Speaker 1: Bloomberg Audio Studios, Podcasts, Radio News.
Speaker 2: Hello and welcome to another episode of the Odd Lots podcast.
Speaker 3: I'm Joe Wisenthal and I'm Tracy Alloway.
Speaker 2: So, Tracy, one of the things that we've been talking
Speaker 2: about a fair amount everyone's talk about it, I guess,
Speaker 2: is how the biggest most profitable companies in America. They're
Speaker 2: still really big and they're still really profitable, but they've
Speaker 2: switched from being throwing off tons of free cash flow
Speaker 2: to big investors spending a lot of money.
Speaker 4: Yeah, that's right.
Speaker 3: So we've had years and years and years of big
Speaker 3: tech basically I guess, generating infinite Yeah, once of cash,
Speaker 3: it feels like, and now they're switching to actually spending
Speaker 3: some of that cash to build very expensive data centers
Speaker 3: and things like that. And you're right, it is kind
Speaker 3: of a change for the market. Yeah, right, Like, we
Speaker 3: haven't seen that scale of investment for a very long time,
Speaker 3: certainly not I don't think in our lifetimes have we I.
Speaker 4: Don't know, No, it doesn't feel like it.
Speaker 2: I mean, you know, I guess maybe we'll get into
Speaker 2: this in the conversation. You know, I think if you
Speaker 2: go back to like PREGFC era when a lot of
Speaker 2: the really big companies in the index were like, you know,
Speaker 2: Exon was the biggest company in the for a long time,
Speaker 2: so they would have always been having to like spend
Speaker 2: because you can't just sort of like passively collect oil,
Speaker 2: et cetera. But it does seem generally true that the
Speaker 2: big theme, both with financials and tech is this incredible
Speaker 2: ability to generate huge returns with fairly modest capital outlays,
Speaker 2: whether we're talking about equipment, plants, or even human labor.
Speaker 3: Well, the other big switch is just you know, if
Speaker 3: you look at it, just at the tech sector basically,
Speaker 3: which has been you know, the dominant force in our
Speaker 3: equity markets for a while now. But for much of
Speaker 3: the two thousands, the investment was in sort of like
Speaker 3: intangible you know, sas type stuff, and now we're switching
Speaker 3: to really like brick and mortar. They're paying to build
Speaker 3: energy capacity, and they're paying for actual chips and actual
Speaker 3: buildings to house a bunch of air conditioners and servers
Speaker 3: and all of that.
Speaker 4: No, it's totally true. This is the big theme, right,
Speaker 4: is just this.
Speaker 2: So the question is like, Okay, they're still make a
Speaker 2: ton of money, They're still very profitable, and maybe these
Speaker 2: these investments will pay off in a massive way at
Speaker 2: some point down the future. But can investors expect the
Speaker 2: same level of returns that they've seen in the past
Speaker 2: if there's this big switch in terms of strategic decision
Speaker 2: making in terms of capital outlays and so forth, taking
Speaker 2: on debt, what does this mean for the markets? What
Speaker 2: does this mean for investors? And I don't know the answer,
Speaker 2: but maybe our guest.
Speaker 3: Well also, I mean you and I. I think for
Speaker 3: the past twenty years, we have all gotten very used
Speaker 3: to everyone saying that the tech sectors overvalued, right, even
Speaker 3: as it throws off infinite amounts of cash. Everyone is like, ah,
Speaker 3: so overvalue, the market's at the top, the markets at
Speaker 3: the top. That has been the case for pretty much
Speaker 3: like my entire mature investing age lifetime.
Speaker 2: Right, And so you bring up a really another important
Speaker 2: dimension of this, which is just that valuations by traditional metrics.
Speaker 2: I mean, I remember, you know, early on.
Speaker 4: What was the Schiller the Schiller.
Speaker 2: Cape ratio, and there's like, no, it's like this has
Speaker 2: got a mean revert and this is we're at the
Speaker 2: ninety eighth percentile of historical valuations, and it keeps going up.
Speaker 3: And so mean reversion is always around the corner.
Speaker 2: Joe, it's it's it's always, it's always.
Speaker 4: But no, this is another question. Why didn't it mean
Speaker 4: revert right?
Speaker 2: And why have just the multiples that we've seen on
Speaker 2: traditional price to earnings ratios. You look at them, they
Speaker 2: make it go crazy, and they got to come down.
Speaker 4: Why haven't they right?
Speaker 2: That's also an interesting question that we need to get
Speaker 2: answers to, even beyond the specific capital question.
Speaker 3: Yeah, let's do it all right.
Speaker 2: Well, I'm very excited to say we do have the
Speaker 2: perfect guest today because we are speaking to someone who's
Speaker 2: really done a lot of research on some of these
Speaker 2: exact questions, including he published a paper co authored a
Speaker 2: recent paper that really caught my eye back in January
Speaker 2: called a Macroeconomic Perspective on Stock Market Valuation Ratios. So
Speaker 2: it's good data. You brought up the earnings metrics. We're
Speaker 2: going to be speaking with Jonathan Heathcote, one of the
Speaker 2: co authors of this paper. He's an economist at the
Speaker 2: Minneapolis Fed. We're going to talk all about this. So, Jonathan,
Speaker 2: thank you so much for coming on.
