The equity illusion

March 12, 2009

John Kemp Great Debate— John Kemp is a Reuters columnist. The views expressed are his own —

Even after its recent decline, the U.S. equity market does not look especially “cheap” or “undervalued” when viewed over time; the bear market has simply brought valuations back into line with long-term trends.

At a fundamental level, equity is a claim on a corporation’s residual cash flow after wages, interest, taxes and other costs have been paid.

In aggregate, the total value of equity outstanding cannot grow faster than nominal GDP (which is simply the economy-wide sum of cash flows). Otherwise, corporations and their owners would need to capture an ever-increasing share of national income at the expense of everyone else.

For four decades between 1952 and 1992 this stable relationship between equity valuation and nominal GDP did indeed seem to hold in the United States.

Click here for PDF

The chartbook shows how U.S. GDP, as well as profits, debt, interest rates and the market value of equity capital evolved between 1952 and September 2008 (the latest date for which full data is available).

Between 1952 and 1992, the value of outstanding equity rose at much the same rate (8.5 percent per year) as nominal GDP (7.5 percent).

But from 1992 onwards, the relationship broke spectacularly. The market value of equity has risen almost twice as fast (9.5 percent per year) as nominal GDP (5.4 percent) (Chart 1).

As a result, the value of outstanding equity, which had been stable for four decades at 40-80 percent of GDP, doubled to 160 percent of GDP at its peak in Q1 2000 (the height of the millenarian boom). It has remained above 100 percent of GDP for most of the current decade (Chart 2).


Rising equity valuations relative to nominal income were underpinned by three factors:

(1) Profits began to rise as a percentage of GDP from the early 1990s onwards as corporations succeeded in retaining more of the value of output in the form of surplus/profits and reduced the amount captured by employees (wages), government (taxes) and other investors (interest payments on debt). Between 1992 and 2006, the share of corporate profits in national income increased from 7 percent to 13 percent (Chart 3).

(2) In an increasingly integrated world, U.S. corporations derived a growing share of profits from operations and subsidiaries abroad. Profits overseas are tied to GDP growth in foreign countries rather than the United States. Since developing countries have grown faster than the United States over this period, the foreign component of corporate profits could (and did) increase faster than domestic profits or U.S. GDP. As a result, the proportion of foreign profits in total earnings has risen from 16 percent to 26 percent (Chart 4).

(3) Because equities are a claim on profits in future as well as the present, valuations are sensitive to the discount rate used to convert future profits back into current values. By lowering the discount rate, the steady fall in long-term U.S. interest rates between 1982 and 2007 as part of the “Great Moderation” made these future profits much more valuable, driving up equity prices even further (Chart 5).

But two of these factors (a rising share of profits in GDP, and a reduction in the discount rate) could not be sustained indefinitely. To some extent they represented a one-off structural shift.

The share of profits in GDP cannot rise forever at the expense of wages, interest charges and tax payments. The discount rate applied to future profits cannot fall below zero.

So for a time, equity valuations could grow faster than nominal GDP as the market moved from a low-profit high-discount rate equilibrium to a high-profit low-discount one.

Once the transition was complete, however, it was inevitable that the rise in equity valuations would again be limited to the rate of nominal GDP growth (albeit from a higher baseline).


The rise in equity valuations was also sustained by a massive increase in borrowing and indebtedness. Share buy-backs, management buyouts and the debt-funded acquisitions by private equity firms substantially increased the amount of debt in the corporate capital structure and reduced shareholders’ equity (the leverage ratio).

In effect, the long period of sustained expansion during the 1990s and the early 2000s, characterized by a mild business cycle, together with falling interest rates, increased risk appetite, and falling borrowing costs made firms comfortable taking on more debt relative to their cash flow than before.

Some of that debt was used to retire outstanding equity, heightening the leverage ratio further.

Because leverage is measured as an increase in debt (liabilities) relative to equity (residual assets) the strong rise in equity prices masked the real increase in underlying leverage.

Between 1952 and 1992, corporate debt, like equity valuations, rose roughly in line with nominal GDP. But after 1992, corporate debt, like equity values, accelerated sharply (Chart 6).

So long as equity values continued to rise, the leverage ratio remained unchanged. In fact, strong growth in equity values cut the ratio from almost 100 percent to less than 50 percent between 1987 and early 2007 (Chart 7).

But the capital structure became increasingly vulnerable to any setback in equity prices; the borrowing boom could only be sustained as long as interest rates fell and the share of profits in GDP rose.

The U.S. economy and capital markets were thus set on an unsustainable course. And as President Richard Nixon’s chief economic adviser Herbert Stein noted in the 1970s, if something cannot continue indefinitely, it will eventually stop. That is what happened when the mortgage crisis erupted in the summer of 2007 and the music suddenly stopped playing.

