Forecasting Equity Returns - An Analysis of Macro vs. Micro Earnings and An Introduction of A Composite Valuation Model

Forecasting Equity Returns: An Analysis of Macro vs.
Micro Earnings & an Introduction of a Composite Model
Forecasting Equity Returns:

An Analysis of Macro vs. Micro Earnings and an
Introduction of a Composite Valuation Model
Stephen E. Jones, CFA*

President, String Advisors, Inc.
Analyses of P/E10 and Market Value/GDP (MV/GDP) market valuation ratios reveal P/E10s
reliance on misconceptions of the differences between micro and macro earnings. Kaleckis profit function
is used to identify and avoid these problems, contest P/E10s theoretical support, reveal MV/GDP as the
metric providing better theoretical and statistical support, introduce the concept of macro-earnings
negativity, and provide other important implications for economic theory. Based on the MV/GDP metric,
we develop a multi-variable forecasting model utilizing both new and prior-researched variables, the most
effective of which is a demographic measure. The resulting composite model is much more accurate than
popular benchmark metrics, and, relative to popular benchmarks, forecasts considerably lower returns for
the coming decade.
*Stephen Jones, CFA, is President of String Advisors, Inc., 245 E. 58th St.,, #29A, New York, NY 10022, USA, Tel.: 212-5993571, E-mail: stephenejones1960@gmail.com. Special thanks go to Professors Terence Agbeyegbe, Anthony Laramie, Caleb
Stroub, and other reviewers. The use of we is largely in recognition of their contributions; however, this is not to imply that
they agree with the views of this paper or hold responsibility for any errors.
Forecasting Equity Returns: An Analysis of Macro vs. Micro Earnings & an Introduction of a Composite Model
Forecasting Equity Returns: An Analysis of Macro vs. Micro Earnings

and an Introduction of a Composite Valuation Model
1.
Literature Review
For over a century, researchers have developed strategies to forecast equity market returns, only to
see others conclude that such strategies do not outperform the market. Thorough surveys of the history of
these studies can be found in Huang and Zhou (2013); Scholz, Nielsen, and Sperlich (2013); Rapach and
Zhou (2012); and Campbell and Thompson (2008). An early notable strategy is the approximately 255 Wall
Street Journal editorials written by Charles H. Dow (1851-1902). Though Dow never used the expression
Dow Theory, that term typically refers to these works. Later, Cowles (1933), in Can Stock Market
Forecasters Forecast? tracked Dow Theory forecasts and found that they underperformed the market by
about 3.5% a year. Cowles also found that recommendations by 24 other publications underperformed by
4% a year. From Cowles (1933) through the mid-1980s, the efficient market hypothesis dominated, and
market returns were generally considered to be unpredictable. Major research supporting this view includes
those of Godfrey, Granger and Morgenstern (1964); Fama (1965); Malkiel and Fama (1970); and Malkiels
(1973) book, A Random Walk Down Wall Street.
The 1980s, however, saw a surge of research backing up the claim that market returns could be
forecasted. The research supported a variety of variables:
Book to Market: Kothari and Shanken (1997), Pontiff and Schall (1998), Welch and Goyal (2008),
Campbell and Thompson (2008);
Consumption Wealth Ratio: Lettau and Ludvigson (2000), Welch and Goyal (2008), Campbell
and Thompson (2008);
Corporate Activities: Lamont (1988), Baker and Wurgler (2000), Boudoukh, Michaely,
Richardson, and Roberts (2007), Welch and Goyal (2008), Campbell and Thompson (2008);
Dividend Yields: Hodrick (1982), Rozeff (1984), Fama and French (1988), Campbell and Shiller
(1988a, 1988b), Nelson and Kim (1993), Kothari and Shanken (1997), Lamont (1998), Lettau and
Van Nieuwerburgh (2008), Cochrane (2008), Welch and Goyal (2008), Campbell and Thompson
(2008);
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Economic Combined with Technical: Huang and Zhou (2013);

Earnings: Fama and French (1988), Campbell and Shiller (1988a, 1988b), Lamont (1998), Welch
and Goyal (2008), Campbell and Thompson (2008);
Inflation Rate: Nelson (1976), and Fama and Schwert (1977), Campbell and Vuolteenaho (2004),
Welch and Goyal (2008), Campbell and Thompson (2008);
Interest Rates & Bond Yields: Fama and Schwert (1977), Keim and Stampaugh (1986), Campbell
(1987), Breen, Glosten, and Jaganathan (1989), Fama and French (1989), Campbell (1991), Ang
and Bekaert, (2007), Welch and Goyal (2008), Campbell and Thompson (2008);
Relative Valuations of High and Low Beta Stocks: Polk, Thompson, and Vuolteenaho (2006);
Stock Volatility: French, Schwert, and Stambaugh (1987), Guo (2000), Goyal and Santa-Clara
(2003), Welch and Goyal (2008), Campbell and Thompson (2008).
However, after claims that several variables were able to forecast market returns, arguments disputing
those claims returned, the most prominent of which comes from Goyal and Welch (2007). Their study
reexamined the performance of variables that have been suggested by the academic literature to be good
predictors of the equity premium, and, based on extensive out-of-sample testing, they found that these
models would not have helped an investor with access only to available information to profitably time the
market. Goyal and Welch also brought out-of-sample testing to widespread, if not universal, acceptance
as a benchmark for testing investment strategies. Goyal and Welchs findings brought a response from
Campbell and Thompson (2008), which accepted the use of out-of-sample results, but show that many
predictive regressions beat the historical average return once weak restrictions are imposed on the signs of
coefficients and return forecasts. Campbell and Thompsons response appeared to accelerate research into
alternative methods of identifying and testing forecasting variables. Rapach and Zhou (2012) covered this
topic thoroughly, and, in brief, show that recent studies provide forecasting strategies that deliver
statistically and economically significant out-of-sample gains, including strategies based on:
economically motivated model restrictions (e.g., Campbell and Thompson, 2008; Ferreira and
Santa-Clara, 2011);
forecast combination (e.g., Rapach et al., 2010);
diffusion indices (e.g., Ludvigson and Ng, 2007; Kelly and Pruitt, 2012; Neely, Rapach, Tu, and
Zhou, 2012);
regime shifts (e.g., Guidolin and Timmermann, 2007; Henkel, Martin, and Nadari, 2011; Dangl and
Halling, 2012).
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Both efficient market theorists and their critics continue to have strong proponents on each side.
Evidence that both sides of the field are highly respected is the concurrent awarding, in 2013, of the Nobel
Prize in economics to both Eugene Fama, a proponent of efficient markets, and Robert Shiller, who claims
markets are irrational.
Our research does not utilize the alternative strategies offered by Rapach and Zhou (2012), above,
although utilization of such strategies may improve the already statistical and economically significant gains
we find available. Our focus returns to the use of fundamental and macro factors to forecast long-term (10year) equity returns. Currently, the most popular of this type of measure are probably P/E10 (sometimes
called CAPE), and Tobins q. Each of these methods gained popularity in 2000 by the publication of two
books. The more popular of these two books is Robert J. Shillers Irrational Exuberance, which proposed
the P/E10 measure. Also well received was Andrew Smithers and Stephen Wrights Valuing Wall Street,
which supported Tobins q, a measure of the markets price to its book value, introduced in 1969 by
Nobel laureate James Tobin. Each of the above books 2000 forecast correctly foretold poor equity returns
over the coming decade, and propelled their proposed ratios into prominence. Of the two metrics, the most
common is P/E10, a measure of the price of the broad market relative to its earnings over the prior 10 years.
Despite evidence that Tobins q is simpler and more effective (see, Harney, Tower, 2003), there is still a
strong preference for P/E10s earnings based measure. This preference appears to be due to the belief that
earnings are the most important factor behind holding a specific equity, and that the sum of historical
combined individual (micro) company earnings is the best indicator of future macro earnings.
John Campbell and Robert Shiller first popularized P/E10 in Valuation Ratios and the Long-Run
Stock Market Outlook (1998). Although their earnings-based equity valuation model possessed good
predictive ability, and their 1998 and 2001 forecasts for poor market returns over the coming ten years were
largely correct, our research into earnings factors on a macro level reveals a conflict with using historical
collective individual corporate earnings as an indicator of future macro earnings. Moreover, significant
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increases in government and personal debt since the 1998 popularization of P/E10 have resulted in this
conflict being more obvious and more important than ever.
2.
Identification of a Forecasting Variable

Despite efforts to identify methods to forecast equity returns, conspicuously uncommon is a variable
with the strongest predictive abilities: Market Value1/Gross Domestic Product2 (MV/GDP). Proving a
scarcity of coverage is difficult, but MV/GDP is not even mentioned in any of the following research:
Valuation Ratios and the Long-Run Stock Market Outlook, by Campbell and Shiller (1999 and
2001).
Forecasting Stock Returns, an extensive review of forecasting strategies, by Rapach and Zhou
(2012).
A Comprehensive Look at the Empirical Performance of Equity Premium Prediction, by Welch
and Goyal (2008). This award winning article, which comprehensively reexamines the
performance of variables that have been suggested by the academic literature to be good predictors
of the equity premium, does not include MV/GDP.
Predicting Excess Stock Returns Out of Sample: Can Anything Beat the Historical Average? This
study of at least 12 standard predictor variables does not include MV/GDP.
In summary, there is no academic study, to our knowledge, that researches MV/GDP as a variable to
forecast equity returns. In the investment community, MV/GDP has been used, but rarely so, despite Warren
Buffets claim that it is probably the best single measure of where valuations stand at any given moment.3
No study of the popularity of market valuation variables appears to be available, but several analyses have
pointed out the overwhelming popularity of P/E ratios4,5,6,7. We found only one study of market valuation
measures based on their degree of popularity, and it did not list MV/GDP among its six metrics5. Additional
evidence of MV/GDPs lack of popularity is that the variable is rarely even mentioned in the more popular,
non-academic coverage of market valuation measures. For example, it was not a metric covered in
Vanguards 2012 study, Forecasting Stock Returns: What Signals Matter, and What Do They Say Now?,
which tried to assess the predictive powers of more than a dozen metrics. And, in their August 2013
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Strategy Snippet (Subramanian, 2013), Bank of America Merrill Lynch reported on the 15 valuation
metrics we analyze; none of which were MV/GDP. The omission of MV/GDP, and, moreover, the lack
(to our knowledge) of criticism for the omissions, is evidence that MV/GDP is not considered to be as
popular or widely accepted as other valuation measures.
Given MV/GDPs strong forecasting ability, it is difficult to determine why it isnt used more often. Of
course, one could justifiably argue that brokerages want to avoid the measures bearish forecasts, as bullish
forecasts both provide customers what they want to hear as well as end up boosting the brokerages bottom
lines. As Bill Gross (2015) notes, it never serves their business interests to forecast a decline in the
product they sell. Another logical reason for the measures absence from research, and for its unpopularity
in the investment world, is a perception that the variable lacks theoretical justification as a forecaster of
equity returns. Such a lack of theoretical justification would raise concerns of a spurious relationship
between market value and GDP, and thus discourage its use as a forecasting variable. Another potential
argument against the measure is that large fluctuations in the proportions of private vs. public company
ownership could distort the accuracy of this measure. In markets with low or fluctuating proportions of
private vs. public company ownership, this latter argument may be a valid criticism; however, in the U.S.
market, with a fairly consistently high percentage of pubic versus private companies, this is not an important
factor. Therefore, the primary theoretical reason behind not using the MV/GDP measure appears to be a
concern that the factor lacks proper theoretical justification.
2.1. Verifying a Variables Theoretical Fundamentals
Our response to concerns that MV/GDP lacks theoretical justification begins with a comparison
between the theoretical justifications of PE10 and MV/GDP. Our findings will both reject the theoretical
support of P/E10 and, perhaps ironically, conclude that MV/GDP is a better indicator of true future earnings
and has, therefore, stronger theoretical justification. Section 3 first explains how P/E10, proposed as a
measure to value the entire market, was founded on the principles of evaluating individual equities. We
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next reveal a conflict in valuing the overall market on the same principles of valuing individual equities by
revealing how the earnings processes of individual companies differ significantly from those of the overall
market. Evidence is then presented which suggests that PE/10 largely obtains its predictive power (relative
to the one-year P/E) from the strengths of the MV/GDP ratio, and then reveals how and why MV/GDP is a
better measure, both theoretically and statistically, of recurring earnings. Kaleckis profit equation is
introduced in this argument, with the purpose of, first, identifying the sources of macro earnings and
revealing additional differences between macro and micro earnings. Second, we reveal how these sources
of macro earnings experience non-fundamental and non-sustainable fluctuations, and then explain the
importance of adjusting for these fluctuations in order to derive a more fundamental or permanent measure
of earnings. An adjustment process is then introduced which normalizes the factors in Kaleckis identity on
the basis of historical averages. These normalized earnings, calculated as a basis of GDP, are shown to
equate to MV/GDP, therefore indicating that MV/GDP is a better theoretical P/E measure. With the use
of out-of-sample testing, we then show that MV/GDP has, from a statistical perspective, also been most
accurate at forecasting future real 10-year market returns. The section concludes by addressing the causality
issue in Kaleckis equation.
Using historical data, we then explain, clarify and confirm the theoretical support presented earlier.
Section 4 concludes with a comparison of MV/GDP to the price/sales metric as well as introduces further
important implications which, though unnecessary for the composite model, are informative. Likewise,
statistics showing the recent record imbalances of global debt levels indicate that our conclusions are also
applicable to the other global developed equity markets.
2.2. Development of a Composite Model

