The Big Macro Force That's Been Driving Stocks Higher for Years

0:00Hey, Fidelity. What's it cost to invest with the Fidelity app? Start with as little as$1 with no account fees or trade commissions on U.S. stocks and ETFs. Hmm. That's music to my ears. I can only talk.

0:17Jonathan Heathcote:Investing involves risk, including risk of loss. Zero account fees apply to retail brokerage accounts only. Sell order assessment fee not included. A limited number of ETFs are subject to a transaction-based service fee of$100. See full list at Fidelity.com slash commissions. Fidelity Brokerage Services, LLC. Member NYSE SIPC. Sonesta Travel Pass makes traveling more rewarding, designed to help you get more out of every stay. Sign up at Sonesta.com to enjoy instant savings, bonus points, and valuable perks like early check-in, late checkout, room upgrades, and free stays over time. With Sonesta Travel Pass, every stay brings you closer to your next reward.

0:50Jonathan Heathcote:Choose from more than 1 ,100 hotels across 13 distinctive brands and unlock the best available rates when you book direct with Sonesta Travel Pass. Here today, roam tomorrow. Join now at sonesta.com. Terms and conditions apply.

1:29where it actually pays off, deep in the work that moves the business. Let's create smarter business, IBM. Bloomberg Audio Studios, podcasts, radio, news.

1:53Hello and welcome to another episode of the Odd Lots podcast. I'm Joe Weisenthal. And I'm Tracy Allaway. So, Tracy, one of the things that we've been talking about a fair amount, everyone's talking about it, I guess, is how the biggest, most profitable companies in America, they're still really big and they're still really profitable, but they've switched from being throwing off tons of free cash flow to big investors spending a lot of money. Yeah, that's right. So we've had years and years and years of big tech basically, I guess, generating infinite amounts of cash, it feels like. And now they're switching to actually spending some of that cash to build very expensive data centers and things like that.

2:33And you're right. It is kind of a change for the market. Right. Like we haven't seen that scale of investment for a very long time. Certainly not. I don't think in our lifetimes, have we? I don't know. No, it doesn't feel like it. I mean, you know, I guess maybe we'll get into this in the conversation. You know, I think if you go back to like pre-GFC era, when a lot of the really big companies in the index were like, you know, Exxon was the biggest company in the world for a long time. So they would have always been having to like spend because you can't just sort of like passively collect oil, etc.

3:05But it does seem generally true that the big theme, both with financials and tech, is this incredible ability to generate huge returns with fairly modest capital outlays, whether we're talking about equipment, plants, or even human labor. Well, the other big switch is just, you know, if you look at it just at the tech sector, basically, which has been, you know, the dominant force in our equity markets for a while now. But for much of the 2000s, the investment was in sort of like intangible, you know, SaaS type stuff. And now we're switching to really like brick and mortar. They're paying to build energy capacity and they're paying for actual chips and actual buildings to house a bunch of air conditioners and servers and all of that.

3:49No, it's totally true. The big theme is just this. So the question is, okay, they're still making a ton of money. They're still very profitable. And maybe these investments will pay off in a massive way at some point down the future. But can investors expect the same level of returns that they've seen in the past if there's this big switch in terms of strategic decision making in terms of capital outlays and so forth, taking on debt? What does this mean for the markets? What does this mean for investors? And I don't know the answer, but maybe our guest. Well, also, I mean, you and I, I think for the past 20 years, we have all gotten very used to everyone saying that the tech sector is overvalued.

4:27Right. Yes. Like, even as it throws off infinite amounts of cash, everyone is like, oh, so overvalued. The market's at a top. The market's at a top. That has been the case for pretty much like my entire mature investing age lifetime. Right. And so you bring up a really another important dimension of this, which is just that valuations. by traditional metric. I mean, I remember, you know, early on, what was the Schiller, the Schiller-CAPE ratio? And it's like, this has got a mean revert. We're at the 98th percentile of historical valuation, and it keeps going up. And so mean reversion is always around the corner, Joe.