Speaker 5: Odd lots, thanks a lot for having me yeah, I
Speaker 5: should just say right at the side, I'm I should
Speaker 5: give a disclaim. I'm an economist at the Federalists of
Speaker 5: Bank of Minneapolis, and anything I say is going to
Speaker 5: be my views, not those the Federalist of Bank of
Speaker 5: Minneapolis or the Federalists of system.
Speaker 3: Thank you for getting the disclaimer out of the way.
Speaker 3: We are very used to hearing that from FED researchers
Speaker 3: and economists. So the title of the paper, I think
Speaker 3: Joe already said it, a macroeconomic perspective on stock market
Speaker 3: valuation ratios. Why did you decide to look at this
Speaker 3: particular topic at this particular moment in time too?
Speaker 5: Yeah, so, actually we started out before we worked on this,
Speaker 5: we were working on a paper on the US net
Speaker 5: fign asset position and I noticed that, you know, the
Speaker 5: value of US assets minus AUR liabilities that had been
Speaker 5: declining really fast over the last ten years, and historically
Speaker 5: people had mostly thought about that in terms of the
Speaker 5: US running big current account deficits running up a bigger
Speaker 5: and bigger debt with the rest of the world. And
Speaker 5: we realized that the kind of international gross asset positions
Speaker 5: had gotten really big and a lot of the decline
Speaker 5: in the net foreign asset position was driven by the
Speaker 5: fact that foreigners had invested a lot in US equity
Speaker 5: markets and a lot of foreign direct investment into the US,
Speaker 5: and when the US markets were booming much more so
Speaker 5: than the rest of the world, that was driving up
Speaker 5: the value of these foreign investments in the US, and
Speaker 5: that was driving down the US net foreign asset position.
Speaker 5: And so after that we kind of became more interested
Speaker 5: in trying to understand what's driving valuations more generally. I mean,
Speaker 5: our background's not really we're not really in finance. We're
Speaker 5: sort of more macroeconomists. But we've been working on this
Speaker 5: for a few years now and that's where this paper started.
Speaker 2: This seems like, just from a sort of theoretical big
Speaker 2: picture perspective, this link between sort of macro economics and
Speaker 2: stock markets, and it doesn't feel like all of these
Speaker 2: are worlds that talk past each other, and the macro
Speaker 2: people aren't talking about stock market valuations that much, and
Speaker 2: stock market people they think they don't even have to
Speaker 2: care about macroeconomics in many cases. But this strikes me
Speaker 2: as interesting, how like novel is this or talk to
Speaker 2: us about this attempt to bridge the gap between the
Speaker 2: two worlds here.
Speaker 5: Yeah, I think there's a lot of strong connections. And
Speaker 5: we've talken about the same things in a slightly different frame.
Speaker 5: So one thing macroeconomists have been talking about for a
Speaker 5: long time, for example, is the fact that it looks
Speaker 5: like labor share of output is being drifting down over time,
Speaker 5: So a larger share of the piece seems to be
Speaker 5: going to owners of firms and a smaller share as
Speaker 5: wages to workers. And obviously that ties directly into thinking
Speaker 5: about valuations. If they're firms making bigger profits, that's going
Speaker 5: to drive up valuations. So I think there's a lot
Speaker 5: of connections. I think for a long time historically there
Speaker 5: was a sense that it was kind of really hard
Speaker 5: to understand valuations. They were driven by wild, various in
Speaker 5: risk premia that had not much to do with kind
Speaker 5: of standards, slow moving macro stuff, and so you know,
Speaker 5: there were two separate, two separate camps, one studying the finance,
Speaker 5: one stetting the macro and it was hard to connect them.
Speaker 5: But I think, you know, I think people are working
Speaker 5: on that, and I think there's a lot of connections.
Speaker 3: Okay, well let's dive into the paper's conclusion then, because
Speaker 3: I think everyone when we talk about high valuations, the
Speaker 3: temptation is always to be like, no, the people who
Speaker 3: are satisfied with these high valuations, like they're the crazy ones, right,
Speaker 3: Like I'm the one that sees the truth. But your
Speaker 3: paper actually sets out like a pretty reasonable explanation for
Speaker 3: why these high valuations have persisted and have not mean reverted.
Speaker 3: As Joe mentioned, talk to us about both, I guess
Speaker 3: the labor component in your paper as well as the
Speaker 3: investment component.
Speaker 5: Yeah, sure, so, you know, I think Joe was mentioning
Speaker 5: a minute ago the price earnings ratio. That's the sort
Speaker 5: of a classic valuation metric people have looked at for
Speaker 5: a long time, and the idea always was that, well,
Speaker 5: if prices get too far ahead of profits, then maybe
Speaker 5: that GAP's going to narrow again going forward, So either
Speaker 5: you're going to have to have really fast growth in
Speaker 5: earnings or the prices are going to come down, so
Speaker 5: you're going to get low returns. And people have looked
Speaker 5: at that ratio. Shila has like the famous version of it,
Speaker 5: and the problem is that it's been drifting up and up,
Speaker 5: the price earnings ratio, and it's been kind of way
Speaker 5: above its historical average for a long time, and that
Speaker 5: gap just seems to keep getting bigger. So we were
Speaker 5: kind of went back to that. We looked at it
Speaker 5: in macro data instead of financial data, but it looks
Speaker 5: much the same if you look at standard financial accounts,
Speaker 5: and we went back to nineteen fifty two. Yeah, you
Speaker 5: see this big run up in the price earnings ratio,
Speaker 5: but no, there are other metrics you can look at.
