Wednesday, January 16, 2019

Equity Values and Business Cycles

This chart is basically a "Financial Accounts of the US" version of the P/E ratio.  Also, here I show corporate debt as a ratio with corporate profit.
Source

These are as of the 3rd quarter of 2018.  After the recent pullback in equities, while earnings are strong, the P/E ratio (blue) is back to the teens.  And, corporate leverage is in a conservative range too.

Going forward it seems that there are two likely paths:

1) Stable NGDP growth leads to slightly lower profit growth, but higher wage growth and higher real total growth.

2) Unstable NGDP growth leads to lower profits and wages.

If (2) happens, equity losses will be widely blamed on valuations and debt even though they will more likely be caused by unstable NGDP growth.  In hindsight, it will always look like high valuations caused equity contractions and high debt levels, because equity prices will be lower and vulnerable firms will suddenly be too leveraged.  But cyclical contractions rarely have anything to do with valuations or corporate debt.

4 comments:

  1. Every asset value decline is a morality lesson.

    Recessions cleanse the economy of weaklings, or hubris masquerading as business. Easy money allows such folly.

    Strong economies do not cleanse the economy of weakling businesses that cannot pay going labor rates. Strong economies validate weak and overleveraged business models.

    :)

    OT (well, maybe not):

    https://en.wikipedia.org/wiki/Verdoorn's_law

    I like this Verdoon's Law. Greater output (which I read as greater demand) leads to higher productivity. That was the 1990s picture and seems to happening again now.

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