5:03It's always coming. It's always waiting. But no, this is another question. Why didn't it mean revert? And why have just the multiples that we've seen on traditional price to earnings ratios, you look at them, they make you go crazy, and they got to come down. Why haven't they? That's also an interesting question that we need to get answers to, even beyond the specific capital question. Yeah, let's do it. All right. Well, I'm very excited to say we do have the perfect guest today, because we are speaking to someone who's really done a lot of research on some of these exact questions, including he published a paper, co-authored a recent paper that really caught my eye back in January called A Macroeconomic Perspective on Stock Market Valuation Ratios.

5:44So it's good that you brought up the earnings metrics. We're going to be speaking with Jonathan Heathcote, one of the co-authors of this paper. He's an economist at the Minneapolis Fed. We're going to talk all about this. So Jonathan, thank you so much for coming on Odd Lots. Thanks a lot for having me. Yeah, I should just say right at the start, I should give a disclaimer. I'm an economist at the Federal Reserve Bank of Minneapolis, and anything I say is going to be my views, not those at the Federal Reserve Bank of Minneapolis or the Federal Reserve System. Thank you for getting the disclaimer out of the way.

6:13We are very used to hearing that from Fed researchers and economists. So the title of the paper, I think Joe already said it, A Macroeconomic Perspective on Stock Market Valuation Ratios. Why did you decide to look at this particular topic at this particular moment in time, too? Yeah, so actually, we started out, before we worked on this, we were working on a paper on the U.S. net foreign asset position, And we'd noticed that the value of U.S. assets minus our liabilities, that had been declining really fast over the last 10 years. And historically, people had mostly thought about that in terms of the U.S.

6:46running big current account deficits, running up a bigger and bigger debt with the rest of the world. And we realized that the kind of international gross asset positions had gotten really big. And a lot of the decline in the net foreign asset position was driven by the fact that foreigners had invested a lot in U.S. equity markets and a lot of foreign direct investment into the U.S. And when the U.S. markets were booming, much more so than the rest of the world, that was driving up the value of these foreign investments in the U.S. And that was driving down the U.S. net foreign asset position.

7:14And so after that, we kind of became more interested in trying to understand what's driving valuations more generally. I mean, our background is not really we're not really in finance. We're sort of more macroeconomists, but we've been working on this for a few years now. And that's where this paper started. This seems like, just from a sort of theoretical, big picture perspective, this link between sort of macroeconomics and stock markets. And it does feel like often these are worlds that talk past each other. And the macro people aren't talking about stock market valuations that much. And stock market people, they think they don't even have to care about macroeconomics in many cases.

7:49But this strikes me as interesting. How novel is this? Or talk to us about this attempt to bridge the gap between the two worlds here. Yeah, I think there's a lot of strong connections. And we're talking about the same things in a slightly different frame. So one thing macroeconomists have been talking about for a long time, for example, is the fact that it looks like labor share of output has been drifting down over time. So a larger share of the pie seems to be going to owners of firms and a smaller share as wages to workers. And obviously, that ties directly into thinking about valuations. If the firm's making bigger profits, that's going to drive up valuation.

8:24So I think there's a lot of connections. I think for a long time, historically, there was a sense that it was kind of really hard to understand valuations. They were driven by wild variations in risk premia that had not much to do with kind of standard slow moving macro stuff. And so, you know, there were two separate camps, one studying the finance, one studying the macro, and it was hard to connect them. But I think, you know, I think people are working on that. And I think there's a lot of connections. Okay, well, let's dive into the paper's conclusion then, because I think everyone, when we talk about high valuations, the temptation is always to be like, no, the people who are satisfied with these high valuations, they're the crazy ones, right?