Speaker 5: And another thing you can look at is you can
Speaker 5: look at prices relative to free cash flow, and it's
Speaker 5: sort of a similar ratio. It's just that you've got
Speaker 5: pre cash flow and the denominator, and the only difference
Speaker 5: between earnings and pre cash flow is in measuring earnings
Speaker 5: you subtract a measure of depreciation. In measuring precash instead
Speaker 5: of subtracting depreciation, you take out all capital expenditure. And
Speaker 5: then the nice thing about free cash flow is sort
Speaker 5: of a measure of everything that's left at the end
Speaker 5: of the data to be paid to the owners of
Speaker 5: the firm. So you take the sales of farms, you
Speaker 5: subtract the input costs, payments to labor, subtract their taxes,
Speaker 5: subtract their capital expenditure, everything that's left is money that
Speaker 5: the firm can pay out to its owners. So if
Speaker 5: you look at that ratio the value of all the
Speaker 5: firms in the US relative to the total cash flow
Speaker 5: that're generating, it bounces around a bunch over time, but
Speaker 5: it doesn't have like a long, long term drift. It's
Speaker 5: not like it's kind of systematically moving up over time.
Speaker 5: So if you look at that ratio, you'd say, maybe
Speaker 5: the market's not so overvalued today. Maybe prices are roughly
Speaker 5: where they, you know, roughly within historical range compared to this,
Speaker 5: to this ratio, this strikes me as.
Speaker 2: Very important, and so we should just pause on this
Speaker 2: point or stick with this point for a second. So
Speaker 2: we've all seen the shoulder cape and various other versions.
Speaker 2: What you're saying is if you just and not always thought,
Speaker 2: let's just measure free cash flow, that's all I care
Speaker 2: about if I'm an investor, just how much money comes
Speaker 2: back to me at the end of the day. But
Speaker 2: you're saying that when you look at the entire market
Speaker 2: through this lens, it just does not have the same
Speaker 2: extreme drift outside of normal ranges that you see when
Speaker 2: you look at price turnings ratios.
Speaker 5: Yeah, that's right. I mean it bounces around over time.
Speaker 5: But if you look at where it was, say in
Speaker 5: nineteen eighty, so that was a low for stock values.
Speaker 5: If you look at it in nineteen eighty and you
Speaker 5: look at it in the second quarter of twenty twenty two,
Speaker 5: that ratio of value a free cash flow is the
Speaker 5: same in both cases is about the historical average. Now
Speaker 5: if you look over the last three years, you know
Speaker 5: that ratio has kept moving up. So now we are
Speaker 5: above the historical average, but we're not wildly outside the
Speaker 5: range that is spluctuated in over the last sixty seven years.
Speaker 3: And just going back to the labor and investment component,
Speaker 3: if we think about it very simplistically, I think you
Speaker 3: use the pie analogy earlier, Like if you think about
Speaker 3: that cash as a giant pie, less of it is
Speaker 3: going to labor, less of it has been going on investment,
Speaker 3: and more of it is being spent or returned to
Speaker 3: capital i e. The shareholders.
Speaker 4: Yeah, that's right.
Speaker 5: So if you look at the price earnings ratio, it's
Speaker 5: not like earnings haven't grown. They've grown pretty fast, and
Speaker 5: they've grown pretty fast because the share of the output
Speaker 5: that's going to workers has been going down, and the
Speaker 5: share that's going to owners of firms has been going up.
Speaker 5: So earnings have grown, but cash flow has grown even faster.
Speaker 5: And cash flows grown even faster because firms have been
Speaker 5: able to generate these extra earnings without doing a lot
Speaker 5: of extra investment. I think what investors care about at
Speaker 5: the end of the day, what they may be want
Speaker 5: to care about, is, you know, how much income is
Speaker 5: actually they're going to be receiving. And if firms are
Speaker 5: going to do a lot of investment to keep sustaining
Speaker 5: those earnings, that's income that can go to the owners
Speaker 5: of the firm. But that investment seems to have been
Speaker 5: relatively weak over time, and as a share of firm
Speaker 5: value has been declining, so cash flow has grown fast.
Speaker 2: Talk to us about this measure of labor share. Obviously
Speaker 2: on an individual basis, for an individual company basis, you
Speaker 2: can just like you know, find out how much is
Speaker 2: going to labor versus other things at the aggregate level,
Speaker 2: which is where you're working. At the macro level, this
Speaker 2: lit line, and I've seen it for years, People talk
Speaker 2: about labor share and it's generally going down.
Speaker 4: How robust is that measure?
Speaker 2: How that single number because it looks pretty bad for
Speaker 2: workers when you look at the long term labor share trend.
Speaker 2: How like methodologically or sort of intellectually robust is this data?
Speaker 5: Yeah, I think it's something the macroeconomists have been looking
Speaker 5: at for a long time. I think it's pretty robust.
Speaker 5: If you look at the corporate sector, you just measure
Speaker 5: it in the national accounts. You can look at wages
Speaker 5: and saturdays of employees and you can compare that against
Speaker 5: the output of the corporate sector, and those wages and
Speaker 5: salaries have fallen by about eight percentage points since nineteen
Speaker 5: eighty I think from nineteen eighty to twenty twenty two,
Speaker 5: so that's eight percentage points to GDP. That's a big change.
