GDP, M&A, EBITDA, P/E, NASDAQ, Econo-thread Part 11

[Adam Smith]

Just noticed today that there are some pretty smart people (Bill Miller at Legg Mason, plus Clipper Funds) scooping up Tyco (TYC) stock, plus a lot of people willing to sell it. Anybody know what is going on here?

[Roland]

"Rather, the nominal long-term GDP growth rate is assumed to be 6% (3.5% real growth + 2.5% unreal)."

The 2.5 % being the BEA's fudge factor ?

Anyway GDP growth has nothing to do with stock price appreciation, unless you'd get it from a stagnant capital stock.

"Then take a look at forward S&P P/E, which shows a 5-6% return at current price."

Where are we now ? And which earnings are we supposed to use for that ?

Anyway stocks should yield something a good deal over the average return on capital for their volatility, and 7 % is a reasonable estimate there which also happens to be a long term average.

[Roland]

Haven't followed Tyco. Maybe they are speculating or have insider info that someone will take over some junks. GE was interested in Tyco's lending business, was it not ?

Which deverses a big fat

[DrSpike]

[QUOTE] Originally posted by Roland

Anyway GDP growth has nothing to do with stock price appreciation.

Don't see your thinking here. The price of a stock is predominantly the sum of discounted flows that ownership of the stock entitles you to, which of course depend on profits. The 2 modifiers that are critical are the rating investors ascertain to those profits (usually picked up by the p/e ratio) and the equity risk premium. This exists because of volatility, but more importantly because equity is settled after debt if the sh1t hits the fan.

Personally I expect 6%-7% nominal over the next few years (the hard part is not the profit outlook but the behaviour of the slippery equity risk premium ).........the long term investor should be ok.

[Roland]

"The price of a stock is predominantly the sum of discounted flows that ownership of the stock entitles you to, which of course depend on profits."

Sure. Just that GDP growth is roughly in line with the growth of the Capital stock. So if a company can grow my return without deluding my share, excellent. Just in the aggregate I'm very skeptical of any significant movement in that direction.

[DrSpike]

Still a little perplexed as to why you think real gdp growth doesn't have a widespread effect on company profits. That just isn't true. Otherwise why would stock markets rise in real terms at all?

[Roland]

GDP growth (long term, forgetting short term effects like pricing power etc) has an effect on aggregate corporate profits. It just does not help the profit per unit of employed capital, assuming the capital stock expands in line with GDP.

"Otherwise why would stock markets rise in real terms at all?"

Ehm... why would my point exclude stocks rising in real terms ?

[DanS]

"It just does not help the profit per unit of employed capital, assuming the capital stock expands in line with GDP."

Isn't this just a fancy-schmancy way of saying that companies retain earnings?

"Where are we now ?"

31x past earnings. Assume 20x or so forward earnings.

[DrSpike]

EDIT: DP - my first ever!

[DrSpike]

Originally posted by Roland
GDP growth has an effect on aggregate corporate profits. It just does not help the profit per unit of employed capital, assuming the capital stock expands in line with GDP.

Whilst it is admirable that you attempt a steady state analysis this is unfortunately misleading here. At present demand growth in the US is insufficient to close to the output gap, so as GDP growth returns towards trend growth both aggregate profits and the profit per unit of employed capital will undoubtedly rise. Also, the earnings rise is usually augmented by re-rating (p/e rises) as expectations change.

In the steady state the statement isn't quite true either......but that's not that relevant to the debate. Check out the Solow model if you're interested (yes this is the same Solow whose interview I linked to above).

[Sten Sture]

Originally posted by DrSpike
... more importantly because equity is settled after debt if the sh1t hits the fan.

That's right lads, get in line back there -->


On the GSE wrap coverage: GNMA is the lower income lower loan size wrap. Their loans are maxed at ~125m or so, but the average loan is much less... 50-65 iirc.

Again, the GSEs are secondary marketing vehicles. They repackage and wrap conforming loans from the banks that make the loans. Effectively they just commoditize an existing, but previously illiquid product. This "subsidy" is probably the most cost effective thing the US govt has ever done, with the best social results. Encouraging home ownership is a hands down public policy winner.

If residential housing is super affordable for nearly everyone in the States, I don't see how that can be construed as a bubble. There certainly isn't the supply and demand imbalance that have accompanied other bubbles in history.


By the by, I will state again that we have not had a widespread bubble economy, we have had a capital markets bubble in a relatively small sector. The GDP numbers prove this out. The internet never amounted to much of the real economy. Retail sales over the internet were less that 0.5% of all retail sales in 2000 iirc. In 97-2000 there was difficulty in the manufacturing economy. If Greenspan would have tightened FedFunds to try to crimp the tech stock bubble it would have likely had the reverse effect by further damaging beat-up sectors of the actual economy, and depressing those stocks - making pie-in-the-sky hyper growth dreams seem even better in comparison. The tech bubble was not a result of Fed policy, it was the natural outgrowth of modern portfolio theory favoring growth stocks in the wake of the capital gains tax cut. And I for one don't want the Fed to make system wide policy changes to a Poke-mon trading card bubble in the marketplace at the expense of the real economy.

Don't blame the Fed.

(I sold a truck full of Tbonds last week do-dah do-dah )

[DrSpike]

Finance guy talks sense. Sense is good

[Roland]

"Isn't this just a fancy-schmancy way of saying that companies retain earnings?"

Almost, yes.

"At present demand growth in the US is insufficient to close to the output gap, so as GDP growth returns towards trend growth both aggregate profits and the profit per unit of employed capital will undoubtedly rise."

Which is why I said above "GDP growth (long term, forgetting short term effects like pricing power etc)". Or should I say trend growth rates, ignoring cyclical effects.

"In the steady state the statement isn't quite true either......"

First I'm not talking about a steady state (assuming you mean one where net investment is zero).

Second what would the Solow model tell us about it ? Are you talking about the technology component, or what ?

[Roland]

Sten:

"By the by, I will state again that we have not had a widespread bubble economy, we have had a capital markets bubble in a relatively small sector."

With a household savings rate that dipped to around zero, a current account deficit that's approaching 5 % of GDP, and record debt levels ?

Nope.

[DrSpike]

Originally posted by Roland
Which is why I said above "GDP growth (long term, forgetting short term effects like pricing power etc)". Or should I say trend growth rates, ignoring cyclical effects.

Man you are slippery. There is a whale of a difference between what you indicated first time and what you just added, as I'm almost certain you know. You must command a high price as a laywer.

The statement you made that I originally quoted only makes sense at all in a steady state (though not quite as strict an interpretation as zero net investment) - if you weren't aiming for that it makes no sense. So you now agree there will be a cyclical effect, and since the original debate was about whether a pick up in growth would affect stock market valuations you agree with what I said.

Hence gdp growth - profit growth (and probable rerating) - stock price growth, which contradicts the quote from your post I originally made that I objected to.