9:05I'm the one that sees the truth. But your paper actually sets out a pretty reasonable explanation for why these high valuations have persisted and have not been reverted, as Joe mentioned. Talk to us about both, I guess, the labor component in your paper as well as the investment component. Yeah, sure. So, you know, I think Joe was mentioning a minute ago the price-earnings ratio. That's sort of a classic valuation metric people have looked at for a long time. And the idea always was that, well, if prices get too far ahead of profits, then maybe that gap's going to narrow again going forward. So either you're going to have to have really fast growth in earnings or the prices are going to come down.

9:45So you're going to get low returns. and people have looked at that ratio. Shiller has the famous version of it, and the problem is that it's been drifting up and up, the price-earnings ratio, and it's been kind of way above its historical average for a long time, and that gap just seems to keep getting bigger. So we kind of went back to that. We looked at it in macro data instead of financial data, but it looks much the same if you look at standard financial accounts. And we went back to 1952. Yeah, you see this big run-up in the price-earnings ratio. But there are other metrics you can look at.

10:19And another thing you can look at is you can look at prices relative to free cash flow. And it's sort of a similar ratio. It's just that you've got free cash flow in the denominator. And the only difference between earnings and free cash flow is in measuring earnings, you subtract a measure of depreciation. In measuring free cash flow, instead of subtracting depreciation, you take out all capital expenditure. And then the nice thing about free cash flow is it's sort of a measure of everything that's left at the end of the data to be paid to the owners of the firm. So you take the sales of firms, you subtract the input costs, payments to labor, subtract their taxes, subtract their capital expenditure.

10:53Everything that's left is money that the firm can pay out to its owners. So if you look at that ratio, the value of all the firms in the U.S. relative to the total cash flow they're generating, it bounces around a bunch over time. But it doesn't have like a long term drift. It's not like it's kind of systematically moving up over time. So if you look at that ratio, you'd say, maybe the market's not so overvalued today. Maybe prices are roughly within historical range compared to this ratio. This strikes me as very important. And so we should just pause on this point or stick with this point for a second.

11:30So we've all seen the Shiller Cape and various other versions. What you're saying is if you just, and I've always thought, let's just measure free cash flow. That's all I care about. If I'm an investor, just how much money comes back to me at the end of the day. But you're saying that when you look at the entire market through this lens, it just does not have the same extreme drift outside of normal ranges that you see when you look at price turning ratios? Yeah, that's right. I mean, it bounces around over time. But if you look at where it was, say, in 1980, so that was a low for stock values.

12:02If you look at it in 1980 and you look at it in the second quarter of 2022, that ratio of value to free cash flow is the same. And both cases is about the historical average. Now, if you look over the last three years, you know, that ratio has kept moving up. So now we are above the historical average, but we're not wildly outside the range that it's fluctuated in over the last 60, 70 years.

12:40Hey Fidelity, what's it cost to invest with the Fidelity app? Start with as little as$1 with no account fees or trade commissions on U.S. stocks and ETFs. Hmm, that's music to my ears. I can only talk.

12:57Jonathan Heathcote:Investing involves risk including risk of loss. Zero account fees apply to retail brokerage accounts only. Sell order assessment fee not included. A limited number of ETFs are subject to a transaction-based service fee of$100. See full list at Fidelity.com slash commissions. Fidelity Brokerage Services LLC member NYSE SIPC. Now I'd like to introduce you to Meaningful Beauty, the famed skincare brand created by iconic supermodel Cindy Crawford. It's her secret to absolutely gorgeous skin. Meaningful Beauty makes powerful and effective skincare simple, and it's loved by millions of women. It's formulated for all ages and all skin tones and types, and it's designed to work as a complete skincare system, leaving your skin feeling soft, smooth, and nourished.

13:33I recommend starting with Cindy's Full Regiment, which contains all five of her best-selling products, including the amazing Youth Activating Melon Serum. This next generation serum has the power of Melon Leaf stem cell technology. It's Melon Leaf stem cells encapsulated for freshness and released onto the skin to support a visible reduction in the appearance of wrinkles. With thousands of glowing five-star reviews, why not give it a try? Subscribe today and you can get the amazing Meaningful Beauty system for just$49.95. That includes our introductory five-piece system, free gifts, free shipping, and a 60-day money-back guarantee.