Speaker 5: You know, if you look at the non corporate sector,
Speaker 5: you're looking at small businesses. That's hard as a measure
Speaker 5: because kind of hard to say for a small private
Speaker 5: business how much of their output is really payments to
Speaker 5: labor versus payments to capital. But for big corporations it's
Speaker 5: sort of straightforward. There is there is an ext you know,
Speaker 5: one wrinkle to that, which is that you know, some
Speaker 5: firms have been paying more, they've been compensating some of
Speaker 5: their workers with stock options and things like that, and
Speaker 5: so that kind of complicates it a little bit because
Speaker 5: you know, you want to call that a payment to
Speaker 5: labor or you want to call that part of income
Speaker 5: to capital. So but putting that aside, I think it
Speaker 5: is there is there has been a big shift with
Speaker 5: less income going to labor, more income going either to
Speaker 5: capital or just as pure rants to the owners of firms.
Speaker 3: Wait now, I'm really curious in your own research, how
Speaker 3: did you classify stock based compensation. Was that an increase
Speaker 3: in labor? Was that an increase in capital?
Speaker 4: Yeah, we just.
Speaker 5: Follow the We just follow basically the national accounts, so
Speaker 5: the Pewer Economic Analysis and the flow of funds. They
Speaker 5: put together this data set called the Integrated Macroeconomic Accounts,
Speaker 5: and it's really just a version of the standard National
Speaker 5: income and Product accounts, and they classify labor income the
Speaker 5: standard way, which is wages and salaries. And I think
Speaker 5: they include in that standard national income measure when stock
Speaker 5: options exercise, that counts as part.
Speaker 4: Of the wage income.
Speaker 5: But you know, when they're granted that, you know, so
Speaker 5: there's some details there, but you know, they're supposed to
Speaker 5: be at least partially captured there in that waging commissure.
Speaker 3: Okay, And on the investment side, what about intangibles, because
Speaker 3: this is the thing that constantly comes up when we're
Speaker 3: talking about of valuations and the broader macroeconomy. So much
Speaker 3: of what companies do nowadays, especially in big tech, has
Speaker 3: to do with intangible so you know, ephemeral brand value
Speaker 3: and things like that. Would that have been captured in
Speaker 3: that investment number.
Speaker 5: Yes, So they've changed a little bit over time the
Speaker 5: way they try and measure investment, and they're trying to
Speaker 5: capture more of investment and intellectual property, investment in software
Speaker 5: and stuff that wasn't historically captured. There's still a question
Speaker 5: about how well they're capturing that and how much of
Speaker 5: it is measured.
Speaker 4: But in terms of.
Speaker 5: Measuring free cash flow, one reason we like the free
Speaker 5: cash flow measure is that in terms of the income
Speaker 5: that's available to go to the owners of the firm,
Speaker 5: it doesn't really matter whether that spending on intangibles that
Speaker 5: could be counted as a purchase of an intermediate input
Speaker 5: that's subtracts from value added or could be counted as
Speaker 5: a capital investment. Then it's going to subtract from investment,
Speaker 5: So the free cash flow measure is going to be
Speaker 5: the same either way. So I think that's a nice
Speaker 5: thing about free cash flow. It is just a measure
Speaker 5: of the income that's left over after the firm's paid
Speaker 5: all its bills, and it doesn't really matter whether you
Speaker 5: count those bills as an input cost or capital expenditure.
Speaker 5: So I think you know, that's one advantage of looking
Speaker 5: at this cashplumation.
Speaker 2: So when you embarked on this paper, how much was
Speaker 2: it in the was your thinking? You talked about the
Speaker 2: intellectual origins of it with your prior research, but how
Speaker 2: much was it motivated or driven by this current twenty
Speaker 2: twenty six or probably twenty twenty five when you started
Speaker 2: a reality that there is a very big change in
Speaker 2: corporate behavior afoot. We don't know how long it's going
Speaker 2: to last, but this is the big story of arguably
Speaker 2: the last two to three years, is how much these
Speaker 2: very profitable companies have seriously shifted into investment mode.
Speaker 5: Yeah, I would say we weren't that We were maybe
Speaker 5: a little behind on that. We were work on this
Speaker 5: for a while, so I think you know, that's not
Speaker 5: something that was particularly on our radar. We've kind of
Speaker 5: tweaked onto that a little bit more recently. Now, it's
Speaker 5: true that that investment on AI sented investment by the
Speaker 5: big tech firms that's been booming. Other kinds of investment
Speaker 5: have been kind of weak. Residential investment for example, it's
Speaker 5: been weak. So investment overall, yeah, look kind of relatively
Speaker 5: strong for the whole US economy, but it's not outsized
Speaker 5: and aggregate. So yeah, I think it's definitely a question.
Speaker 5: I think, as you said right at the start this story,
Speaker 5: that farms have been able to generate a bunch of earnings.
Speaker 5: Some of these farms that are generated a bunch of runnings,
Speaker 5: especially in tech, they've done it without a lot of
Speaker 5: capital expenditure, and that's meant that the cash flow has
Speaker 5: grown really strongly, and now they are starting to spend,
Speaker 5: So it is it is a question going forward is
Speaker 5: that spending gonna you know, is it gonna pay off?