Section 5 introduces the development of a composite model to forecast future real 10-year equity
returns. Though not original, the use of a composite model is uncommon, despite an abundance of individual
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forecasting variables. The model is based on the MV/GDP metric, and is improved significantly with a
unique implementation of a demographic metric. Further improvements come from the addition of both
newly developed and prior researched variables. Historical evidence suggests that the resulting model is
able to forecast future real equity returns significantly better than any model we are aware of.
This research not only provides a better measure for forecasting equity returns, but, as it does so,
clarifies the nature of macro earnings and their relationship with public and private debt, corporate
investments, dividends, and other economic variables. This understanding of the relationship of macro
earnings to economic variables, combined with the composite models forecast for real equity returns over
the coming decade, indicates that the current economic environment is in a unique, if not dangerous,
situation. Although this uniqueness makes forecasting more difficult, from a timeliness perspective it is
worth noting that the models current forecast is not only at its greatest deviation in history relative to the
commonly used measures, but is also forecasting returns over the coming decade to be worse than at any
time in the models 60-year history.
3. Evidence of Differences Between Micro and Macro Markets

John Campbell and Robert Shiller most prominently proposed the P/E10 measure in Valuation
Ratios and the Long-Run Stock Market Outlook, in 1998, as well as in an update in 2001. Although their
P/E10 measure, which they named CAPE, did well at forecasting a sub-par market performance over the
following decade, our research into earnings factors on a market-wide (macro) level reveals a conflict with
using measures of historical individual corporate (micro) earnings as appropriate indicators of future macro
earnings, and explains how the theoretical justification behind P/E10s macro (overall equity market) based
earnings is mistakenly founded on micro (individual equity) theory.
In valuing the market, it has been common, historically, to apply the same methods used in valuing
individual securities. Campbell and Shillers development of P/E10 is an example of this. In Valuation
Ratios and the Long-Run Stock Market Outlook: An Update (2001) Campbell and Shiller wrote:
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A clearer picture of stock market variation emerges if one averages earnings over several years.
Benjamin Graham and David Dodd, in their now famous 1934 textbook Security Analysis, said that
for purposes of examining valuation ratios, one should use an average of earnings of not less than
five years, preferably seven or ten years (p. 452). Following their advice we smooth earnings by
taking an average of real earnings over the past ten years (p. 6-7).
This quote was not simply interesting supplemental information, but also appears to function as the
theoretical justification of the P/E10 measure. Years earlier, Campbell and Shiller (1988b) had noted that
the thirty-year moving average earnings-price ratio performed much better than the 10-year measure at
forecasting future equity market returns. The 30-year measure explained 56.6% of the variance of ten-year
real forward returns; however, the ten-year moving average ratio only explained 40.1% of the variance. The
obvious inclination is to use the ratio with the higher predictive ability; however, without theoretical
justification, models lack validity, and are unlikely to be any better predictors of future events than spurious
indicators, such as which league wins the Super Bowl8 (this topic of spurious relationships is covered again
in the discussion of the MV/GDP ratio). There is no theoretical justification for a measure having 30 years
of earnings; however, Campbell and Shiller thought they found theoretical justification for the P/E10
measure in Graham and Dodds methodology for valuing individual securities. Therefore, without
questioning the differences between the earnings of an individual company and the earnings of the overall
market, Campbell and Shillers modelalong with most of the investment communityvalues the overall
market with methods used to value individual securities. However, the following perspectives reveal that
there are very different, even conflicting, fundamental differences between micro and macro earnings.
3.1. Earnings Impacts from a Transactions Perspective

One may think that the impact of a single transaction on an individual company would be
comparable to the impact of the same transaction upon all the companies in the market. However, such is
not the case, and evidence suggests that the earnings process of corporations from a macro perspective is
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very different, and in many way oppositional to, the earnings process of an individual company. For
example: If an individual company were to reduce redundant staff by 10%, that companys costs would
generally fall by the amount of staff cuts, and earnings would likely increase by the amount of staff cuts.
However, if the whole market were to cut staff by 10%, such a cut would also result in a comparable cut to
personal incomes and, as a result, to a comparable reduction to overall (macro) spending for the economy
and, therefore, to revenues for corporations. Therefore, if the market in general were to cut staff by 10%,
such cuts would unlikely benefit earnings of the market as a whole, or at least the overall earnings gains per
company would be significantly smaller. Similarly, if an individual company were to make an investment
in a long-term asset, such an investment would have little to no near-term impact on earnings, and have a
comparable negative impact on cash flow. However, if all companies were to make a similarly sized
investment in a long-term asset, such investments would generally lead to similar increases in near-term
earnings of all companies and have little significant impact on cash flow. These examples show that the
same activities applied to both micro and macro situations can produce dramatically different, and even
opposite, results.
3.2. Earnings Impacts from an Accounting Perspective

The process of deriving the earnings of an individual company is well known, and is described in
the following simplified income statement:
ABC Company
Income Statement for the Year Ended December 31, 2001
+ Revenues
- Cost of Sale
= Gross Profit
- General & Admin. Expenses
= Net Profit
10
10,000
4,500
5,500
3,000
2,500
However, the derivation of earnings on the macro level is very different. Kaleckis profit equation,
described in more detail later, recognizes the following identity:
+ Net Investment
+ Government Net Borrowing
Foreign Savings (Current Account Balance)
+ Dividends
Personal saving
Net Capital Transfers
Statistical Discrepancy
Corporate Profits (after taxes)
Therefore, not only do identical corporate transactions have different impacts on the micro
and macro markets, but the accounting derivations of micro and macro earnings are different as well. Thus,
it is not reasonable to conclude, as is implied by the P/E10 model, that valuation processes applied to
individual companies (the micro level) are equally applicable to the results of all companies combined (the
macro level). For a deeper analysis of the tendency within economics to falsely reduce macroeconomics to
microeconomic processes, see Debunking Economics, (Keen, 2011).
3.3. Impact on the P/E Ratio by Extending the Earnings Period: P/E83?
Yet another perspective of the differences between macro and micro earnings comes from
examining the number of years chosen in the P/E10 metric. The rationale for using 10 years in the P/E10
measure is based on valuation procedures for individual companies, as shown in the earlier quote, on page
9xxx, of Campbell and Shiller. However, considering the use of measures with different numbers of years
produces informative results. Given that 1871 is the oldest dateand the date Shiller starts withfor
available earnings data, and given that 1954 is the starting point of our study, the P/E ratio with the highest
possible number of years is P/E83. When looking at P/E83, it becomes conspicuously apparent that the
ability of P/E83 to forecast returns, as indicated by adjusted R2 of 0.50, is 34% better than the predictive
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ability of P/E10, which has an adjusted R2 of only 0.38. Initially P/E83 appears to be a positive find;
however, despite being significantly more accurate, P/E83, like Campbell and Shillers P/E30 measure,
loses the necessary theoretical association to earnings which P/E10 claims to have, above. Furthermore, it
would be difficult to imagine that the predictive strength that comes from such a long period of macro
earnings could originate from the valuation process of individual corporate earnings. Our detailed
examination of MV/GDP shows why the derivation of P/E10s predictive ability is more attributable to the
MV/GDP ratio, which, perhaps ironically, is shown below to be a better indicator of recurring earnings than
actual earnings measures.
3.4. Comparing the P/Es Extended Earnings Period to MV/GDP

As the earnings periods in P/E ratios are extended, the correlation between the P/E ratio and the
MV/GDP ratio approaches one.
Figure 1:
Correlation P/E Ratio, by Number of Years, to MV/GDP

1.00
0.95
0.90
0.85
0.80
0.75
0.70
0.65
0.60
0.55
1
10
20
30
40
50
60
70
83
Thus, by steadily increasing the earnings period used in the P/E ratio, two important characteristics
are discovered. First, the accuracy of the P/E ratios ability to forecast returns increases from 0.28 for one
year, to 0.38 for 10 years, to 0.50 for 83 years, when it approaches that of the MV/GDP ratio, of 0.52.
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Second, the correlation of the P/E ratio to the MV/GDP ratio merges towards one. The fact that increasing
the number of years in the P/E denominator causes the P/E ratios forecasting ability to merge towards the
forecasting ability of the MV/GDP ratio, and causes their correlation to approach one, suggests a strong
association between earnings and GDP.
Figure 2: Performance and Relationships of Metrics:

Adj. R2
.28
.38
.44
.49
.50
.52
Regressed to ten-year future real total returns:

Real Price9/Real One-Year Earnings9:
Real Price/Real 10-Year Earnings (P/E10)9:
Tobins q12:
Market Value1/GDP2:
Correlation to
MV/GDP
.58
.92
.93
.94
.97
1.00
t Stat.
-15.5
-19.3
-22.0
-24.2
-24.8
-25.5
Thus, increasing the number of years in the P/E ratio increases its effectiveness towards that of the
MV/GDP metric, while also increasing the correlation of the two ratios towards one. Therefore, the
effectiveness of P/E10 appears to be largely attributable to the numerator (price), and the increased
correlation of the P/E ratio to MV/GDP as the number of years in the denominator increases. Further
evidence of this is presented in Figure 2, above. Given that the numerators of the P/E and MV/GDP variables
are both market-price driven, then comparisons indicate that earnings, the denominator in the weaker
measure, actually reduces the effectiveness of the variable. This becomes clearer when comparing the
adjusted 2 of P/E10 to the adjusted 2 of MV/GDP (see directly above), a variable that is both steadier
and easier to calculate than P/E10. The reason why the earnings denominator reduces the effectiveness of
the variable becomes clearer later, most notably in Section 4.2, when it is shown why increases in earnings
relative to GDP are typically associated with deteriorating economic fundamentals and, likewise, why
decreases in earnings relative to GDP are typically associated with improving economic fundamentals.
Likewise, one will also likely find that the ratio of the price of the overall market to any variable that closely
tracks GDP also tends to forecast future real returns approximately as well as P/E10. Therefore, it appears
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to be the tendency of longer periods of historical earnings to track GDP which provides PE10 with its
forecasting ability. We will later provide more evidence of why this is the case.
Another indication that P/E10s forecasting ability is already included in MV/GDP is that the
addition of P/E10 to MV/GDP to form a composite indicator does not support the necessary premise that
higher earnings, at a given price, should lead to improved returns over the models 10-year forecasting
period. Compared to the MV/GDP standalone results, the adjusted 2 does climb from 0.52 to 0.64, and
the P/E10 indicator initially appears to be very significant, with a t-stat of 14.8; however, the sign of the
coefficient switches, indicating that, adjusted for MV/GDP, higher/lower earnings for a given earnings
multiple lead to lower/higher real equity returns 10 years later. This is, of course, contrary to the
assumptions behind using the 10-Year PE to forecast future equity returns, presents another conflict when
trying to justify the theoretical assumptions of P/E ratios to value the macro market, and further supports
the concept that higher macro earnings relative to GDP are often associated with deteriorating economic
fundamentals, and that lower macro earnings relative to GDP are often associated with improving economic
fundamentals. This is statistical support of our concept of negativity of macro earnings, which relates that
that macro earnings growth in excess of GDP is negatively correlated with future growth in macro earnings,
relative to GDP. This concept will be explained in more detail later.
3.5. Using Multiple Years of Earnings to Value Individual Companies

