Update 201802 Short C

Macro vs.
Micro Earnings, “Macro-Earnings Negativity”, and an Introduction to a Composite Valuation Model
Macro vs. Micro Earnings, “Macro-Earnings Negativity”, and an

Introduction to a Composite Valuation Model
Stephen E. Jones, CFA*

February, 2019
Earnings of the overall market are typically viewed in the same perspective as earnings of
individual companies. Conflicts between these perceptions are revealed with the use of Kalecki’s profit
function to reveal the identification of negative characteristics with macro earnings, introduce the concept
of “macro-earnings negativity”, and demonstrate the theoretical and statistical superiority of MV/GDP
valuation measure versus earnings-based measures. Based on the MV/GDP metric, a multi-variable
forecasting model is developed which utilizes both new and prior-researched variables, the most effective
of which is a demographic measure. The resulting composite model is statistically superior to popular
metrics, and, relative to popular benchmarks, forecasts considerably lower returns for the coming decade.
*Stephen Jones, CFA, independent financial and economic analyst, 129 E. 62nd Street, New York, NY 10065, USA, Tel.:
917-442-9773, E-mail: stephenejones1960@gmail.com. Special thanks go to Professors Terence Agbeyegbe, Anthony
Laramie, Caleb Stroub, and other reviewers. The use of “we” and “our” is largely in recognition of their contributions;
however, this does not imply their agreement with the views herein, or that they hold any responsibility for errors.
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Macro vs. Micro Earnings, “Macro-Earnings Negativity”, and an Introduction to a Composite Valuation Model
Macro vs. Micro Earnings, “Macro-Earnings Negativity”, and an

Introduction of a Composite Valuation Model
1. The Questionable Use of Earnings as an Indicator of Stock Market Value

Earnings are generally considered a significant, if not primary, benefit of equity ownership. From
an individual company, or micro, perspective, such is typically the case. However, what is rarely
considered is that macro-level earnings, or earnings of the overall market, have a negative component.
Here, we seek to identify and explain this “macro-earnings negativity”.
Our identification and explanation of “macro-earnings negativity” focuses on the use of broad,
market-level earnings to value the equity market. Currently, the most popular equity market valuation
metric is P/E10 (sometimes called CAPE), a measure of the value of the stock market relative to its
earnings over the prior 10 years. The measure, created by Yale professor and Nobel-prize winner Robert
J. Shiller, gained popularity in 2000 by the publication of Shiller’s Irrational Exuberance, which proposed
the P/E10 measure. Also, well received was Andrew Smithers’ and Stephen Wright’s book Valuing Wall
Street, which supported “Tobin’s q”, a measure of the market’s 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,
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however, the most common is P/E10, the earnings-based measure. Despite evidence that Tobin’s q is
simpler and more effective (see, Harney, Tower, 2003), there is still a strong preference for P/E10’s
earnings-based measure. This preference appears to be due to the belief that earnings are the most
important factor behind owning 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 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. The Preference for Earnings-Based Measures