Speaker 5: So at the moment, I guess, yeah, I guess there's
Speaker 5: a bunch of companies whose cash flow temporarily is negative
Speaker 5: right now. The storic people made big pre cash flow,
Speaker 5: and so that's the question investors are thinking about.
Speaker 3: How do you think about aggregates versus I guess sectors
Speaker 3: or you know a handful of big tech companies in
Speaker 3: those data, because again you are looking at the aggregate
Speaker 3: numbers like the macro variables. But if we think about
Speaker 3: the market right now and who's actually spending money, it's
Speaker 3: like a handful of tech firms, right.
Speaker 5: Yeah, that's right. We have been mostly looking at the aggregates.
Speaker 5: We've started looking a little bit at the farm level
Speaker 5: data in CRISP and compustat and you know what you see,
Speaker 5: what we've seen so far looking at the firm level
Speaker 5: data is that, yeah, it's a relatively small number of
Speaker 5: firms that account for most of the growth in value,
Speaker 5: most of the growth in the total stock market value,
Speaker 5: maybe say fifty firms. But those fifty farms are the
Speaker 5: same firms that have had the fastest growth in cash flow.
Speaker 5: So cash flow and value have grown roughly in lockstep
Speaker 5: for say fifty fifty of the biggest firms in the US.
Speaker 5: And so these, I mean, I guess a bunch of
Speaker 5: these are big tech firms. And it's these big tech
Speaker 5: firms have been generating mountains of cash and the high values.
Speaker 5: They're not built on sand, they're not built on expectation
Speaker 5: that we're going to make big future profits. The profits
Speaker 5: are then now, and I guess the question is, you know,
Speaker 5: are those profits gonna persist going forward?
Speaker 2: Let's get back to the labor share component. I mean,
Speaker 2: one of the things that comes up is this question
Speaker 2: of like, is the booming stock market based on the
Speaker 2: perpetuation of inequality? Right to some extent like this idea.
Speaker 2: You know, back in the twenty tens, everyone and all
Speaker 2: these corporate leaders and people would go to Davos and
Speaker 2: they say, oh, we really care about inequality, right, you know,
Speaker 2: it sounds nice, et cetera. But also everyone wants the
Speaker 2: stock market to go up. Seems if we tease this
Speaker 2: out a little bit, that there is some tension, right,
Speaker 2: is that it seems like there's some tension with if
Speaker 2: you actually had some sort of meaningful shift in terms
Speaker 2: of the ratio profits that go from capital to labor.
Speaker 4: If part of the story.
Speaker 2: In your line go up is the declining labor share,
Speaker 2: then it does seem like there's pretty obviously some fundamental tension.
Speaker 1: Yeah.
Speaker 5: So I think that you know, if the people who
Speaker 5: are owning the farms were the same people who are
Speaker 5: earning the wage income. Then you know, it would just
Speaker 5: be a reshuffling of income. You'd be getting less income
Speaker 5: in one pocket more income in your other pocket, and
Speaker 5: that would be kind of a wash for inequality. But
Speaker 5: I guess the concern is that the people who own
Speaker 5: a large part of the stock market are one group
Speaker 5: of people, and then the workers. You know, many workers
Speaker 5: don't have a lot of that stock market wealth and
Speaker 5: so they don't benefit from these higher stock prices. So
Speaker 5: that that is a concern, and I guess it's a
Speaker 5: concern going forward to people thinking about AI how that's
Speaker 5: going to change labor markets going forward, and how that's
Speaker 5: going to change the pie, whether that's going to reduce
Speaker 5: the share of the pie that's going to work as
Speaker 5: still further and increase still further the share that's going
Speaker 5: to owners of firms.
Speaker 3: Actually this reminds me of a related question. But you know,
Speaker 3: you're at the Minneapolis FUD and I assume when you
Speaker 3: publish a research paper like this, you want your bosses
Speaker 3: to look at it. I guess that's Cashcari right now,
Speaker 3: and you want there to be some sort of policy implication.
Speaker 3: What exactly should policy makers take away from something like
Speaker 3: this paper? Because you know, at the FED, I'm sure
Speaker 3: they care about wealth inequality, but they don't have a
Speaker 3: wealth inequality mandate. They do have a financial stability mandate,
Speaker 3: so you know, you could even make the argument that
Speaker 3: they wouldn't want to unsettle the you know, current equity
Speaker 3: market valuations, which would argue potentially for not increasing labor
Speaker 3: share of that cash flow. But anyway, when you publish
Speaker 3: a paper like this, what are policy makers supposed to
Speaker 3: take away or what do you hope that they actually
Speaker 3: take away.
Speaker 5: I think that at the FED we do follow equity markets,
Speaker 5: and we follow them because we sort of want to
Speaker 5: get a sense of the headwinds and tailwinds for the
Speaker 5: economy and all else equal. If the stock market is stronger,
Speaker 5: that's a little bit of a bigger tailwind, and higher
Speaker 5: stock prices, you'd expect a little bit more consumer spanning,
Speaker 5: a little bit more busines this investment. So the FED,
Speaker 5: for sure, we're kind of interested in understanding stock markets.
Speaker 5: I think, you know, forecasting forecasting stock prices is hard
Speaker 5: and we're not trading, and it's hard to make money
Speaker 5: on that. But yeah, for sure we're monitoring that. And
Speaker 5: in terms of financial stability, then yes, there's a concern always,
Speaker 5: like you know, there's always a risk that you worry.