Given the differences between micro and macro earnings, the following is not needed for our
argument; however it is worth noting that, despite Graham and Dodds indisputably deserved positive
reputation, empirical evidence (Gray and Vogel (2012), Gray and Carlisle (2012), and Loughran and
Wellman (2012)) indicate that longer-term metrics are not better at predicting returns than one-year metrics.
Therefore, other than Graham and Dodds hypothesis, there is no support behind P/E10s assumption that
a measure with multiple years of earnings results in a better valuation measure than does one year of
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earnings. Therefore, not only is Graham and Dodds hypothesis about the valuation of individual companies
unjustly applied when it is used to support an indicator which values the overall market, the notion that
more years of earnings help value an individual company is simply not correct. As indicated above and
below, the strength P/E ratios derive from more years of earnings is the result of the increasing association
with the MV/GDP variable.
In summary, P/E10 lacks theoretical justification its predictive ability does not come from the sum
of the earnings of individual companies, as the measure is defined, but from the predictive abilities of
MV/GDP. This argument is further strengthened by our following analysis, which provides theoretical
justification for MV/GDP by revealing its relationship to earnings.
4. What Are Earnings?

To clarify the relationship between GDP and earnings, we utilize Kaleckis profit identity to take a
closer look at macro and micro earnings. With a clearer understanding of the differences between macro
and micro earnings, and of the relationship of macro earnings to GDP, it becomes apparent that MV/GDP
does not have the problems inherent in traditional macro earnings based measures, such as P/E10, and why
MV/GDP is, theoretically, a better indicator of real future equity returns. As a result, MV/GDP should be
recognized as both a theoretically and statistically better metric to forecast equity returns. Also important
is that the divergences between these measures have recently reached their largest levels ever. Moreover,
the relationships between macro and micro earnings and GDP introduce other important implications which,
although they unnecessary for the legitimacy of our model, also merit attention.
4.1. Where Do Earnings Come From?

The accounting behind determining profits for an individual company is widely recognized. From a
macroeconomic perspective, however, where do profits come from, and what determines how much they
are? Such was the question that Michal Kalecki sought to answer when he developed his profit equation.
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Although practically unheard of by the general public, Kaleckis profit equation is a long utilized
and well regarded accounting identity which equates macro earnings with macroeconomic factors.
Kaleckis profit equation may have been first discovered by Jerome Levy about a decade before Kalecki,
and later Keynes, utilized it extensively in the 1930s; however, Kalecki is generally credited with doing the
most work in the area. Despite the models longevity and respect within economics, the identity is not well
known, and it is rarely utilized as a measure to forecast equity market returns. Here, however, Kaleckis
profit equation is used to identify, quantify, and theoretically justify the extent to which the sum of historical
corporate earnings is not the best indicator of future macro profits. The process of identifying and
quantifying the problems behind summing up actual historical earnings also provides solid theoretical
justification for using MV/GDP as a better variable to forecast future earnings and equity returns.
Kaleckis profits equationan accounting identity, not a theoryshows how corporate profits are
derived on a macro scale. An understanding of this formula will help determine the sources of
macroeconomic corporate profits and to understand why reported corporate (macro) profits ought to revert
to a ratio of GDP. Kaleckis profits equation yields the following formula:
4.a. Kaleckis Profits Equation:

Corporate Profits + Net Investment
(after taxes)
+ Government Net Borrowing
Foreign Savings (Current Account Balance)
+ Dividends
Personal saving
Net Capital Transfers
An excellent source (and the basis for our derivation, in Appendix 1) which identifies and quantifies
the variables in Kaleckis profits equation is Laramie and Mairs (2008), Accounting for Changes in
Corporate Profits: Implications for Tax Policy. Thorough coverage of the topic is found in the book
Profits and the Future of American Society, (Levy & Levy, 1983). Typically, Kaleckis equation is used
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to forecast how recent or proposed events affect near-term earnings or economic trends. The clearest
example of this is the Jerome Levy Forecasting Center. Seldom is the formula used as a contrary indicator
of longer-term corporate profits. An exception to this is Montiers What Comes Up Must Come Down,
which utilizes Kaleckis equation to explain a negative forward outlook for profit margins and corporate
profits.
Our use of Kaleckis profits equation reveals why higher earnings relative to GDP, even under
conditions of a stable P/E, could be a negative indicator of future equity returns if the earnings had been
driven by non-sustainable and/or non-fundamental factors. One example would be increases in macro-level
earnings caused by increased government and/or personal debt levels. However, this increased debt, nor the
boost that it provides to macro earnings, is sustainable. Similarly, if the government and/or consumers were
to reduce their debt, this increased savings nor the reduction it provides to macro earnings is sustainable.
Again, neither the reduction of savings, nor the boost that it provides to macro earnings, is sustainable. The
P/E10 measure, and most of the financial community, does not identify the extent to which earnings are
impacted by these unsustainable changes in debt. Furthermore, even if the investment community were to
appropriately discount unsustainable earnings with a lower market value, the P/E10 measure would still
forecast above-average future returns, given the lower P/E10 ratio. If the investment community valued
equities with an average P/E10 multiple, the average multiple would imply average future returns; however,
this forecast would not take into account the higher probability of an eventual return to normal debt levels
and the negative impact such a move would have on future earnings. Regardless of the equity valuation
the numeratorestablished by the market, the ability of P/E10 to forecast future equity returns is
compromised because the denominator in the P/E10 ratio is not able to distinguish between sustainable and
unsustainable earnings. Without adjusting for the unsustainable changes, the levels of macroeconomic
earnings are not suitable for identifying sustainable earnings. Utilizing Kaleckis profit equation to identify
and quantify these non-sustainable factors leads to the development of normalized earnings and reveals
17
a relationship between normalized earnings and GDP. The development of normalized earnings will then
form the basis for new theoretical justification for MV/GDP as a better valuation variable.
4.2.
Normalized Earnings, and the Negativity of Increases in Macro Earnings

We have just seen how and why fluctuations in the components of Kaleckis profit equationmost
specifically government and consumer debtproduce unsustainable fluctuations in macro earnings. Here,
Kaleckis profits equation is used to explain the tendency for earnings to revert to a ratio of GDP, to show
why such a ratio represents normalized earnings, and then to develop normalized earnings into a
variable. We first consider an increase in government net borrowing. According to Kaleckis profits
equation, net increases in government and or personal borrowing boosts corporate profits. However,
because such increases of debt relative to GDP cannot continue over the long term, and because it will incur
future costs, the ability of higher debt relative to GDP to continually increase earnings is limited. Likewise,
increased savings or reductions in debt would initially create a negative impact on earnings; however, the
resulting increased savings or lower debt levels places the economy in a better position to spend savings or
increase debt, and thus increase earnings, in the future. Therefore, all else being equal, if earnings-based
valuation models use the reported earnings of the overall market, these models should, but fail to, place
lower/higher valuation multiples on earnings which are higher/lower due to increased/decreased
government debt, relative to GDP. The same argument applies to the other variables in Kaleckis equation,
such as personal savings. For example, all else being equal, an increase/decrease in personal savings would
bring about a comparable decrease/increase in corporate earnings during that period, and valuations should
reflect the non-persistence of those changes. Also, when viewing the situation from a forward looking
perspective, large historical increases/decreases, relative to GDP, in government debt leads to a greater
chance of a reversion of that change, suggesting larger than average decreases/increases in future earnings.
18
The above are further examples of how increases of debt boost earnings, and how this earnings boost
is not sustainable. The same argument applies generally to factors in Kaleckis equation, suggesting a
negative aspect behind increased macro-level earnings. This does not just apply to increased debt, which is
generally accepted to be a negative factor of economic fundamentals. For example, increases in capital
spending relative to GDP is typically considered an economic positive; however, from a macro earnings
perspective increases in capital spending have already gone to earnings, from a macro perspective, and the
assumption that future capital spending will return to historical norms is a negative for future macro
earnings. The evidence presented in both Section 3.4 and in Section 4.4 provide statistical support for this
concept of macro earnings negativity.
When looking at the variables in Kaleckis profit equation, it is important that they are not measured
from an absolute perspective, but relative to GDP, which adjusts over time for the impact of inflation and
the size of the economy. When measured relative to GDP, Kaleckis profit equation can then be used to
explain the tendency for earnings, relative to GDP, to revert to historical norms. As the factors in Kaleckis
equation naturally tend to revert to historical norms relative to GDP, we will show how Kaleckis profits
equation reveals that earnings, the sum of these factors, will, by definition, likewise tend to revert to a ratio
of GDP. We will clarify the theory behind this argument, and identify the level to which earnings revert as
normalized earnings. Below, we will see that although all factors in Kaleckis profits equation influence
reported earnings, it is government debt, personal savings, and net investment which are the largest
contributors to the equation.
4.3.
Not Just an Identity

As an accounting identity, Kaleckis equation suggests neither the direction nor existence of a
cause/effect relationship. While the conclusions in our research do not require causality in Kaleckis profits
equation, recognizing the causality in the relationship significantly improves the understanding of
19
underlying economic forces. Although it is impossible to prove a cause/effect relationship between profits
and the variables in Kaleckis equation, several perspectives provide convincing evidence that it is the
variables in Kaleckis equation which influence earnings, and not the earnings which influence the
variables.
4.3.1. Intuitive Support

An intuitive argument that the factors in Kaleckis equation are causal is made extensively by Levy
& Levy (1983) in their book Profits and the Future of American Society. Their illustration reveals how
increases in government and personal debt meanall else being equalincreased expenditures on goods
and services and, thus, increased corporate revenues. Depending on the nature of fixed costs, corporate
profits in such an environment will likely increase even more than the increase in revenues. As a result, it
is understandable how increased debt leads to increased earnings. Otherwise, the most likely cause/effect
relationship which could explain Kaleckis equation would be for increased earnings to somehow cause
increased government and personal debta relationship that is difficult to envision. In What Goes Up Must
Come Down, James Montier (2012) also argued for causality for factors in Kaleckis profits equation when
he said:
This is, of course, an identitya truism by construction. However, it can be interpreted with some
causality imposed. After all, profits are a residual; they are the remainder after the factors of
production have been paid. Thus, it can be comfortably argued that the left-hand side of the equation
(profits) is determined by the right hand side. (p.4)
4.3.2. Support of Actual Results