Once rates and spreads had reached ultra-low levels in the mid-2000s they could not be reduced any further. In fact the Federal Reserve began to lift short-term interest rates, cautiously, from mid-2004, putting gentle upward pressure on longer rates. Losses on imprudent subprime lending became apparent from 2006.

Suddenly the cheap-credit dynamic that had previously supported increases in both corporate debt and equity valuations stalled and went into reverse.

The high-debt, high-equity valuation equilibrium proved immensely unstable. As the economy stalled and nominal growth fell, credit availability and costs rose, and the equilibrium fell apart. Looming deflation threatens to wreak even deeper destruction, because it would push nominal GDP growth below zero.

Suddenly the highly valued equity that supported an immense pile of debt has been re-valued downwards, sending leverage ratios soaring and exposing the underlying vulnerability.

The economy-wide leverage ratio reported by the Federal Reserve jumped 16 percentage points from 41 percent to 57 percent in just 15 months between June 2007 and September 2008. Recent declines in share values will push the ratio closer to 100 percent when data for Q4 2008 and Q1 2009 become available in the next few months.

In some sense, the sharp drop in equity valuations over the last six months has restored the historical relationship between equity values and nominal GDP. It has undone much of the “structural shift” in equity valuations to GDP experienced in the last 15 years (Chart 8).

Whether equity prices settle here or recapture some or all of their previous level depends on what caused that structural shift; how much of it proves sustainable; and how much is now reversed.

Share valuations may rise from current levels, but higher credit costs and a lower share of profits in GDP will almost certainly ensure valuations do not regain their previously elevated level in relation to the rest of the economy.


We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see

the dollar may also be a tad overvalued…. so foreign equities might be a thing? just maybe?

Posted by Steven Stoffers | Report as abusive

Remarkable in-depth analysis. Excellent article.
In sum, it appears like the US economy in the past decade and a half was over-valued by foreign investors, who were the main source of cheap money that inflated a credit bubble of epic proportions.

Posted by YR | Report as abusive

Thanks John, as allways good to read fresh analysis. Somehow it seems that the mainstream economists (including those paid by the government) were too busy with other things last couple of years, while the signals outlined in your article would have given pretty convincing signal that something has to give any time soon. I’m also convinced that it would make no difference if there was a Democratic administration.

Posted by Franz Kafka | Report as abusive

Brilliant — and frightening.

Posted by John Mack | Report as abusive

It’s a systematic logical analysis put together in an manner easy to comprehend. It’s a great article and brings a different perspective into stock valuation

Posted by AK | Report as abusive

I agree with YR: good research and excellent article. It reminds me of the kind of analysis Ed Easterling does but with more causative application to what’s currently happening in the market. I plan to hang on to and revisit this article for awhile. Thanks John.

Posted by Barry Northrop | Report as abusive

When you look back over the last 15 years we had both Democrats and Republicans in both the White House and in control of the House and Senate. I don’t think it makes a difference which party is in power we all saw the things that John is talking about but we all accepted them as normal until the end of 2008.
Good article it is refreshing to have these things brought to light.

Posted by Craig Coal | Report as abusive

A thorough and refreshing analysis of the past couple of decades. It’s evidence of a complete dereliction of oversight, duty and leadership among our politicians and business leaders.

The US has to come to terms, that we no longer are king of the hill. We have to compete with smart people on other continents for scarce resources. We have to produce more efficiently. I know the US will rise to the occasion as it always has in the past.

Posted by MAX MANJIT MOHAN | Report as abusive

check up if this layman version of financial crisis would be of any help.

The american banks loaned money to the american consumer.
The american consumer bought goods from other countries with those dollars.
The other countries saved those dollars by depositing in U.S.Treasuries.
The treasury spent that money to balance budget deficits.
The same dollars circulated in the US economy and finally ended up in bank deposits again.
The banks lended those dollars to the american consumer again.
Again the consumer imported goods from foriegn countries exchanging those dollars.
This cycle went on for decades together the result being trillions and trillions of dollars ending up in chinese, japanese and all other asian country’s forex reserves.

The collateral for the loans the banks made were houses whose prices were assumed to go only up and up forever.
suddenly new houses were built in every nook and corner leading to supply of new homes far far outpacing demand which leads to subprime lending.
Sub prime borrowers start defaulting leading to foreclosure.
The more and more foreclosed homes come up for sale the less and less the takers for them ultimately resulting in house price collapse.
The more and more the foreclosures the more and more the losses for banks.
some how the banks want the dollars they loaned out to consumers back.
The consumer is broke, broke and broke long back. Only reason he survived thus far was by drawing home equity from the appreciated value of his house year after year and also credit cards which again he has started defaulting in droves.
Now that house prices have started going down nowhere could he turn up to refinance the loan.
Ultimately the consumer and bank both are bankrupt.
Now comes the stupid govt.
It loans money to banks and ask banks to loan them to consumers again.
Now the bank is saved.But still the consumer is broke.
The bank doesn’t want to lend to the consumer again.