Speaker 5: One thing you worry about is, well, maybe what would happen.
Speaker 5: It's always kind of a scenario in the background, what
Speaker 5: would happen if stock prices fell? Not that it's in
Speaker 5: real time ever going to be easy to predict that,
Speaker 5: but just hypothetically, you know, you want to think through
Speaker 5: what might happen if stock prices fell substantially? And stock
Speaker 5: prices now are really high. So you know, a ten
Speaker 5: percent fall in prices when prices are really high is
Speaker 5: going to be a larger fall in household wealth than
Speaker 5: a ten percent fall when prices are low. So I
Speaker 5: think all else equal. You know, the fact that these
Speaker 5: valuations are so high, you know, it makes you think
Speaker 5: a little bit more about about those downside risks.
Speaker 2: So going back to the question of these cycles of
Speaker 2: capital expenditure, and you mentioned you know, we're in one now,
Speaker 2: we'll see how long it lasts, and so forth. In
Speaker 2: your research, what other prior waves should.
Speaker 4: We look at?
Speaker 2: You know, you mentioned the trend since nineteen eighty, but
Speaker 2: are there prior waves where you can see, Okay, the
Speaker 2: stock market valuations on a free cash flow basis compressed
Speaker 2: or stocks just felt and there was some at the
Speaker 2: same time, some sort of some massive decrease in free
Speaker 2: cash flow that we can point to that Okay, this
Speaker 2: helps explain a decline or a bear market or something
Speaker 2: like that.
Speaker 4: Yeah.
Speaker 5: I think one thing that was interesting I look back,
Speaker 5: there was a paper it's an old paper now, but
Speaker 5: I think it's probabished around two thousand by Hobying and Jovannivic,
Speaker 5: and they were interested in why stock prices were really
Speaker 5: low around nineteen eighty and that story was well. Now
Speaker 5: late seventies early eighties, people could see that there was
Speaker 5: an IT revolution coming, that the microchips are out there,
Speaker 5: could anticipate they were going to be widely adopted, and
Speaker 5: this was going to be a big wave of investment
Speaker 5: and it was going to create a bunch of the
Speaker 5: new winners. Yeah, it's going to create a bunch of
Speaker 5: new winners and losers in the economy. And the idea
Speaker 5: of the paper was, well, you know, some of these
Speaker 5: old firms are going to get wiped out because they're
Speaker 5: not going to be able to implement this new IT.
Speaker 5: They they don't have the technology, they don't know how
Speaker 5: to do it, and there's going to be some new
Speaker 5: firms that are going to come in. And they did
Speaker 5: come in, you know, the Intels and the Microsoft's came in,
Speaker 5: but at the time, you know, those were not mostly
Speaker 5: publicly traded companies, and nobody quite knew at the time
Speaker 5: which were going to be the winners, which were going
Speaker 5: to be the losers. But they had a sense that
Speaker 5: this was going to be a you know, a radical transformation.
Speaker 5: So that was a story for their paper for why
Speaker 5: prices were low in the early nineteen nineteen eighties. So
Speaker 5: I thought that was kind of that feels a little
Speaker 5: bit like it's not exactly the same as AI, but
Speaker 5: it's sort of like it was a big change. People
Speaker 5: could see it coming, but they just didn't know at
Speaker 5: the time exactly how it was going.
Speaker 4: To play out.
Speaker 3: Yeah, definitely a historical echo there. Conversely to Joe's quite
Speaker 3: I mean, a lot of the papers explaining why if
Speaker 3: you look at valuations they're high, but in a macro sense,
Speaker 3: they you know, they might be quite rational. Were there
Speaker 3: any moments throughout history, I guess since I think you
Speaker 3: said nineteen fifty two, was it the beginning.
Speaker 4: Of the data?
Speaker 3: Were there any moments since nineteen fifty two where actually
Speaker 3: valuations did just look really irrational and it was just
Speaker 3: you know, investors getting ahead of themselves and animal spirits
Speaker 3: going wild.
Speaker 5: Yeah, well, I think you know, a natural one for
Speaker 5: that would be the dog kom boom in two thousands.
Speaker 5: That that was a time when cash flow was weak
Speaker 5: and you have valuations with sky high and you know,
Speaker 5: with hindsight, investors did get ahead of themselves then and
Speaker 5: took a hit. You know, some of those technologies they
Speaker 5: were excited about. They actually, you know, with ten years later,
Speaker 5: they really did pay off and the market bounced back
Speaker 5: higher than it had been. But at the time I
Speaker 5: think that was a little bit of an irrational exuberance.
Speaker 4: It does seem it's hard to pull it.
Speaker 2: Yeah, I mean, like I obviously I'm not going to
Speaker 2: like put you on this spot and say, all right,
Speaker 2: give us your stock market forecast for the next five years.
Speaker 4: We don't want to do that either.
Speaker 2: All that being said, it certainly seems like an implication
Speaker 2: of this research is that when you have a major
Speaker 2: switch that gets flipped from we were just producing mountains
Speaker 2: of cash, much of it returning to shareholders, and a
Speaker 2: lot of it in the form of buybacks. When you
Speaker 2: have this switch that gets flipped where it's just tons
Speaker 2: of free cash flow and suddenly, not only is that
Speaker 2: cash flow all being redeployed into investment, but furthermore, some
Speaker 2: of these companies are going into debt. So negative cash flow.