Support for a causal relationship between debt and profits is also evident in actual results. Figure 3,
below, shows a very strong negative relationship between the changes in government and personal saving
and the changes in corporate profits six quarters later.
20
Figure 3:
Changes in Government & Personal Savings vs. Growth in Corporate Profits:
Source: John Hussman, Weekly Market Comment, 6/17/2013
An in-depth statistical perspective is found in What Drives Profits? An Income-Spending Model,

in which Giovannoni and Parguez (2007) inquire into the role and determinants of aggregate profits.
Their several cause/effect studies support the notion that it is the factors of profits that cause changes in
profits, and not vice versa. Furthermore, they also point out that:
There is a puzzle in consumption fostering profits and compensation dragging them. The
reconciliation between the two findings could be that a growing share of American consumption is
being funded by credit, a well-known phenomenon. This amounts to stating that the major source of
profits, consumption, actually hides an increased indebtness trend (p. 114).
Moreover, the degree to which debt can be directly and indirectly controlled further supports the
notion that profits are caused, or at the very least it diminishes the relevance of arguing the extent to which
causality is a factor in Kaleckis profit equation.
21
4.4.
Historical Evidence
In Figures 4 and 5, it is apparent that earnings, in relation to GDP, have generally been on a steady
rise since the Great Depression, and have recently hit all-time highs. Without discriminating between
sustainable and unsustainable earnings, it would appear that positive fundamental drivers have been steadily
pushing earnings, relative to GDP, increasingly higher. However, by breaking down Kaleckis profits
equation it becomes evident that the primary drivers behind the earnings growth, relative to GDP, have been
increased government debt and reduced personal savings, characteristics which are usually considered
economic weaknesses rather than strengths.
Figure 4:
Historical Profits, As a % of GDP

18.0%
16.0%
14.0%
12.0%
10.0%
Profits, as % of GDP
8.0%
Average
10-Year Average
6.0%
2014
2011
2008
2005
2002
1999
1996
1993
1990
1987
1984
1981
1978
1975
1972
1969
1966
1963
1960
1957
1954
1951
1948
1945
1942
1939
1936
1933
1930
4.0%
Again, this trend is not progress, but indicates that profits as a percent of GDP have trended higher
as a result of higher proportions, relative to GDP, of the factors in Kaleckis profits equation.
22
Figure 5: Corporate Profits as Percent of GDP:

(Impact of Each Factor on Corporate Profits)
STD:
Avg.
Date
1930
1931
1932
1933
1934
1935
1936
1937
1938
1939
1940
1941
1942
1943
1944
1945
1946
1947
1948
1949
1950
1951
1952
1953
1954
1955
1956
1957
1958
1959
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
4.3%
15.8%
4.8%
4.7%
1.9%
-0.7%
1.0%
3.1%
3.1%
10.2%
0.2%
-0.2%
0.7%
0.5%
2.5%
12.4%
Net
Invest.
8.8%
5.3%
1.3%
7.7%
7.3%
10.2%
11.9%
14.0%
7.9%
11.7%
14.4%
16.9%
7.8%
4.0%
4.2%
5.7%
16.9%
17.2%
19.1%
13.6%
20.5%
18.4%
15.3%
15.8%
14.9%
17.7%
17.9%
16.4%
14.8%
16.5%
16.0%
15.3%
16.0%
16.2%
16.4%
17.6%
18.0%
16.7%
17.0%
17.6%
16.4%
17.2%
18.3%
20.1%
20.2%
15.9%
Govt.
Borrowing
1.0%
4.7%
3.9%
3.1%
4.3%
3.6%
4.6%
0.4%
2.7%
3.7%
1.7%
4.6%
21.1%
24.0%
25.2%
19.6%
-0.1%
-3.7%
-1.5%
3.2%
-0.2%
0.8%
3.5%
4.0%
4.4%
1.8%
1.3%
2.5%
5.0%
3.3%
2.4%
3.7%
3.6%
2.8%
3.3%
2.8%
3.1%
4.6%
3.4%
2.1%
4.6%
5.4%
4.1%
2.7%
3.3%
7.3%
Foreign
Savings
0.8%
0.3%
0.3%
0.3%
0.6%
-0.1%
-0.1%
0.2%
1.4%
1.1%
1.5%
1.0%
-0.1%
-1.0%
-0.9%
-0.6%
2.2%
3.7%
0.9%
0.3%
-0.6%
0.3%
0.2%
-0.3%
0.1%
0.1%
0.6%
1.0%
0.2%
-0.2%
0.6%
0.7%
0.6%
0.8%
1.1%
0.8%
0.5%
0.4%
0.2%
0.2%
0.3%
0.0%
-0.3%
0.6%
0.4%
1.2%
Net
Dividends
6.0%
5.3%
4.2%
3.5%
3.9%
3.8%
5.3%
5.1%
3.7%
4.1%
3.9%
3.4%
2.6%
2.2%
2.0%
2.0%
2.5%
2.5%
2.5%
2.6%
2.9%
2.5%
2.3%
2.3%
2.4%
2.5%
2.5%
2.5%
2.4%
2.4%
2.5%
2.5%
2.5%
2.5%
2.7%
2.7%
2.5%
2.5%
2.5%
2.4%
2.3%
2.1%
2.1%
2.1%
2.1%
2.0%
Personal
Savings
8.0%
8.5%
5.4%
4.5%
6.0%
8.2%
9.5%
9.1%
6.6%
8.2%
8.9%
13.7%
22.2%
21.5%
21.2%
17.8%
11.3%
7.6%
9.6%
8.7%
10.4%
11.1%
11.2%
11.1%
10.9%
10.3%
11.4%
11.5%
11.9%
10.8%
10.6%
11.5%
11.1%
10.7%
11.3%
11.1%
10.8%
11.7%
10.9%
10.7%
12.3%
12.9%
11.9%
12.7%
12.8%
13.3%
Capital
Transfers
-0.2%
-0.3%
-0.3%
-0.3%
-0.3%
-0.5%
-0.6%
-0.5%
-0.6%
-0.5%
-0.5%
-0.4%
-0.4%
-0.3%
-0.3%
-0.4%
-0.4%
-0.4%
-0.4%
-0.3%
-0.3%
-0.3%
-0.3%
-0.3%
-0.3%
-0.3%
-0.4%
-0.4%
-0.4%
-0.3%
-0.1%
-0.2%
-0.1%
-0.2%
-0.2%
-0.2%
-0.2%
-0.3%
-0.4%
-0.3%
-0.4%
-0.4%
-0.4%
-0.6%
-0.6%
-0.3%
Stat.
Disc.
-0.4%
0.9%
0.5%
0.9%
0.6%
-0.3%
1.4%
-0.1%
0.8%
1.4%
1.1%
0.2%
-0.5%
-0.9%
1.1%
1.7%
0.5%
1.2%
-0.1%
0.6%
0.4%
1.0%
0.7%
1.0%
0.7%
0.5%
-0.5%
-0.1%
0.1%
0.0%
-0.3%
-0.2%
0.0%
-0.2%
0.0%
0.1%
0.6%
0.4%
0.3%
0.2%
0.5%
0.8%
0.6%
0.4%
0.5%
0.8%
Corp.
Profits
9.2%
6.3%
4.4%
9.4%
9.7%
10.0%
11.4%
11.1%
8.9%
11.4%
11.9%
12.5%
10.2%
9.0%
8.5%
7.6%
9.9%
11.4%
11.9%
10.7%
12.1%
10.1%
9.6%
9.8%
10.4%
11.6%
11.7%
11.3%
10.7%
11.4%
11.2%
11.1%
11.7%
12.0%
12.3%
13.0%
12.9%
12.5%
12.3%
11.8%
11.1%
11.5%
12.1%
13.0%
13.4%
12.5%
23
Date
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Net
Invest.
18.0%
19.8%
21.3%
22.0%
20.0%
20.4%
17.6%
17.7%
20.4%
19.1%
18.3%
18.7%
18.3%
18.0%
16.8%
15.2%
15.5%
16.1%
17.4%
17.4%
17.6%
18.4%
18.9%
19.5%
19.9%
18.1%
17.5%
17.7%
18.9%
19.5%
19.6%
18.5%
16.7%
13.0%
14.3%
14.7%
15.3%
15.9%
16.0%
Govt.
Borrowing
5.1%
3.9%
3.1%
2.6%
4.0%
3.5%
6.0%
6.7%
5.5%
5.7%
5.9%
4.9%
4.1%
4.0%
5.0%
5.7%
6.7%
5.9%
4.5%
4.2%
3.0%
1.6%
0.4%
0.0%
-0.8%
1.4%
4.8%
6.0%
5.5%
4.3%
3.1%
3.7%
7.2%
12.8%
12.2%
10.7%
9.3%
6.4%
6.1%
Foreign
Savings
0.4%
-0.5%
-0.5%
0.0%
0.3%
0.1%
-0.1%
-1.0%
-2.2%
-2.6%
-3.1%
-3.2%
-2.2%
-1.6%
-1.3%
0.1%
-0.7%
-1.1%
-1.6%
-1.4%
-1.4%
-1.5%
-2.2%
-3.0%
-4.0%
-3.7%
-4.1%
-4.5%
-5.1%
-5.6%
-5.7%
-4.9%
-4.6%
-2.6%
-3.0%
-2.9%
-2.7%
-2.3%
-2.5%
Net
Dividends
2.1%
2.1%
2.2%
2.2%
2.2%
2.3%
2.3%
2.3%
2.2%
2.2%
2.3%
2.3%
2.5%
2.8%
2.8%
2.9%
2.9%
3.0%
3.2%
3.4%
3.7%
3.9%
3.9%
3.6%
3.7%
3.5%
3.6%
3.8%
4.6%
4.4%
5.2%
5.7%
5.5%
3.9%
3.8%
4.5%
4.7%
5.4%
5.1%
Personal
Savings
11.7%
11.0%
11.0%
10.8%
11.7%
12.1%
12.7%
11.0%
11.7%
10.0%
9.8%
9.2%
9.6%
9.5%
9.5%
9.8%
10.3%
9.1%
8.3%
8.4%
8.0%
7.8%
8.2%
6.8%
6.7%
7.1%
7.8%
7.7%
7.7%
6.3%
7.0%
6.8%
8.3%
9.3%
8.7%
8.6%
8.4%
7.6%
7.7%
Capital
Transfers
-0.4%
-0.4%
-0.2%
-0.3%
-0.4%
-0.4%
-0.3%
-0.3%
-0.2%
-0.2%
-0.2%
-0.1%
-0.1%
-0.1%
-0.1%
-0.1%
-0.1%
-0.2%
-0.2%
-0.3%
-0.3%
-0.3%
-0.3%
-0.3%
-0.3%
-0.3%
-0.2%
0.0%
0.0%
0.1%
-0.1%
0.0%
0.3%
0.8%
0.4%
0.3%
0.1%
0.0%
0.0%
Stat.
Disc.
1.1%
0.9%
1.0%
1.7%
1.5%
1.1%
0.2%
1.5%
1.0%
1.2%
1.7%
0.8%
0.0%
1.1%
1.5%
1.4%
1.7%
2.2%
1.9%
1.2%
0.7%
0.1%
-0.7%
-0.3%
-0.9%
-1.0%
-0.6%
-0.1%
-0.1%
-0.3%
-1.6%
0.1%
0.7%
0.5%
0.3%
-0.3%
-0.1%
-0.8%
-0.6%
Corp.
Profits
13.2%
13.8%
14.3%
14.5%
13.6%
13.5%
13.3%
13.5%
13.5%
13.4%
12.1%
12.8%
13.2%
12.6%
12.4%
12.8%
12.6%
12.7%
13.6%
14.3%
14.6%
14.9%
13.9%
14.0%
13.4%
13.5%
14.8%
15.3%
16.3%
16.4%
16.9%
16.0%
15.4%
16.5%
17.9%
18.4%
18.2%
18.5%
17.7%
From the above charts, we can see that from 1930 to 1960, corporate profits as a percent of GDP
peaked at 12.5%. During the 1960s; the measure peaked at 13.0%; during the 70s and 80s the measure
peaked at 14.5%; during the 90s the measure peaked at 14.9%; during the first decade in 2000, the measure
peaked at 16.9%; and since then, the annual measure recently reached another annual peak in 2012 at
18.1%. It is also evident that the greatest historical contributors to the increases in corporate earnings
24
relative to GDP have been higher government debt and lower personal savings. These changeshigher
government debt and lower personal savingsare typically considered negatives, not positives, for longerterm fundamentals, and suggest that such earnings trends relative to GDP are not sustainable over the long
term. At least part of this long term shift can be attributable to changing global dynamics. Given that savings
investment, our relatively closed economy during the roughly initial two thirds of the twentieth century
had historically promoted more of a balance in these factors. An example of this is during World War II,
when the greatly higher levels of government debt were largely balanced by the higher levels of savings.
However, greater openness in the global economy in the past few decades has facilitated the expansion of
government and personal debt, even while reducing savings and investments, and thus increased earnings
relative to GDP. These changes over the past few years heighten the importance of using Kaleckis profit
equation, and MV/GDP, to highlight the extent to which earnings have increased well beyond their norms
by unsustainable factors. Furthermore, in terms of our model, it appears that, historically, investors were
not aware of, or did not appropriately consider, the extent to which earnings were elevated by unsustainable
factors, and have tended to overpay/underpay for markets when earnings are relatively higher/lower to
GDP. This is supported by the earlier example of the sign change, discussed in section 3.4., of the 10-Year
PE coefficient when adjusted by MV/GDP, and further supported by the following variable:
Corp. Profits10/GDP (5 Year Avg.) * Market Value/GDP
With an 2 of 0.40, not only is the product of the above variables more effective on a standalone
basis than the 10-Year PE method, but it is able to measure the extent to which investors tend to improperly
value earnings relative to GDP. The negative coefficient of this variable indicates that, even with a fixed
market value relative to GDP, higher earnings lead to lower market returns. This process also provides
statistical support of the concept of macro earnings negativity, discussed in Section 4.2. While this
25
argument further supports the use of MV/GDP as a valuation measure, the following clarifies a theoretical
identity between the MV/GDP ratio and a P/E (price/normalized earnings) ratio.
Figure 6, below, shows, on a relative scale, the simple ratio of market value divided by earnings, as
derived from Kaleckis profits equation. The resulting measure tracks relatively closely with the other,
traditional, valuation indicators.11
Figure 6:
Comparison of MV/Earnings vs. Popular Measures