Posted by chandru | Report as abusive

a very good analysis with a strong logic.

Posted by arlind | Report as abusive

It seems that Reuters’ commentators will not let us see a gleam of hope. Somehow, I belive there must be a tiny hope somewhere.

Posted by Marconi | Report as abusive

Thank God, finally Reuters have posted the truth of the matter. John, it is good to know that there are rational shining lights out there and thank you for this artcle.

I can’t possibly add to or critique the truth embedded in John’s analysis.

Posted by Gregory | Report as abusive

Very perceptive analysis and an interesting discussion. If you look at a DJIA chart for the past 50 years or so and extend the natural curve *before* the recent speculation reflected in Kemp’s charts, it should be somewhere between 6,000 and 6,800 today. If you extend the curve from 1929, it would probably be somewhere in the range of 4,500 to 5,000.

Having been burned once in the dot-com bust, I took my chips off the table when the Dow was at 14,150 — mostly because of news reports that mergers and acquisitions having a diminishing impact on keeping the markets roaring. M&A is not real value – just fuel for speculation, and I reacted to those long term curves. I still smile at what some thought was a foolish decision.

I think now that many observers are missing a small point: having been overextended in consumer spending, the average American is pulling back either as a result of coming to the end of the credit rope or out of fear that they might. They are going to be haunted by this for a while. This means go-go spending, no matter how much the bank credit lines are juiced, is going to be sluggish… and so, too, will the economy (by comparison, anyway).

keep up the good reporting!

Posted by Geoffrey Mehl | Report as abusive

Thank God, it is good to know that there are rational shining lights out there to provide the truth of the matter.

Thank you for an excellent article John.

Posted by Gregory | Report as abusive

I totally agree. Right now many stocks look ridiculously cheap based on the last 12-16 months, but when you look back to 5 years it is obvious there was a totally irrational rise in share prices during the last 3 years in particular. It’s amazing to see how obvious the charts show that the rise in equity value could not be justified or sustained…. I guess we’re headed for a long time of “monitary modesty”…which will do the world a world of good…Until the next financial ‘genius” comes up with a new game….

Posted by L Marceau | Report as abusive

I like the article and agree with the other readers that it seems a lot of economist up the hill where to bussy doing anything except keeping the economy in check.
What worries me is that though market has corrected towards the levels of 1996 and now all of a sudden CEO´s of Citi or Morgan Stanley are capable of drawing a “rosy” picture and even talk the markets up as if the whole market forgot about how we got to those levels in the first place. CEO´s such as the one mentioned above should have been sacked quite a while ago however it seems more than a human misstake once again to take them for granted. And here we go all over again…. Where to buy? It is cheap to get in now! We´ve touched bottom and bla bla bla.
So I guess the auto industry is fine now, the housing market is back on track, credit is flowing into the markets, unemployment is in check and for that … yes greed all over again.
Don´t get me wrong here I am in favour of free enterprise and a Kaptitalist with a Capital “K” but I do believe we realy should take a hard look where we are at right now and not take statements such as the ones that have been made the last couple of days for granted cause they where the ones who have been cheating and deceiving in the first place. Madoff is the one to be convicted but a lot of other CEO´s should have a space reserved beside his cell as well cause it is a US Ponzi scheme blown out of all proportions.

Posted by Robert Simons | Report as abusive

Great analysis.
The reason it makes sense is because there were no quants involved in creating it.

Posted by Maria | Report as abusive

Excellent penetrating analysis. Proves that hindsight is 20-20. But what are the greater implications of these observations? To me it appears as if Economics, “the dismal science” really needs an overhaul. It is an irrational system when you have to be able to look back 15 years to be able to assess what you should have done in order to not self-destruct. Our economic system appears to have engendered a generation of speculators whose earnings have been derived from non-productive activities. This includes corporations, investors, the Fed, the government, businesses and households. The only way to have shared in the benefits of this frenzy of musical chairs was to be the last one standing. Problem is that when there are billions of players and only a few chairs (the underlying fundamentals) the risk of systemic collapse is 100%. Is this any way to run an economy?

Posted by Jonathan Cole | Report as abusive

We are witnessing the true costs of a previously growing world economy that was built not on real asset values but on derivatives on top of derivatives on top of irrational credit availability on top of illusions of value. It was financial legerdemain by realtors, insurers and lenders worldwide. Now you see your money, now you don’t. Poof!
A disappearing act that will entertain taxpayers and future generations for decades to come as they continue to supply coins to fill the magicians’ empty but capacious hats.