Speaker 2: Perhaps it seems like a safe implication for investors today
Speaker 2: is at least we should take this very seriously, that
Speaker 2: there is a flip that's underway. And if one explanation
Speaker 2: for high stock market evaluations is this free cash flow,
Speaker 2: we have to take pretty seriously the fact that for
Speaker 2: many of these big companies it's either gone to zero
Speaker 2: or flip negative.
Speaker 5: Yeah, so we looked at we only you know, we
Speaker 5: looked at we were looking at quarterly data. This macro
Speaker 5: data is only quarterly a little bit, you know, not
Speaker 5: totally up to date. The last quarter we had was
Speaker 5: the third quarter or twenty twenty five. If you look
Speaker 5: at the total corporate sector, then no cash flows. You
Speaker 5: don't see a decline in cash flow up until that
Speaker 5: third quarter, So maybe that's changed the last on. Once
Speaker 5: we get the next quarter or two or data, we'll
Speaker 5: see something different. But you know, overall, I think in aggregate,
Speaker 5: the economy is still generating a bunch of free cash flow.
Speaker 5: So it's true that, you know, for some of these
Speaker 5: big tech firms at the top, those numbers might be different.
Speaker 5: I think, you know, the view, the optimistic view is well,
Speaker 5: this is one or two years of investment that's going
Speaker 5: to generate a ton of free cash flow going forward.
Speaker 5: And I think historically that's why when you're looking at
Speaker 5: individual companies, maybe it makes sense to look at prices
Speaker 5: compared to earnings instead of prices compared to cash flow,
Speaker 5: because this investment, if you have a period where you're
Speaker 5: doing a ton of investment, yeah, you know, this cash
Speaker 5: flow measure looks weak for a quarter or two and
Speaker 5: then it's kind of bounce back, and maybe earnings is
Speaker 5: a way to smooth through that. But you know, so
Speaker 5: for sure, but for sure, though the outlook going forward,
Speaker 5: it's going to depend on whether these investments pay off.
Speaker 5: I think you can make a case that this AI
Speaker 5: is going to reduce labor share of income further, right,
Speaker 5: so that would be a plus for stock values. On
Speaker 5: the other hand, I think this idea that you know
Speaker 5: AI is kind of there for free that you can
Speaker 5: just adopt it. And get these bigger profits without any investments.
Speaker 5: I think that's not going to be quite right. I think,
Speaker 5: I mean, you see the big tech firms, there's definitely
Speaker 5: doing plenty of capital expenditure. And I think even average
Speaker 5: firms that are just planning to adopt AI and increase productivity,
Speaker 5: it's not like they can just tell their workers, you know,
Speaker 5: please try and use chet GPT and be a little
Speaker 5: bit more productive. They're going to have to do big
Speaker 5: investments too to actually adopt. So I think I don't
Speaker 5: have my own view. I wouldn't want to make a forecast,
Speaker 5: but I think you can tell glass half full, glass
Speaker 5: have empty.
Speaker 4: Story on that.
Speaker 2: One thing I feel confident Tracy is that you know,
Speaker 2: you investors go back and then say, well, look at
Speaker 2: all this free cash flow companies are generating. These valuation
Speaker 2: measures are totally robust, and then we get to twenty
Speaker 2: twenty five and they say, well, look at these price
Speaker 2: to earnings ratios. They don't ignore the free cash flow
Speaker 2: lots and just switch back and ratio. I think it'll
Speaker 2: be very comfortable for strategy just to sort.
Speaker 3: Of pick everyone cherry picks.
Speaker 4: Yeah, whatever makes it look tolerable at that moment.
Speaker 3: But actually, Jonathan, so I we really don't want to
Speaker 3: put you on the spot and make you forecast the future,
Speaker 3: but it does seem like the current moment in time
Speaker 3: that AI boom could be a very natural, you know,
Speaker 3: real life experiment for some of the factors you point
Speaker 3: out in your paper. So on the one hand, you
Speaker 3: have a potential investment boom. On the other hand, as
Speaker 3: you just touched on, maybe firms you know, save even
Speaker 3: more on labor costs. Can you just walk us through,
Speaker 3: like broad brushstrokes, a hypothetical scenario where companies spend a
Speaker 3: bunch on AI and reduce their labor costs. What would
Speaker 3: that look like in your framework of thinking about valuations.
Speaker 5: Yes, so I think that what companies like would like
Speaker 5: is just you know, sort of like a magic that
Speaker 5: just drops fruit and you just keep generating cash grow
Speaker 5: without doing any investment. And you know, some of the
Speaker 5: big tech companies they did important investments early on, and
Speaker 5: maybe we didn't measure those well at the time, but
Speaker 5: they've been just machines generating cash without a lot of
Speaker 5: capital expenditure. So I think that is the optimistic view
Speaker 5: on asset valuations. And yeah, in terms of labor share.