2.30
Relative Market Value/Earnings
1.80
Relative Tobin's q
Relative P/E10
1.30
0.80
1954
1955
1957
1958
1960
1961
1963
1964
1966
1967
1969
1970
1972
1973
1975
1976
1978
1979
1981
1982
1984
1985
1987
1988
1990
1991
1993
1994
1996
1997
1999
2000
2002
2003
2005
2006
2008
2009
2011
2012
2014
2015
0.30
However, the above earnings have not been adjusted for the degree to which they have been driven
by unsustainable components in Kaleckis profit equation. Basing the components to historical norms
makes adjustments to the components straightforward, making it evident that, market valuation levels being
equal, earnings which are higher/lower relative to GDP suggest lower/higher future market returns.
Therefore, it becomes evident that historical normal levels of earnings relative to GDP indicate normal
or average future market returns. As such, adjusting earnings by the extent to which they are higher/lower
relative to historical GDP averages would yield a more effective price/earnings (P/E) indicator.
Furthermore, the resulting steps yield a logical and interesting conclusion. When taking the market value
and dividing it by the historical norm of earnings relative to GDPsuch as Market Value/12.4% of GDP
as the appropriate measure of the components of Kaleckis profits equation, then adjusting that formula to
historic norms results in normalized earnings being a consistent ratio of GDP. Depending on the
26
timeframe being utilized, this ratio will likely vary, just as historical norms of P/E10 or Tobins q vary.
However, given that we have determined that normalized earnings would be a percentage of GDP, then
whatever that percentage of GDP is, the ratio of MV/GDP is a consistent multiple of that ratio, and, thus,
MV/GDP represents a simpler equivalent. As such, when plotted on a relative scale, the chart of
normalized earnings is equivalent to that of Market Value/GDP, a ratio which is simply a consistent
multiple of normalized earnings. Therefore, the MV/GDP ratio has, ironically, better theoretical
justification as a price/sustained-earnings indicator than do traditional earnings-based measures. This
valuation measure, seen in black in Figure 7, below, has also been, historically, a much more effective
forecaster of future real equity returns.
Figure 7:
Comparison of MV/GDP vs. Popular Measures

2.30
Relative Market Value/Earnings

Relative Tobin's q
1.80
Relative P/E10
Relative Market Value/GDP
1.30
0.80
1954
1955
1957
1958
1960
1961
1963
1964
1966
1967
1969
1970
1972
1973
1975
1976
1978
1979
1981
1982
1984
1985
1987
1988
1990
1991
1993
1994
1996
1997
1999
2000
2002
2003
2005
2006
2008
2009
2011
2012
2014
2015
0.30
What becomes increasingly obvious in Figure 7, above, is the growing disparity over the past 15
years between MV/GDP and the other measures. This is due to the fact that the corporate profits/GDP ratio
has averaged 17.3% over the past decade, vs. 13.6% in the 1990s, 13.2% in the 1980s, 12.9% in the 1970s,
12.1% in the 1960s, 10.9% in the 1950s, and 10.4% in the 1940s. Therefore, the evidence that MV/GDP
is a better indicatorboth theoretically and statisticallyof future real equity returns, and the fact that the
ratio is near its greatest disparity ever relative to traditional ratios, should raise investors attention.
27
Furthermore, excluding the bubble periods since 1995, this ratio suggests that markets are currently about
50% more overvalued than during its earlier peak in the late 1960s, a time which preceded flat real equity
returns over the following 15 years.
With an R2 of 0.52 , the historical ability of MV/GDP to forecast future real equity returns has also
easily exceeded that of the other traditional valuation metrics. Furthermore, with a steady denominator and
a numerator that can be easily adjusted with the current market value, it is even simpler to calculate.
4.5.
Market Value/GDP and Price/Sales:

Generally, calculating GDP includes the changes in inventory. For example, if companies
manufactured more than consumers purchased, the excess manufactured would still contribute to
inventories, the latter reduction of which would reduce future GDP. Likewise, the reduction of inventories
means that consumers purchased more than was produced, and this portion of consumer purchasing was
not reflected in GDP. Therefore, our calculation of GDP adjusts for the changes in private inventories to
derive a more appropriate measure of GDP. This adjustment to GDP is a good introduction to the price/sales
ratio, because adjusting GDP adjusted for changes in private inventories brings the measure closer to Real
Final Sales. As such, MV/GDP is sometimes compared to the price/sales measure. There is some
justification for the comparison; however, it is reasonable to think that, looking at Kaleckis profit identity,
that the profit factors are also likely to influence profit margins, and not just sales. Also, a major difficulty
in valuing the S&P 500 by a price/sales measure is the insufficient length and accuracy of the data; therefore,
statistically supporting the price/sales metric is also more difficult.
4.6.
Additional Implications
The issues discussed above bring up other important implications and considerations, although they
are not necessary for the primary issues in this research. For example, it is worth noting that the components
of GDPinflation, population growth, and productivityare not directly affected by earnings; additional
28
evidence that earnings may not be the most effective denominator to prices as an indicator of valuation or
future returns. Furthermore, one may assume that 1), real long-term equity returns are not affected by
inflation, and 2), population growth would likely produce a proportional increase in the number of
companies (for example: the uniting of two identical countries would result in doubling the population and
GDP of the newly formed country, but the market value/GDP would unlikely change). Given these
assumptions, it is interesting to note that the primary determinants of long term total real equity returns are,
therefore, dividends and productivity. Also note that productivity, though important to GDP, does not have
to result in higher earnings, a fact which provides further support of our argument that reported earnings
are not as good as GDP as an indicator of stock-market valuations. Another important and interesting
implication of our use of Kaleckis profits equation is that, on a macroeconomic perspective, earnings are
not so much produced by corporations collectively as they are allocated to corporations as a whole as the
result of corporate, government, and personal spending decisions. Although the collective activities of
corporations can influence GDP, and thus have an influence on earnings at the macro level, individual
corporations largely compete for as large a share as possible of a relatively predetermined level of macro
earnings. In brief, macro-level earnings are a pie, the size of which is largely determined by the factors in
Kaleckis profit equation, and each individual corporation is competing for as large of a slice of this pie as
they can get. This understanding of earnings provides further evidence that macro earnings have not have
been as greatly boosted by widespread cost-cutting and lower rates, as is often argued, but largely by the
higher levels, relative to GDP, of personal and government debt.
Furthermore, while we often note how high debt levels are affecting corporate earnings, the scope
of this research is insufficient to make a judgment on the appropriateness of these levels. Likewise, the
following discussion on the global debt imbalances does not influence the validity of our arguments, but
does reveal the importance of the debt issues we are highlighting, and that these imbalances are also at or
near historic levels globally. As such, the following discussion emphasizes the importance of our issue.
29
The Relationship of Government Debt to GDP Growth

If the practical limits of personal and government debt are well above current levels, then there is plenty
of time for further increases in debt. However, the issue is widely debated. It is import to understand the effects
and potential limits of government debt, as the impacts of debt on Kaleckis profits equation are substantial. The
subject of the appropriate level of government debt has been well examined. While some, such as Paul Krugman
(2012), minimize the importance of debt relative to other issues, Checherita and Rother, 2010, investigated the
average effect of government debt on per-capita GDP growth in 12 Euro-area countries over a four-decade period
beginning in 1970. Their research
finds a non-linear impact of debt on growth with a turning pointbeyond which the government debt-to-GDP
ratio has a deleterious impact on long-term growthat about 90-100% of GDP. Confidence intervals for the debt
turning point suggest that the negative growth effect of high debt may start already from levels of around 70-80%
of GDP, which calls for even more prudent indebtedness policies. At the same time, there is evidence that the
annual change of the public debt ratio and the budget deficit-to-GDP ratio are negatively and linearly associated
with per-capita GDP growth. The channels through which government debt (level or change) is found to have an
impact on the economic growth rate are: (i) private saving; (ii) public investment; (iii) total factor productivity
(TFP) and (iv) sovereign long-term nominal and real interest rates.12
The first two of their channels through which government debt (level or change) is found to have an impact on
the economic growth rate play an integral role in Kaleckis profits equation, the third features productivity, a
major factor in GDP, and the fourth, interest rates, has been found in prior research to strongly influence future
equity returns. (Though interest rates are an effective (negative) indicator of future equity returns, their correlation
with demographic measures, discussed later, largely eliminated their effectiveness in our composite model.)
In their updated (corrected for earlier errors) studywhich also reviews other research on the topic
Reinhart, Reinhart, and Rogoff (2012) researched the periods since the early 1800s in which advanced economies
endured public debt/GDP levels exceeding 90% for at least five years. They found:
the cumulative effects can be quite dramatic. Over the twenty-six public debt overhang episodes we
consider, encompassing the preponderance of such episodes in advance economies since 1800, growth averages
1.2% less than in other periods. That is, debt levels above 90% are associated with an average growth rate of
2.3% (median 2.1%) versus 3.5% in lower debt periods. Notably, the average duration of debt overhang episodes
was 23 years, implying a massive cumulative output loss. Indeed, by the end of the median episode, the level of
output is nearly a quarter below that predicted by the trend in lower-debt periods. This long duration also
suggests the association of debt and growth is not just a cyclical phenomenon.
30
Reinhart and Rogoff (2010), also point out:

For example, war debts are arguably less problematic for future growth and inflation than are large debts
accumulated in peacetime. Postwar growth tends to be high as wartime allocation of manpower and resources
funnels to the civilian economy. Moreover, high wartime government spending, typically the cause of the debt
buildup, comes to a natural close as peace returns. In contrast, a peacetime debt explosion often reflects unstable
political economy dynamics that can persist for very long periods.Reinhart and Rogoff (2010)
In the post war period, they found that average GDP growth for those countries with public debt less than
30% was 4.2%; 30% - 60%, 3.0%; 60% - 90%, 2.5%; >90%, 1.0%. Government debt levels for 2013, as estimated
the IMF13, are: Austria, 74%; Belgium, 100%; Canada, 86%; France, 90%; Germany, 82%; Greece, 159%;
Ireland, 117%; Italy, 127%; Japan, 238%; Singapore, 111%; Spain, 84%; UK, 90%; US, 107%.
While commenting on the current global situation, they also note that:
The scope and magnitude of the debt overhang public, private, domestic and external facing the advanced
economies as a group is in many dimensions without precedent. As such, it seems likely that our historical
estimates of the association between high public debt and slow growth might, if anything, be understated when
applied to projections going forward.
Moreover, the rise in global private debt appears to have been too recent to research long-term impacts;
however, its increase has been dramatic.
Figure 8:
Total (Public & Private) External Debt, % of GDP:
(22 Advanced and 25 Emerging Market Economies, 1970-2011)
1970 1975 1980 1985 1990 1995 2000 2005 2010
Contrary to popular views, the world has not started to delever. Furthermore, although our research focuses
on the United States, much of it applies globally.
31
5.
Expanding MV/GDP into A Composite Model

The process of determining the merits of the MV/GDP ratio to forecast equity market returns
introduced us to additional forecasting metrics. The scarcity of composite models was surprising,
especially given the wide variety and number of individual variables used to value and forecast the
market. Therefore, after establishing the merits of MV/GDP as a predictor of equity returns, we
considered other variablesboth original and from prior researchto combine with MV/GDP to form a
composite model. The realization of the negativity of macro earnings, as explained above, suggested
that there are other macro forces important in forecasting normalized earnings and future equity returns.
Although our research into earnings and Kaleckis profit equation reveals that individual corporations
play a smaller role in macro profits than originally thought, corporations as a whole do play important
roles in wages and salaries, and, thus, personal spending. Importantly, personal income is surprisingly
negatively correlated to corporate earnings (Laramie, 2007) and, as such, the two personal income
variables we identified are not only effective forecasters of future equity returns, but are uncorrelated
with the Market Value/GDP variable described above. As a result, they become highly complementary
to the Market Value/GDP variable when constructing our composite model. To our knowledge, neither
of these variables14 has been used before as a means to forecast future equity returns.
Our development of a composite model also led to the identification of two variables which,
although not popularly used, have been researched extensively, and they effectively incorporate
productivity, profitability, and other cyclical measures. The first is a measure of demographics, which
research has linked to market valuations, spending, and productivity (and thus GDP). The second is Real
10-year Historical GDP Growth, which prior research has found to be negatively correlated to future real
equity returns. Our method of combining the demographic variable with Market Value/GDP appears to
be unique; however, the demographic and historical GDP growth variables had been extensively
developed and analyzed by others in prior research.
32
5.1.
Demographics
By far, the most powerful addition to the composite model is the demographic measure. The post-
World War II years between 1946 and 1964 saw a large rise in births. This baby boom generation has had,
and will continue to have, a large impact on the U.S. economy. The boomers earnings and investing
powers began to escalate in the early 1980s, and probably peaked in the early years of the 21st century. If
that is the case, historical evidence suggests that their retirement years would likely bring about a selloff
of their assets, and thus depress equity values.
Much has been written on the influences of demographics on stock prices. Good summaries and
other noteworthy research into the topic can be found in Young (2002), Bosworth, Bryant, and Burtless
(2004), and Arnott and Chaves (2012). Furthermore, the major global economies are, as a whole, also
aging quite rapidly, as indicated by the following data:
Figure 9: Global Aging Population Aged 65 and over (%):

GDPRank
1
2
3
4
5
6
7
8
9
10
Country:
United States
China
Japan
Germany
France
United Kingdom
Brazil
Italy
India
Canada
1950
8.3%
4.5%
4.9%
9.6%
11.4%
10.8%
3.0%
8.1%
3.1%
7.7%
2000
12.4%
6.9%
17.2%
16.3%
16.0%
15.8%
5.5%
18.3%
4.4%
12.5%
2050
21.4%
23.9%
36.5%
32.7%
25.5%
24.7%
22.5%
33.0%
12.7%
24.7%
2100
26.7%
28.2%
35.7%
34.2%
30.0%
29.6%
32.6%
32.9%
23.9%
29.5%
Source: Population Division of the Department of Economic and Social Affairs of the United Nations
Secretariat, World Population Prospects: The 2012 Revision, http://esa.un.org/unpd/wpp/index.htm
Despite disparities in views on the degree of the impact and in how demographic environments
should be quantified, it is generally, if not unanimously, accepted that demographic forces have stimulated
economic and stock market activity over the past 100 years, and will likely provide economic headwinds
over the next 50. Our model largely originated from research by Liu and Spiegel (2011), which uses a
33
ratio of those aged 40-49 divided by those aged 60-6915. Their study identifies the ratio as a good indicator
of the markets current P/E ratio (Note: this is further evidence the market considers P/E as the standard
valuation metric). After the introduction of an error correction model, they find that the actual P/E ratio
should decline from about 15 in 2010 to about 8.3 in 2025 before recovering to about 9 in 2030.16
Figure 10: Actual vs. Model Generated Market P/E Ratios:
Source: FRBSF Economic Letter, August 22, 2011

The above chart shows the actual and model-generated estimated P/Es. To forecast stock prices,
Liu and Spiegel then assumed 3.4% annual real earnings gains going forward and found that real stock
prices are not expected to return to their 2010 level until 2027.17 To clarify, their analysis of a
demographic variable was not used in this research; however, our research did follow their methodology
of creating a demographic variable for use in a composite model.
As explained above, P/E ratios are not as appropriate as MV/GDP, which we used instead of the
P/E metric. Most importantly, though, it is evident that demographics do play important roles in market
valuations. Liu and Spiegel found the ratio of those aged 40-49 divided by those aged 60-69 to be a good
indicator of current stock market valuation ratios. Our development of a variable to help forecast returns
10 years in the future logically found the ratios of younger groups, those 55-64 divided by those 35-44, to
best complement our MV/GDP variable to forecast 10-year forward returns. Furthermore, because the
34
demographic ratio interacts with both the numerator (Market Value) and the denominator (GDP) of the
MV/GDP variable, it is most appropriate, statistically, to link the two variables together, and to use the
log of the product of the MV/GDP and demographic variables to linearize the multiplicative relationship.
Therefore, though the demographic variable has been well researched before, to our knowledge, this
method of applying demographics in a forecasting model is original. The resulting enhanced variable is:
Figure 11: Combined MV/GDP and Demographic Variable

7
18
17
Log (Market Value /GDP *(# aged 55-64) /(# aged 35-44) )
Adj R2
.86
t Stat
-62.0
Clearly this represents a substantial and significant statistical improvement, at least from an historical
perspective, in forecasting future equity market returns. Additional variables will provide further
improvements. Although the contribution of the additional variables may not first appear to be significant,
they have a combined adjusted R2 of .47, and they reduce the remaining unexplained volatility of the
composite model by over 25% (by increasing the R2 from .86 to .90).
5.2.
The Other Earnings: Bringing it Home and Making it Personal

Even if earnings may not be produced by corporations as a whole as much as they are allocated to
them, corporations do play an important role in personal income and personal spending. Moreover,
personal income and personal spending are roughly six times the size of combined corporate earnings, are
the leading source of all revenues, are the primary basis of all investments, and are a major corporate
expense. Furthermore, personal income and personal spending are important factors behind productivity,
a key factor behind long-term equity returns. Two of our added variables incorporate personal income.
Specifically, these factors are:
1. Personal Income19/Book20 and
2. Change in Personal Consumption21/Personal Income10
35
Importantly, these variables are little correlated with the MV/GDP variable described above. As a
result, they become highly effective additions to MV/GDP when constructing our composite model.
An interpretation of what these variables reflect may be of benefit. At least two dynamics appear to
be at work. One, the low personal income/book variable indicates a condition when costs for the macro
corporate economy, relative to its tangible value, are low. This is logically a beneficial situation for the
economy, and historical analysis supports the ability of the PI/Book variable to forecast future real GDP
growth. Regressed to future real GDP growth, Personal Income/Book is negatively correlated, with a t
statistic of -11.0.
While this low-cost situation represented by the Personal Income/Book has been shown to be
beneficial for the economy, the Change in Personal Consumption/Personal Income indicator appears to
be a different type of stimulus. Furthermore, although the stimulus it creates could influence the economy
directly, the evidence that it influences future GDP growth is mixed, and it perhaps leads or is correlated
to the investment attitudes and activities of individual investors. As a group, individual investors have,
historically, tended to not invest according to fundamentals, but to invest and spend more heavily during
times of greater confidence, and to divest and reduce spending during times of less confidence. To our
knowledge, neither of these personal income variables22 has been used before as a means to forecast future
equity returns.
5.3.
Real 10-Year Historical GDP Growth

Historical GDP growth is a metric well supported by prior research as an effective predictor of
equity returns, and is also complementary to our composite model. Like the earlier added variables, it
appears to describe cycles that vary from that of our ten-year model. Historical GDP growth has been
negatively correlated with future equity returns (Chen, 1991; Ritter, 2005). While historical GDP growth
does not appear to be a good indicator of future GDP growth, it does seem to be correlated with investment
and economic cycles; i.e. high historical growth suggests poor real returns going forward. Potential
36
reasons for this include assumptions that recent GDP growth will continue at historical rates and/or that
investor confidence, especially by individual investors, is correlated with GDP growth. Unusually
high/low recent GDP growth typically brings about excessive optimism/pessimism by investors, and
reality later leads to a correction, perhaps excessively so, in perceptions of consumers and/or investors.
6. Composite Model Results

Our demographically adjusted and market adjusted (DAMA) composite model, which combines
all the variables discussed above, has historically been much better than traditional models at forecasting
10-year forward real equity returns. The statistics of the DAMA model are as follows:
Figure 12:
Breakdown of DAMAs Forecast
(Based on data available on 2/06/2015, when the S&P 500 closed at 2055.)
DAMA Composite Model:
Adj. R2
.90
Multiple R
.95
Components:
t Stat
Intercept (I):
2.3
Personal Income12/Book13 (PI/B):
-11.7
Personal Consumption14/Personal Income12(PC/PI):
14.3
7
6
16
Log MV /GDP *Demographics O/M Ratio :
-53.4
MV/GDP Factor:
Demographic Factor:
Real GDP 10-Year Prior Growth (RGDP):
- 5.7
= 0.0195 -0.0888*PI/B
+0.7629*PC/PI
= 0.0195 -0.0888*(0.7460) +0.7629*(-0.0023)
= 1.95% -6.62%
-0.18%
Contribution
Relative to 4.43%
Composite Avg.
0.00%
0.77%
- 0.31%
-14.97%
-10.02%
-4.95%
0.68%
-13.82%
-0.3481*Log MV/GDP*O/M
-0.4725*RGDP
-0.3481*Log((1.2899)*(.9888)) -0.4725*(0.0183)
-3.68%
-0.86%
= -9.39%
In Figure 13, below, we compare the markets actual real 10-year-forward total returns to the
forecasts created by the DAMA model, the Market Value/GDP measure, Tobins q, and the 10-year P/E,
or CAPE, variable.
37
Figure 13:
DAMAs Performance & Forecast vs. Other Valuation Measures:
P/E10:
Tobins q:
Market Value/GDP:
DAMA:
Adj. R2
.38
.49
.52
.90
Mean
Avg. Error
3.4%
3.2%
3.0%
1.3%
Current
Forecast*
2.5%
-0.1%
-4.7%
-9.4%
2025 S&P
Target**
2785
2010
1305
765
*Based on data available as of 2/06/2015, when the S&P 500 closed at 2055. Projected average annual real returns.
**Calculations are based on the assumption that the impacts of dividends and inflation offset each other.
Figure 14:
Comparison of Predicted vs. Actual Performance of DAMA and
Other Common Metrics
13.0%
8.0%
3.0%
-2.0%
-7.0%
P/E10
MV/GDP
DAMA
Actual
Tobin's q
1954
1955
1957
1958
1960
1961
1963
1965
1966
1968
1969
1971
1973
1974
1976
1977
1979
1980
1982
1984
1985
1987
1988
1990
1992
1993
1995
1996
1998
1999
2001
2003
2004
2006
2007
2009
2011
2012
2014
2015
-12.0%
In Figure 14, above, DAMAs projections of 10-year-forward real total annual returns have
historically averaged 4.4% and ranged from -10.1% to 15.1%, making DAMAs current projection for
annual real declines of 9.4% near its most bearish level in history. Worth noting is that the forecasts of
simple valuation measures, like P/E10, Tobins q, and MV/GDP, largely rely on reversion to the mean;
however, such forecasts have, historically, underestimated the tendency for reversions to continue well
38
past the mean. DAMAs greater accuracy is partly due the influence of the demographic and consumer
trends we highlighted earlier. Of course the large cycles in the past may not repeat, but, historically,
reversions from extreme high or low levels have tended to revert to levels significantly beyond the mean.
Typically, the peak-to-trough cycles have taken up to 15 years. It is too soon to tell if the stimulative
monetary policies over the past decade will succeed in breaking this current cycle or just delay it, but
DAMA suggests that there is significant downside to come. The peak valuation levels reached in 2000
substantially exceeded the prior peaks in the later 1960s and even 1929, as suggested by comparisons to
older, simpler, market valuation yardsticks, as evident in Figure 15, below. It would be unusual for the
bottom of the 2000 peak to be the quick and short a reversion to historical norms the market experienced
in early 2009.
Figure 15:
Historical S&P, Inflation Adjusted
1000
100
1871
1874
1878
1882
1886
1890
1894
1897
1901
1905
1909
1913
1917
1920
1924
1928
1932
1936
1940
1943
1947
1951
1955
1959
1963
1966
1970
1974
1978
1982
1986
1989
1993
1997
2001
2005
2009
2012
2016
2020
2024
10
39
If one assumes that the impact of inflation on real returns over the next 10 years is offset by the
impact of dividends, DAMAs projections would position the S&P near 765 in 2025. This forecast initially
appears quite dire; however, as indicated in Figure 15, above, this level would still be well above the 2025
level of historical bear-market bottoms (of about 570).
6.1. Out-Of- Sample Results

