while stocks may look
more attractive than bonds now, given today’s low bond yields, this is most likely a short term trend. So over the long
term stock price gains should mirror the growth of corporate profits since there is little reason to believe that there is a
fundamental reason why stocks have become more valuable to own.
Let’s take a look at the relationship between stocks and corporate profits in recent years. First, Chart #6 shows the
relationship between stocks and corporate profits on an annual basis. The obvious observation is that there can be
large variations between the two in any given year. As we just discussed, this is expected based on investors making
short term value assessments.
However, Chart #7 shows the relationship between two major stock indexes (the Russell 3000 and S&P 500) and
corporate profits since 1987. These two indexes are used because they represent a broad range of stocks.
Several things are obvious when looking at Chart #7. First, through the end of 1995, stocks were growing at a very
similar pace to corporate profits. Second, the stock market bubble of 1999/2000 is very evident. Third, the market
correction and subsequent rebound is also clear. However, maybe the most obvious trend is that stock price
appreciation since the end of 1995 has clearly been outpacing corporate profits. It is also obvious that complete
investor capitulation never materialized after the 1999/2000 bubble. Based on this, it is beginning to look like a
second bubble is forming, or it could be argued that, having never fully deflated, the 1999/2000 bubble is still with us.
This last point seems even more plausible when we look at Chart #8 which compares the S&P 500 including dividend
payments to corporate profits since 1987. Chart #8 is arguably the more accurate comparison in as much as
including dividends demonstrates total returns.
Conclusion
This report establishes a direct correlation between GDP, corporate profits and stock valuations over the long term.
The purpose of this report is not to forecast the rate of future growth in any of these categories. It is to give
perspective on stock valuations today. Even if you assume future growth is at historic rates, stock prices are way out
in front of corporate profits. If you assume that corporate profits have benefited in the past several years by
potentially unsustainable factors such as low interest rates, low capital spending, favorable tax rates, and high
productivity gains, it becomes even more difficult to see how corporate profits can support stock prices at current
levels.
The report also acknowledges that there is much short term volatility in the relationship between GDP, corporate
profits and stock valuations. It is therefore difficult to predict the direction of stock prices in the near term. However,
based on a view of the long term relationship between GDP, corporate profits, and stock valuations, it is clear that the
current risk/reward ratio of stocks is high. There is no prediction made as to how stocks will perform in the short term.
The long term prediction is that stocks are set for a period of under performance when compared to the past decade.
Sources:
Chart #1: Data is from the U.S. Bureau of Economic Analysis (BEA) table 1.1.5 Gross Domestic Product. Net export
of goods and services is negative because it represents the U.S. trade imbalance.
Chart #2: Data is from the U.S. Bureau of Economic Analysis table 2.1 Personal Income and Its Disposition.
Chart #3: Same as Chart #2.
Chart #4: BEA table 1.1.5 Gross Domestic Product and BEA table 1.12 National Income by Type or Income.
Corporate profits are after tax profits without inventory valuation adjustment and capital consumption adjustment.
Chart #5: Same at Chart #4.
Chart#6: Corporate profit data is from BEA table 1.12. and represents after tax profits without inventory valuation
adjustment and capital consumption adjustment. Data on the S&P 500 is from the Standard & Poor website. Stock
prices are as of 12/31 of each year. Corporate profits are for the entire year. 2004 corporate profit data uses data
for the first three quarters and estimates 4th quarter data.
Chart #7: Corporate profit and S&P 500 data sources are same as Chart #6. Data on the Russell 3000 is from
Yahoo Finance website using Russell 3000 index historical data and from the Russell Indexes website. Stock prices
are as of 12/31 of each year. Corporate profits are for the entire year. 2004 corporate profit data uses data for the
first three quarters and estimates 4th quarter data.
Chart #8: Same as Chart #6.
Endnote:
1 It should be noted that the Government’s statistics on personal savings do not include capital gains on personal
assets such as equities and real estate. Therefore, some economists argue that these statistics understate total
personal savings. However, the statistics actually take into account a broad range of income sources. Besides wages
and salaries the statistics include employer contributions to pensions, personal interest and
dividend income to name some of the income sources. Basically, the Government’s statistics on personal savings are
derived by taking all personal income sources (not capital gains) and subtracting out taxes and personal expenditures.