Speaker 5: I think looking back over time, it was more a
Speaker 5: story if people were thinking that it was going to
Speaker 5: be the technology was going to automate kind of low
Speaker 5: skill jobs and we were going to have robots building
Speaker 5: cars instead of workers, and that's where the labor savings
Speaker 5: were going to come from. And now I think, you know,
Speaker 5: that's flipped a little bit, and now you know, the
Speaker 5: high school workers are starting to get a little bit
Speaker 5: nervous that maybe it's going to be some of the
Speaker 5: knowledge workers that are going to get replaced, and it's
Speaker 5: going to be the people doing kind of manual work
Speaker 5: who are going to be indispensable. But still the direction
Speaker 5: would be the same that you can just do the
Speaker 5: same amount of work and you can replace workers with
Speaker 5: eitherm machines or with AI. And in terms of I
Speaker 5: guess inequality, we're going back to that a second ago.
Speaker 5: I think I think that's sort of an interesting thing
Speaker 5: to think about, because the old one seemed like, oh,
Speaker 5: this technology is bad for inequality because it's competition for
Speaker 5: low wage workers and it's going to drive down wages
Speaker 5: of low wage workers, and that's going to be a
Speaker 5: mechanism generating more inequality. Now you know, you could tell
Speaker 5: an optimistic story and inequality, well, now it's kind of
Speaker 5: the high wage workers whose jobs are at risk and
Speaker 5: we're going to need plenty of I like the old story,
Speaker 5: like guys are going to do you know, those guys
Speaker 5: are going to the nurses and the construction workers are
Speaker 5: going to do fine, and it's going to be the
Speaker 5: knowledge workers who are going to take a hit. So
Speaker 5: maybe that's going to compress inequality a little bit.
Speaker 2: But yeah, I like the version of compressing inequality where
Speaker 2: people who got paid less would make.
Speaker 4: More than the one where the knowledge workers.
Speaker 3: Yeah, shrink, it's people being pulled up versus everyone being
Speaker 3: pulled down.
Speaker 4: Story. I guess.
Speaker 2: I guess if we prioritize reducing inequality, we have to
Speaker 2: take it anyway we can get it. Jonathan, thank you
Speaker 2: so much for coming on odd lots. I think this
Speaker 2: is really important research, and I love to stay in touch,
Speaker 2: particularly as you continue to follow on and do more
Speaker 2: tests of your theory.
Speaker 4: Thanks a lot for having me. You know what, Tracy,
Speaker 4: I thought it was.
Speaker 2: Actually it made me take the research even more seriously
Speaker 2: when he said that they didn't really stumble into this
Speaker 2: because they were because it was timely in the news
Speaker 2: right now. Yeah, And so the fact that they've sort
Speaker 2: of arrived at this realization that a lot of this
Speaker 2: can be explained by free cash flows and investment at
Speaker 2: the exact moment when this is all happening. Like I said,
Speaker 2: woever like want like forecast the stock market. Absolutely not,
Speaker 2: But I think investors have to take this pretty seriously
Speaker 2: as a potential turning point here.
Speaker 3: I agree. Also, I'm just I am very much in
Speaker 3: favor of keeping it simple when it comes to evaluation,
Speaker 3: and like free cash flow. See, I know it's not
Speaker 3: necessarily for looking but like it seems like a pretty
Speaker 3: decent thing to be looking at. And if you are
Speaker 3: just looking at cash flow, then the idea that suddenly
Speaker 3: a lot of that is going to be spent on
Speaker 3: a data center build out or something like that, like
Speaker 3: that would seem to change the equation. But I think
Speaker 3: the complicating factor, as we discussed, is you also have
Speaker 3: this push factor on the labor side, where you know,
Speaker 3: again if a bunch of the free cash flow is
Speaker 3: getting freed up because labors share is going down, and
Speaker 3: suddenly you have AI coming in and companies are saving
Speaker 3: enormously on you know, their headcounts or whatever. Then that
Speaker 3: could maybe help keep valuations high. But you know, it
Speaker 3: does seem like does seem like a good thing to
Speaker 3: be looking at.
Speaker 4: It's interesting.
Speaker 2: I forget which conversation it was one of our million
Speaker 2: AI related conversations, but we're talking about, like, what are
Speaker 2: the AI winners going to be, and their winners in
Speaker 2: the sense that they've massively become more productive, and like
Speaker 2: maybe it'll be European chemical companies or drug discovery companies,
Speaker 2: et cetera, and so forth who are not building models
Speaker 2: but just strictly taking advantage of these potential productivity gains.
Speaker 2: And maybe if you look at the stock market this year,
Speaker 2: you could sort of tell that story in the specific
Speaker 2: sense that the US is underperforming the US where we
Speaker 2: build all these models are built in the US, and
Speaker 2: they're spending like crazy, and the US markets have been
Speaker 2: sort of mediocre for a while, and everywhere around the
Speaker 2: world is doing much better. Maybe we're starting to see
Speaker 2: these sort of like some of these some of these
Speaker 2: distributional shifts underway, just in terms of who reaps the
Speaker 2: reward from all this activity.
Speaker 3: I mean, I think it's a really good thing to
Speaker 3: think about. I would also argue that there may be
Speaker 3: some other factors.
Speaker 4: There are other factors.
Speaker 3: The US equity risk premium fairly high at the moment.
Speaker 2: There are definitely, uh, there are definitely the other factors.
Speaker 3: All right, shall we leave it there.
Speaker 4: Let's leave it there.
Speaker 3: This has been another episode of the Odd Thoughts podcast.
Speaker 3: I'm Tracy Alloway. You can follow me at Tracy all
Speaker 3: the Way.
Speaker 2: And I'm Joe Wisenthal. You can follow me at the Stalwart.
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