As discussed in Part 1, Goyal and Welch (2007) established out-of-sample (OOS) testing as a
benchmark for evaluating the predictability of market forecasting variables, and found that the models
they tested (again, they did not consider MV/GDP, and DAMA was not available then) would not have
helped an investor with access only to available information to profitably time the market. With the
exception DAMA, their conclusions were consistent with our out-of-sample test results:
Figure 16:
Out-of-Sample (OOS) Forecasts at Market Highs and Lows:
Date:
Sep-02
Aug-00
Oct-90
May-90
Nov-87
Aug-87
Jul-82
Nov-80
Feb-78
Dec-76
Sep-74
Dec-72
Most Accurate
Forecast
Actual
S&P
Return:
815
5.3%
1518
-4.1%
304
16.3%
361
14.1%
230
14.7%
330
10.0%
107
14.8%
140
8.2%
87
10.1%
107
6.6%
64
7.3%
118
-2.0%
2nd Most Accurate

Forecast
DAMA
5.5%
-6.5%
9.6%
7.3%
11.2%
5.7%
15.0%
7.9%
10.1%
5.6%
7.7%
-2.1%
40
MV/GDP
2.9%
-21.8%
9.7%
6.7%
10.5%
4.4%
17.0%
11.5%
15.5%
10.9%
14.4%
3.8%
Tobin's q
3.9%
-18.1%
8.4%
6.8%
5.4%
6.1%
16.5%
13.1%
13.7%
10.6%
13.3%
0.3%
PE-10
3.1%
-14.3%
6.6%
4.3%
8.1%
4.0%
19.2%
16.2%
19.0%
14.5%
18.1%
6.2%
Figure 17:
Cumulative Out-of-Sample (OOS) Results:
Adjusted R2
Avg. Abs. Error
DAMA
0.64
3.1%
MV/GDP
0.59
5.3%
Tobins q
0.54
6.0%
P/E10
0.41
7.0%
5.0%
Solution
nmf
4.9%
Although the models Goyal and Welch tested would not have helped an investor with access only
to available information to profitably time the market, it is not as clear what their evaluation of MV/GDP
would be, as our 5% benchmark and shorter testing period were not consistent with their methods.
However, the OOS results shown in Figures 16 and 17, above, position MV/GDP as the better individual
variable for forecasting real market returns, and that DAMA is, by far, the best overall model. Figure 16
shows specific OOS forecasts at market highs and lows since 1972. Figure 17 shows the cumulative results
of all OOS forecasts since December, 1972. DAMAs performance clearly stands out, and the results
appear to contradict Goyal and Welchs 2007 assertion. Furthermore, while it is speculative on our end,
the necessary shortness of the OOS test may not have provided DAMA enough time to fully evaluate the
demographic factor, which is quite long term. If so, DAMAs accuracy may even be understated by the
OOS testing process.
Overall, the out-of-sample tests confirm what we observed before with standard regression
analysis. Furthermore, the OOS testing shows that DAMA was not only the most accurate model
historically, but it was the most bullish and the most accurate model at the markets peak in August, 2000,
and was the most bullish and most accurate of the models at the markets recent low in September, 2002.
As such, DAMAs recent record bearish stance merits special attention.
41
7.
Conclusion
This work introduces four major issues. The first identifies a problem with using combined
corporate earnings as an indicator of broad corporate or economic success. With the use of Kaleckis
profits equation, we revealed limitations in using combined corporate earnings as an indicator of either
overall corporate or overall economic success. Given the current popular reliance on the sum of corporate
earnings as a measure of progress and success, and given the recent record extent to which current earnings
have been boosted by government and personal debt, this issue is both timely and important.
During the process of providing evidence against using combined corporate earnings as a valuation
measure or indicator of economic success, we developed theoretical support for our second major
argument: from both a theoretical and statistical perspective, MV/GDP is the optimal single valuation
measure of the broad equity market. In short, adjusting for non-sustainable earnings factors leads to what
we defined as normalized earnings. With the help of Kaleckis profits equation, and with the
understanding that the ideal gauge of a measures true weight is its percentage to GDP, we explain why
the normalized earnings measure is a fixed ratio of GDP. As such, we reveal how the MV/GDP measure
can be viewed as a fixed multiple of the normalized earnings variable, and thus as an easier and more
accurate indicator of normalized earnings.
The third important contribution of our work is that it supports and clarifies what could be
considered a corollary to Kaleckis profit identity, which links corporate profits with economic variables.
Our work clarifies the causal the nature behind Kaleckis identity and, by doing so, indicates that
individual companies are competing for a fixed level of earnings that have been largely determined by the
variables in Kaleckis formula. This contrasts with the generally held view that each company earns its
earnings, and that the sum of corporate earnings is produced by summing the contributions to earnings of
the individual companies.
42
Our fourth contribution is the development of DAMA, a composite model that appears to be much
more effective at forecasting real total equity market returns 10 years forward. The composite model is
based on MV/GDP as the best long-term fundamental indicator, and utilizes several other factors which
influence market valuations. Of the remaining variables in the model, the largest contribution comes from
the demographic measure. Although demographics have been researched before, our method of
incorporating the variable into a composite model is unique. Some of DAMAs other variables are also
unique, while some have been supported by outside research: however, their combination into a composite
model appears to be unique. The success of DAMA, as measured by both in-sample and out-of-sample
adjusted R2, is better than any other model we are aware of.
7.1.
Issues and Concerns

Even single-variable forecast models arouse questions regarding the extent to which future
correlations will match those in the past; therefore, the concerns surrounding a composite model are
potentially greater. Below is a summary of some of the weaknesses and strengths of the points and/or
variables we introduced. The points/variables are roughly ordered according to our degree of confidence
and estimated significance in each subject.
1. Disputing the use of macro corporate earnings as evidence of economic or broad corporate
strength: Though most will be surprised by the idea that macro corporate earnings, adjusted for GDP,
have little, and perhaps negative, correlation to corporate strength, the use of Kaleckis profits
equation makes the point quite conclusively. Kaleckis profits equation, and other supportive
evidence, reveals that macro corporate profits are largely due to economic factors, such as
government and personal debt, and not to the sum of the earnings of individual companies.
2. Using Total MV/for GDP as a market valuation yardstick. MV/GDP is not a new measure, but
linking it to normalized earnings clearly provides strong theoretical justification for its use as a
43
valuation measure. Although accurate calculations of Market Value and GDP are more difficult the
farther back one goes in time, the variable still has a long history, is theoretically sound, and has,
historically at least, been a much more accurate indicator of future real total equity returns than any
other metric. The model also implies an almost exclusive link, perhaps a subject of further research,
between real equity returns and economic productivity.
3. The use of a composite valuation model. It is surprisinggiven the extensive amount of research
on individual drivers of the equity marketthat more has not been done to combine previously
identified drivers of future market returns into a composite valuation model.
4.
Integration of Demographics into the Market Value/GDP Variable. This subject has also been
previously researched. Although it is widely agreed that demographics plays important roles both in
the economy and in equity market valuations, there is wide dispute on how to quantify the variable.
And, since demographic changes are slow, it is difficult, statistically, to determine the degree to which
the relationships are causal or coincidental. In Figure 10, for example, the relationship between
demographics and valuation ratios is high; however, given the low number of demographic cycles
perhaps twoit may be difficult to show the extent to which the relationship is causal or coincidental.
Our unique combination of a demographics variable with a market valuation variable is an important
contribution to obtaining the effectiveness of the composite model.
5. Real GDP 10-Year Growth. Given little correlation between GDP growth over the prior ten years
to GDP growth over the future 10 years, this measure appears to be primarily correlated to
investment cycles. The variable has been well supported in prior research (Chen, 1991; Ritter, 2005).
6. Creation of the Change of Personal Consumption/Personal Income Variable. To our
knowledge, this is the first use of this variable to forecast future equity market returns. Its
effectiveness appears to come from the economic growth that increases in personal income may
stimulate, and/or indications of the increased investment confidence by the general public that could
44
coincide with this variables change. A possible weakness of the variable is the potentially decreased
accuracy and relevance of the calculation of personal consumption and personal income the further
one goes back in time. This is particularly true with periods prior to the end of World War II, when
(going backwards in time) we had World War II, rationing, the Great Depression, World War I, and
a predominantly agrarian society with a much lower percentage of people on salaries or on time
clocks or invested in the stock market. Although the nearly 60-year history in our model does provide
strong support, relative to the above variables we have less, albeit still strong, confidence in the
indicators ability to forecast equity returns.
7. Creation of the Personal Income/Book Variable. This also appears to be the first introduction of
this variable to forecast equity returns. Intuitively, the variable appears to be able to indicate periods
when corporations can operate cheaply and/or is helpful in pointing out cycle bottoms. While the
variable appears to significantly benefit our models forecasting accuracy, its significance does not
appear to be quite as strong as our other variables, and it is affected by the same issues as our Change
in Personal Consumption/Personal Income variable.
8. The Potential Impact of Higher Debt on GDP. A strong benefit of the MV/GDP variable is that
the denominator, GDP, is able to capture the impact that debt and other factors in Kaleckis profit
identity on earnings. However, the GDP denominator is unlikely to be able to capture the impact
that debt, or the other Kalecki factors, have on GDP. The term fiscal multiplier refers to the impact
that higher government spending has on GDP. It is highly debated what the fiscal multiplier is, if it
even exists, the degree to which changes in government debt levels correlate to fiscal spending, and
the extent to which the concept may be applicable to personal spending and personal debt levels.
Our research does not address this issue; however, to the extent to which higher debt levels boost
GDP, adjustments to the MV/GDP denominator would likely result in an even more bearish forecast.
45
It should also be noted that there is much our research does not try to do. For example, though the
impact of higher debt on corporate earnings is often noted, there is no intent to express any view on what
level of debt, if any, is appropriate. Furthermore, there is no effort to go beyond the use of broad
macroeconomic variables to boost the model statistically or to maximize its performance from an
investment return perspective. In this vein, the approach has been consistent with that of Kalecki, who
said to approach the dynamic process in all its complexity is certainly a hopeless task.23 For example,
there are probably many variables that would improve the models forecast statistics or total returns:
momentum is the first which we can think of; however, we have chosen to restrict ourselves to broad
fundamental measures.
7.2.
Closing Comments
When we try to express our views on DAMAs quite dire projections, we cant help but recall
Shillers comments, referring to the likewise dire projections of his model in 2000, when he said:
Noting that the price-smoothed earnings ratio for January 2000 is a record 44.9, the
regression . . . . . . is predicting a catastrophic ten-year decline in the log real stock price. We do not
find this extreme forecast credible; when the independent variable has moved so far from the
historically observed range, we cannot trust a linear regression line.
Unfortunately, the passage of time has shown that his model performed more accurately than his
sentiments. Our hopes also more optimistic than DAMAs forecast; however, hopes do not alter statistical
significance, and we find DAMAs forecast credible. Furthermore, while the model is projecting its most
negative 10-year forecast ever, it has made similar forecasts in two prior periods, and those projections
were largely on target each time (see Figure 14), despite being at odds with traditional valuation measures.
Moreover, although DAMAs current projection may appear extreme, the projected outcome still leaves
market valuations above those of prior bear-market bottoms (see Figure 15). On the plus side, these types
46
of regression models tend to assume reversions to historical means, and that the factors used will have the
same impact in the future as they have in the past; however, many other factors could keep the market
from reaching DAMAs forecast. For example, further increases of debt, relative to GDP, could continue
to increase earnings and maintain the perception that the economy remains healthy. Or, the impacts of
demographic factors could be different from what they were in the past.
The global implications in this study also need to be emphasized. Not only are global markets
correlated, but the two major factors, other than market price, in our composite model are demographics
and debt levels. As is quickly evident in Figures 8 and 9, high global debt levels and unfavorable
demographic trends are factors that appear likely to also challenge other major global equity markets.
Of note, Minsky provides quite different but very complementary research which also covers our
primary issues: debt, earnings, and the relationship of debt and earnings to Kaleckis profit identity. While
Minskys work is not quantitative, it does suggest that higher levels of debt do tend to be correlated to
cycles associated with overconfidence and higher risk.
On a final note, this research may have other significant, albeit non-quantifiable, contributions. As
economists seek to ferret out relationships between GDP, tax policies, corporate earnings, personal
income, personal consumption, and demographics, etc., we anticipate that our work, which touches on all
of these issues, has increased the capabilities of the toolbox that economists have to work with.
47
Appendix: Deriving Corporate Profits from the National Income and Product Accounts (NIPA)
This table, and our use of Kaleckis Profit Equation in general, is based on Laramie and Mairs
(2008) Accounting for Changes in Corporate Profits: Implications for Tax Policy, but modified to take
into account recent tax revisions. Likewise, their method used was similar to that of Levy and Levy (1983),
but also modified to take into account tax revisions.
Appendix Table 1:
Variable Name
NIPA
Table
1.1.5
Line
1
Annual
GDPA
Quarter
GDP
+ Undistributed Corp. Profits w/IVA & CCAdj.