14:06All of that available at MeaningfulBeauty.com. Who doesn't love warm, carby comfort? Satisfying sandwiches, loaded bagels, rich mac and cheese. Crape-worthy and smart, Hero Bread's loaves, bagels, and noodles have just 0-5 gram snack carbs, 0 gram sugar, and up to 19 grams of protein and 32 grams of fiber per serving. Hero Bread bakes with heart-healthy olive oil and delivers a soft, fluffy, flavorful experience you love. Shop now on Hero.co. Use code IHEART for 10 % off. That's Hero.co.

14:40And just going back to the labor and investment component, if we think about it very simplistically, I think you used the pie analogy earlier. Like if you think about that cash as a giant pie, less of it is going to labor, less of it has been going on investment, and more of it is being spent or returned to capital, i.e. the shareholders. Yeah, that's right. So if you look at the price earnings ratio, it's not like earnings haven't grown. They've grown pretty fast and they've grown pretty fast because the share of the output that's going to workers has been going down and the share that's going to owners of firms has been going up.

15:15So earnings have grown, but cash flow has grown even faster and cash flow has grown even faster because firms have been able to generate these extra earnings without doing a lot of extra investment. I think what investors care about at the end of the day, what they maybe ought to care about is, you know, how much income is actually they're going to be receiving. And if firms have got to do a lot of investment to keep sustaining those earnings, that's income that can't go to the owners of the firm. But that investment seems to have been relatively weak over time. And as a share of firm value, it's been declining.

15:45So cash flow has grown fast. Talk to us about this measure of labor share. Obviously, on an individual basis, for an individual company basis, you can just find out how much is going to labor versus other things. At the aggregate level, which is where you're working at the macro level, this line, and I've seen it for years, people talk about labor share and it's generally going down. How robust is that measure? How that single number, because it looks pretty bad for workers when you look at the long term labor share trend. How like methodologically or sort of intellectually robust is this data?

16:21Yeah, I think it's something that macroeconomists have been looking at for a long time. I think it's pretty robust. If you look at the corporate sector, you just measure it in the national accounts. You can look at wages and salaries of employees, and you can compare that against the output of the corporate sector. And those wages and salaries have fallen by about 8 percentage points since 1980, I think, from 1980 to 2022. So that's 8 percentage points of GDP. That's a big change. You know, if you look at the non-corporate sector, you're looking at small businesses, that's harder to measure because kind of hard to say for a small private business how much of their output is really payments to labor versus payments to capital.

17:02But for big corporations, it's sort of straightforward. There is one wrinkle to that, which is that some firms have been paying more. They've been compensating some of their workers with stock options and things like that. And so that kind of complicates it a little bit because, you know, Do you want to call that a payment to labor or do you want to call that part of income to capital? So putting that aside, I think there has been a big shift with less income going to labor, more income going either to capital or just as pure rents to the owners of firms. Wait, now I'm really curious. In your own research, how did you classify stock-based compensation?

17:38Was that an increase in labor or was that an increase to capital? Yeah, we just follow basically the national accounts. So the Bureau of Economic Analysis and the flow of funds, they put together this data set called the Integrated Macroeconomic Accounts. And it's really just a version of the standard national income and product accounts. And they classify labor income the standard way, which is wages and salaries. And I think they include in that standard national income measure, when stock options are exercised, that counts as part of wage income. But, you know, when they're granted, you know, so there's some details there, but, you know, they're supposed to be at least partially captured there in that wage income measure.

18:16Okay. And on the investment side, what about intangibles? Because this is the thing that constantly comes up when we're talking about both valuations and the broader macro economy. So much of what companies do nowadays, especially in big tech, has to do with intangibles. So, you know, the ephemeral brand value and things like that, would that have been captured in that investment number? Yes. So they've changed a little bit over time the way they try and measure investment, and they're trying to capture more investment in international property, investment in software and stuff that wasn't historically captured.