Despite efforts to identify methods to forecast equity returns, conspicuously uncommon is a variable
whose predictive abilities are much stronger than earnings-based measures: 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. The investment community has used MV/GDP, but rarely, despite Warren Buffet’s
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 available, but several analyses have pointed
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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/GDP’s 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 in
Vanguard’s 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 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. Respect for the measure has marginally improved since this paper was first
written in 2013.
Given MV/GDP’s strong forecasting ability, it is difficult to determine why it isn’t used more often.
Of course, one could justifiably argue that brokerages want to avoid the measure’s 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 measure’s 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 a significant 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. Many of these
arguments apply to Tobin’s q, whose popularity exceeds MV/GDP, but lags PE/10. Depending on the
time period used, and even on the version of government accounting used to define GDP and the overall
book market value of the equity market (the denominator in Tobin’s q), the relative effectiveness of the
two measures varies; however, MV/GDP is used here, as it is most suitability to support the justification
of “macro-earnings negativity"
.
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2.1. Verifying a Variable’s 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 ironically conclude—due to macro-earnings negativity—that, because it is not an
earnings based measure, 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 next expose 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. Kalecki’s 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 to derive a more fundamental or permanent measure of earnings. An
adjustment process is then introduced which normalizes the factors in Kalecki’s identity based on
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 Kalecki’s 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 forecasting variables. The model is based on the MV/GDP metric, and is improved significantly
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with a unique inclusion 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’s
ability to forecast future real equity returns is 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 model’s 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 model’s current forecast is calling for market returns over the next 10 years to be
significantly lower than those of other models.
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
associating the significance of individual corporate (micro) earnings with the significance of macro
earnings, and explains how the theoretical justification behind P/E10’s 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 Shiller’s 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:
“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 from Graham and Dodd was taken from their analysis of individual securities; however,
Cambell and Shiller are using it to justify their approach to the overall market, and functions as theoretical
justification of their P/E10 measure. Interestingly, 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
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at forecasting future equity market returns. The 30-year measure explained 57% of the variance of ten-
year real forward returns; however, the ten-year moving average ratio only explained 40% of the variance.
The obvious inclination would be 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 Dodd’s methodology for valuing individual securities. Therefore,
without questioning the theoretical differences between earnings of an individual company and earnings
of the overall market, Campbell and Shiller’s model—along with most of the investment community—
values 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
very different, and in many ways even oppositional to, the earnings process of an individual company.
For example: If an individual company were to reduce redundant staff by 10%, that company’s costs
would generally fall by the amount of staff cuts, and earnings may well 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 overall market, 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 negative, results.
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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, 2015
+ Revenues 10,000
- Cost of Sale 4,500
= Gross Profit 5,500
- General & Admin. Expenses 3,000
= Net Profit 2,500
However, the derivation of earnings on the macro level is very different. Kalecki’s profit equation,
described in more detail later, recognizes the following identity:
+ Net Investment
+ Government Net Borrowing
– Foreign Savings (Current Account Balance)
+ Dividends
– Personal Savings
– 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). A deeper analysis of the tendency within economics to falsely reduce macroeconomics
to microeconomic processes is available in Debunking Economics, (Keen, 2011). Furthermore, one can
simply look at the factors of macro-level corporate profits and see the extent to which they are negatives.
Higher government debt, lower personal savings, and lower foreign savings are all major contributors to
corporate profits; however, these are all economic negatives.
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
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6, of Campbell and Shiller. However, considering the use of measures with different numbers of years
produces informative results. Given that 1871 is the oldest date—and the date Shiller starts with—for
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
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 Shiller’s 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 demonstrates why the derivation of P/E10’s 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 2 3 5 10 20 30 40 50 60 70 83
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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 ratio’s ability to forecast returns increases from 0.28 for one
year, to 0.36 for 10 years, to 0.44 for 83 years, when it approaches that of the MV/GDP ratio, of 0.42.
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 ratio’s 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:

Correlation to
Regressed to ten-year future real total returns: Adj. R2 MV/GDP t Stat.
Real Price9/Real One-Year Earnings9: .28 .58 -15.9
Real Price/Real 10-Year Earnings (P/E10)9: .36 .91 -19.2
Tobin’s q12: .46 .94 -23.7
Market Value1/GDP2: .42 1.00 -21.7
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 𝑅 2 of P/E10 to the adjusted 𝑅 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. Furthermore, one will 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 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.
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Another indication that P/E10’s 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 model’s 10-year forecasting
period. Compared to the MV/GDP standalone results, the adjusted 𝑅 2 of the composite indicator rises
marginally; 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
associated with deteriorating economic fundamentals, and that lower macro earnings relative to GDP are
associated with improving economic fundamentals. This is statistical support of our concept of “macro
earnings negativity”, which suggests that that environments in which macro earnings growth is faster than
GDP are negatively correlated with economic fundamentals. This concept will be explained later in more
detail.
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 Dodd’s 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 Dodd’s hypothesis, there is no support behind P/E10’s
assumption that a measure with multiple years of earnings results in a better valuation measure than does
one year of earnings. Therefore, not only is Graham and Dodd’s hypothesis about the valuation of
individual companies unjustly applied when it is used to support an indicator which values the overall
market, but the notion that more years of earnings help value an individual company is 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, as 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.
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4. What Are Earnings?