+ Corporate Consumption of Fixed Capital
+ Net Dividends
- Inventory Valuation Adjustment
= Corporate Profits
1.12
7.5
1.12
1.12
17
4
16
48
A127RC1A027NBEA
A438RC1A027NBEA
B056RC1A027NBEA
B058RC1A027NBEA
A127RC1Q027SBEA
CCFC
DIVIDEND
CIVA
+ Gross Private Domestic Investment

- Inventory Valuation Adjustment
= Gross Domestic Private Inv. - Inv. Val. Adj.
5.1
5.1
22
6
GPDIA
B058RC1A027NBEA
GPDI
CIVA
+ Gross Government Investment

- Government Consumption of Fixed Capital
+ Government Current Expenditure
- Government Current Receipts
+ Government Capital Transfer Payments
- Government Capital Transfer Receipts
+ Govt. Net Purchases of Non Produced Assets
= Government Net Borrowing
5.1
3.1
3.1
3.1
3.1
3.1
3.1
25
37
15
1
35
31
36
A782RC1A027NBEA
A264RC1A027NBEA
W022RC1A027NBEA
W021RC1A027NBEA
W069RC1A027NBEA
W067RC1A027NBEA
AD07RC1A027NBEA
A782RC1Q027SBEA
A264RC1Q027SBEA
GEXPND
GRECPT
W069RC1Q027SBEA
W067RC1Q027SBEA
AD07RC1Q027SBEA
+ Exports of Goods and Services

- Imports of Goods and Services
+ Income Receipts From the Rest of the World
- Income Payments to Rest of the World (ROW)
- Taxes and Transfer Payments To ROW
= Balance on Current Account, NIPAs
4.1
4.1
4.1
4.1
4.1
4.1
2
14
7
19
25
29
EXPGSA
IMPGSA
B645RC1A027NBEA
A655RC1A027NBEA
A123RC1A027NBEA
EXPGS
IMPGS
B645RC1Q027SBEA
A655RC1Q027SBEA
A123RC1Q027SBEA
NETFI
Net Dividends
1.12
16
B056RC1A027NBEA
DIVIDEND
+ Personal Savings
+ Non Corp. Bus. Consumption of Fixed
Capital
+ Household Consumption of Fixed Capital
= Non Corporate Savings
5.1
A071RC1A027NBEA
PSAVE
7.5
W277RC1A027NBEA
W277RC1Q027SBEA
7.5
18
W279RC1A027NBEA
W279RC1Q027SBEA
+ Government Capital Transfer Payments

- Government Capital Transfer Receipts
+ Govt. Net Purchases of Non Produced Assets
= Net Government Capital Transfers
3.1
3.1
3.1
35
31
36
W069RC1A027NBEA
W067RC1A027NBEA
AD07RC1A027NBEA
W069RC1Q027SBEA
W067RC1Q027SBEA
AD07RC1Q027SBEA
5.1
42
AO3ORC1AO27NBEA
AO3ORCIQ027SBEA
GDP
48
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Market Value: Z1 Flow of funds, Table B.1.02, Line 35. Item FL103164103.Q. 4-Month lag. Current, end-of-month,
estimates are calculated from the interim percentage changes in the S&P 500.
2
GDP: NIPA Table 1.1.5, Line 1. 4-Month lag. Our forecast variable adjusts GDP by the Change in private inventories,
NIPA Table 1.1.5, Line 14.
3
Warren Buffett and Carol Loomis, "Warren Buffett On The Stock Market", Fortune, December 10, 2001.
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Ilmanen, Antti, Expected Returns, An Investors Guide to Harvesting Market Rewards, pg. 33.
8
Historically, there has been an 80% correlation between Super Bowl winners from the National Football League (NFL) and
stock-market success, according to a February, 2008 Wall Street Journal article Patriots Lost Markets Win?
9
Real Price, Real 1-Year Earnings, Real 10-Year Earnings, Real 83-Year Earnings, and real 10-year total returns are
calculated from the data on Robert Shillers website. We changed his month-average S&P prices with month-end prices,
available from yahoo.com. Shillers data can be downloaded at: www.econ.yale.edu/~shiller/data/ie_data.xls
10
As determined by Kaleckis profits equation. See Appendix 1.
11
Tobins q is defined in Flow Of Funds Report, B.102, Line 39. At first, it appears that our earnings-based argument does
not apply to Tobins q. However, book value, the denominator of Tobins q, is heavily, and positively, influenced by
earnings, and is thus affected similarly. A good comparison between p/e and p/b measures can be seen on page 31 in
Fitzherbert (2007).
12
Checherita and Rother, (2010) page 4.
13
Public debt, International Monetary Fund, April 2013 World Economic Outlook Database, estimates for 2013.
14
With the possible exception of our use of book value in the Personal Income/Book variable. Tobins q also uses book value
as a denominator in its Market Value/Book variable; however, the use of book in that case is more as a valuation measure,
and not, as in our case, as an indicator of future GDP growth.
15
Data available at: www.frbsf.org/publications/economics/letter/2011/el2011-26.html
16
Liu and Spiegel, 2011, p.3.
17
Ibid, pp. 3-4.
18
Data available at: United Nations, Department of Economic and Social Affairs, Population Division (2011). World
Population Prospects: The 2010 Revision, CD-ROM Edition.
19
Personal Income: NIPA Table 2.1, Line 1. See Footnote 4.
20
Book Value of Equities: Z.1 Release, Table B.1.02, Line 32. Item FL102090005.Q. See Footnote 4.
21
((Personal Consumption-Personal Income, 1-Yr. Avg.) (Personal Consumption Personal Income, 10-Yr.
Avg.))/(Personal Consumption Personal Income, 10-Yr. Avg.). Personal Consumption: NIPA Table 2.1, Line 29. Personal
Income: NIPA Table 2.1, Line 1.
22
With the possible exception of our use of book value in the Personal Income/Book variable. Tobins q also uses book value
as a denominator in its Market Value/Book variable; however, the use of book in that case is more as a valuation measure,
and not as an indicator of future GDP growth.
23
Feiwel, 1975, P. 159.
55

Forecasting Equity Returns - An Analysis of Macro vs. Micro Earnings and An Introduction of A Composite Valuation Model

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Forecasting Equity Returns: An Analysis of Macro vs.

Micro Earnings & an Introduction of a Composite Model

Forecasting Equity Returns:

Stephen E. Jones, CFA*

Forecasting Equity Returns: An Analysis of Macro vs. Micro Earnings

Economic Combined with Technical: Huang and Zhou (2013);

Identification of a Forecasting Variable

2.2. Development of a Composite Model

3. Evidence of Differences Between Micro and Macro Markets

3.1. Earnings Impacts from a Transactions Perspective

3.2. Earnings Impacts from an Accounting Perspective

3.4. Comparing the P/Es Extended Earnings Period to MV/GDP

Correlation P/E Ratio, by Number of Years, to MV/GDP

Figure 2: Performance and Relationships of Metrics:

Regressed to ten-year future real total returns:

3.5. Using Multiple Years of Earnings to Value Individual Companies

4. What Are Earnings?

4.1. Where Do Earnings Come From?

4.a. Kaleckis Profits Equation:

Normalized Earnings, and the Negativity of Increases in Macro Earnings

Not Just an Identity

4.3.1. Intuitive Support

4.3.2. Support of Actual Results

Source: John Hussman, Weekly Market Comment, 6/17/2013

An in-depth statistical perspective is found in What Drives Profits? An Income-Spending Model,

Historical Profits, As a % of GDP

Figure 5: Corporate Profits as Percent of GDP:

Comparison of MV/Earnings vs. Popular Measures

Comparison of MV/GDP vs. Popular Measures

Relative Market Value/Earnings

Market Value/GDP and Price/Sales:

The Relationship of Government Debt to GDP Growth

Reinhart and Rogoff (2010), also point out:

1970 1975 1980 1985 1990 1995 2000 2005 2010

Expanding MV/GDP into A Composite Model

Figure 9: Global Aging Population Aged 65 and over (%):

Figure 10: Actual vs. Model Generated Market P/E Ratios:

Source: FRBSF Economic Letter, August 22, 2011

Figure 11: Combined MV/GDP and Demographic Variable

The Other Earnings: Bringing it Home and Making it Personal

Real 10-Year Historical GDP Growth

6. Composite Model Results

DAMA Composite Model:

Historical S&P, Inflation Adjusted

6.1. Out-Of- Sample Results

2nd Most Accurate

Issues and Concerns

+ Undistributed Corp. Profits w/IVA & CCAdj.

+ Gross Private Domestic Investment

+ Gross Government Investment

+ Exports of Goods and Services

+ Government Capital Transfer Payments

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