Posted by Ray | Report as abusive

I think it would’ve been interesting to put some of the charts on a log scale. i.e chart 6

Great article, different point of view, thanks!

Posted by Mathieu | Report as abusive

Something seems wrong with the first chart. When looked for the nominal GDP for the US in 2008, I found it to be about 14 trillion. I also found this chart: ph.php?year_from=1952&year_to=2008&table =US&field=NOMINALGDP&log=

I wonder if the chart in this article is mislabeled?

Posted by Michael | Report as abusive

Hello Michael, Figures in the chart have been rebased as an index (1952 = 100) so that growth in GDP and value of equity outstanding can be compared more easily.

Posted by John Kemp | Report as abusive

you are very much on the money with your analysis. that’s why it’s so frustrating to watch out government try to support a bubble when we aren’t yet below historical norms in the valuation perspective. At the same time in order to support equity prices we are torching our currency with neg. real interest rates and hurting the average working man. Europe is doing a much better job with the crisis than we are. They are fixing the banking system so this mess doesn’t happen again, we are shelling out taxpayer dollars to support equity prices and doing everything we can to avoid regulating the people who go us into this mess. Look at the G20 meeting this weekend and see what each government wants if you don’t believe me. We are fighting very reasonable regulations and asking for everyone to provide money for a stimulus. This won’t fix the structural problem, but it will ensure that bankers keep getting rich at our expense.

Posted by dcb | Report as abusive

Don’t blame main street economists for this mess. they understood the system was not sustainable and warned many people. Wall street makes profits by letting the party run, they pay washington to let the party run, and people don’t vote for people who stop the party. It’s that simple.

Posted by dcb | Report as abusive

It is a very good article but somewhere the plot got lost. Financial ratios related to Market Price of Equity are called Valuation ratios and these are independent of level of Debt or Leverage. Valuation ratios are not governed by Debt. If we need to evaluate levels of Debt and their serviceability we should look at Leverage ratios and Interest Cover.
What the author wanted to convey but failed to I will explain very simply. Over the last 2 decades Central Bankers have pushed Interest rates down to unreasonably low levels. This had dual effects on the Market – Savers were penalised and forced to shift Money to Riskier Asset classes like Equity,pushing up their values above fair prices. Corporates benefited by taking on increased Debt at cheap rates and boosting Profitability. This self reinforcing cycle was like shadow chasing and developed its own momentum which everybody wanted to pile onto. Plentiful Credit coupled with Low Interest rates is a disastrous invitation to Speculate and Bubbles are a natural outcome of such a phenomena.
The Government seems to have learnt nothing and continues to follow a policy of quantitative easing and Low Interest rates.
Was not this the phenomena that got us into deep sh_t,in the first case. It is sad and unfortunate that Economists are unable to come up with better ideas.
Let me state herein that “spend today pay tomorrow” philosophy has failed and varying the dose will not solve the problem. The “save today spend tomorrow” policy has worked always. As individuals we need to take responsible Financial decisions which means we do not follow the Herd and rely even less on Government for advise and HELP.
Cheers !!

Posted by F.Daruwala | Report as abusive

not quite right.

There is more in GDP than just cash flowas accruing to owners of public US companies.

There are cash flows accruing to labor
Cash flows for foreign businesses
Cash that is wasted (not in GDP)
Measurement problems with GDP
Cash flows accruing to private businesses
Cash flows attributed to Government activity
Cash flows from illegal activity
Cash from foreign activity
These are just a few..
Returns from changes in capital structure
Changes in interest rates
Blah Blah

Posted by me abdyou | Report as abusive

Good perspective in how things have shaped up in the macro sense.

Lot of us put the blame on politicians and business leaders. But the fact is that we are directly and indirectly responsible. Its the ignorance of a lot of us which fuels this fire. If the banker is willing to lend, isn’t it the stupid’s man mistake to borrow more than you can ever pay ! The greed gets better of us when it comes to investing in the same way. Two years back also these equities were overvalued, but who cares !

THe only thing which will prevent such a disaster again is more awareness. Facts liks these should be publicly available – these are not new, just that they are confined to only a few ppl knowing and general public can’t take the individual decisions because they have no rational data/information available to use to see where they stand in the macro sense.

Posted by Gaurav | Report as abusive

And to think the market value of equity to GDP was the central argument for putting social security into the stock market. Evidently our well educated financial leaders either did not retain or ignored what they learned at their chosen institutions of higher learning. Can such arrogance really be regulated?

Posted by Anubis | Report as abusive



Posted by tramadol | Report as abusive