18:52There's still a question about how well they're capturing that and how much of it is measured. But in terms of measuring free cash flow, one reason we like the free cash flow measure is that in terms of the income that's available to go to the owners of the firm, it doesn't really matter whether that spending on intangibles, that could be counted as a purchase of an intermediate input that subtracts from value added or could be counted as a capital investment, then it's going to subtract from investment. So the free cash flow measure is going to be the same either way. So I think that's the nice thing about free cash flow.

19:23It is just a measure of the income that's left over after the firm's paid all its bills. And it doesn't really matter whether you count those bills as an input cost or a capital expenditure. So I think, you know, that's one advantage of looking at this free cash flow measure. So when you embarked on this paper, how much was it in the, when you're thinking, you talked about the intellectual origins of it with your prior research, but how much was it motivated or driven by this current 2026 or probably 2025 when you started at reality that there is a very big change in corporate behavior afoot? We don't know how long it's going to last, but this is the big story of arguably the last two to three years is how much these very profitable companies have seriously shifted into investment mode?

20:09Yeah, I would say we weren't that, we were maybe a little behind on that. We were working on this for a while. So I think, you know, that's not something that was particularly on our radar. We've kind of twigged onto that a little bit more recently. No, it's true that that investment on AI-centered investment by the big tech firms, that's been booming. Other kinds of investment have been kind of weak. Residential investment, for example, has been weak. So looks kind of relatively strong for the whole US economy, but it's not outsized in aggregate. So yeah, I think it's definitely a question. I think, as you said right at the start, this story that firms have been able to generate a bunch of earnings.

20:53Some of these firms that have generated a bunch of earnings, especially in tech, they've done it without a lot of capital expenditure. And that's meant that the cash flow has grown really strongly. And now they are starting to spend. So it is a question going forward, is that spending going to, you know, is it going to pay off? So at the moment, I guess, yeah, I guess there's a bunch of companies whose cash flow temporarily is negative right now. Yeah. Historically, big free cash flow. And so that's the question investors are thinking about.

21:32hi i'm cindy crawford and i'm the founder of meaningful beauty well i don't know about you but like i never liked being told oh wow you look so good for your age like why even bother saying that. Why don't you just say you look great at any age, every age? That's what Meaningful Beauty is all about. We create products that make you feel confident in your skin at the age you are now. Meaningful Beauty, beautiful skin at every age. Learn more at MeaningfulBeauty.com.

22:06Who doesn't love warm, carby comfort? Satisfying sandwiches, loaded bagels, rich mac and cheese. Crape-worthy and smart, Hero Bread's loaves, bagels, and noodles have just 0 to 5 gram snack carbs, 0 gram sugar, and up to 19 grams of protein and 32 grams of fiber per serving. Hero Bread bakes with heart-healthy olive oil and delivers a soft, fluffy, flavorful experience you love. Shop now on Hero.co. Use code IHEART for 10 % off. That's Hero.co. Per serving, not a low-calorie food. Some products contain allulose. See nutrition info on Hero.co for sodium and sugar content. Discover a spectacular island destination with crystal blue seas, endless sunshine, and the cool Bahamian breeze.

22:45Bahamar, located in Nassau, Bahamas, offers your choice of three luxury hotels, the richly refined Rosewood, the playfully hip SLS, and the stylishly modern Grand Hyatt. With over 45 restaurants, bars, and lounges, Bahamar serves up delicious dining from world-renowned chefs like Daniel Bouloud and Marcus Samuelson, nightlife venues like the new Jean Batiste Jazz Club, and the Caribbean's most luxurious casino. At Baja Mar, you'll find every pleasure under the sun and one-of-a-kind experiences for the entire family, like Baja Bay, our 15-acre lush tropical water park, interactive wildlife experiences, including our daily flamingo parade, world-class golf, tennis, spa, and so much more.