To clarify the relationship between GDP and earnings, we utilize Kalecki’s 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 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, there are widespread misconceptions of where profits come from and what
determines how much they are. Michal Kalecki’s development of his profit equation sheds light on these
issues.
Although practically unheard of by the general public, Kalecki’s profit equation is a long utilized
and well-regarded accounting identity which equates macro earnings with macroeconomic factors. There
is speculation that Kalecki’s profit equation was first discovered by Jerome Levy about a 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 model’s 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,
Kalecki’s 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.
Kalecki’s profits equation—an accounting identity, not a theory—shows 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. Again, Kalecki’s profits equation yields the following formula:
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4.a. Kalecki’s Profit’s Equation:

Corporate Profits  + Net Investment
(after taxes) – Government Net Borrowing
– Foreign Savings (Current Account Balance)
+ Dividends
– Personal Savings
– Statistical Discrepancy
An excellent source (and the initial basis for our derivation, in Appendix 1) which identifies and
quantifies the variables in Kalecki’s profits equation is Laramie and Mair’s (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, Kalecki’s
equation is used to forecast how recent or proposed events affect near-term earnings or economic cycles
and 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 Montier’s “What
Comes Up Must Come Down”, which utilizes Kalecki’s equation to explain a negative forward outlook
for profit margins and corporate profits.
Our use of Kalecki’s 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. One example would be
increases in macro-level earnings caused by increased government and/or personal debt levels. However,
neither 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, neither 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 a return to normal debt levels and the negative impact such a move would have
on future earnings. Regardless of how the market establishes equity valuation in the numerator, the ability
of P/E10 to forecast future equity returns is compromised because the denominator of P/E10 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.
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Utilizing Kalecki’s profit equation to identify and quantify these non-sustainable factors leads to the
development of “normalized” earnings and reveals a relationship between normalized earnings and GDP.
The development of “normalized” earnings will form the basis for theoretical justification of MV/GDP as
a better valuation variable, and show how fluctuations in earnings, relative to GDP, are fundamentally
negative.
4.2. Normalized Earnings, and the Negativity of Increases in Macro Earnings

We have just seen how and why fluctuations in the components of Kalecki’s profit equation—
most specifically government and consumer debt—produce unsustainable fluctuations in macro earnings.
Here, Kalecki’s profit’s 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 Kalecki’s 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,
using earnings-based valuation 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 Kalecki’s 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, and a negative
correlation between earnings changes and economic fundamentals.
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 other factors in Kalecki’s 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, an
increase in capital spending relative to GDP is typically considered an economic positive; however, from
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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 Kalecki’s 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, Kalecki’s profit equation can then
be used to explain the tendency for earnings, relative to GDP, to revert to historical norms. As the factors
in Kalecki’s equation naturally tend to revert to historical norms relative to GDP, we will show how
Kalecki’s 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 Kalecki’s profits
equation influence reported earnings, it is personal savings and net investment which are the largest
contributors to the equation.
4.3. Not Just an Identity

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

An intuitive argument that the factors in Kalecki’s 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 mean—all else being equal—increased 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 Kalecki’s equation would be for increased earnings to somehow cause
increased government and personal debt—a relationship that is difficult to envision. In What Goes Up
15
Must Come Down, James Montier (2012) also argued for causality for factors in Kalecki’s profits equation
when he said:
“This is, of course, an identity—a 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.
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:
16
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 Kalecki’s profit equation. However, even removing the issue of causality, there is
no doubt that earnings are still identified with the negatives in Kalecki’s profit equation.
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 Kalecki’s
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 Percent of GDP

12.0%
10.0%
8.0%
6.0%
4.0%
Average
2.0% Corporate Profits
0.0% 10--Year Average
-2.0%
1979
1991
1929
1932
1935
1937
1940
1942
1945
1948
1950
1953
1955
1958
1960
1963
1966
1968
1971
1973
1976
1981
1984
1986
1989
1994
1997
1999
2002
2004
2007
2010
2012
2015
2017
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 Kalecki’s profits equation.
17
Figure 5: Corporate Profits as Percent of GDP:

(Impact of Each Factor on Corporate Profits)
STD: 3.9% 3.2% 1.9% 1.3% 3.3% 0.9% 2.3%
Avg. 7.7% -2.9% 0.8% 3.6% 6.6% 0.4% 6.5%
Net Government Foreign Net Personal Statistical Corporate
Date
Investment Debt Saving Dividends Savings Discrepancy Profits
1929 9.3% -2.0% -0.8% 5.5% 3.8% 0.7% 9.1%
1930 4.9% -1.2% -0.8% 6.0% 3.6% -0.4% 7.3%
1931 0.1% 2.1% -0.3% 5.3% 3.6% 0.9% 3.2%
1932 -7.1% 2.0% -0.3% 4.2% -0.2% 0.5% -1.0%
1933 -6.5% 1.7% -0.3% 3.5% -0.5% 0.9% -1.2%
1934 -2.1% 2.2% -0.6% 3.9% 1.3% 0.6% 2.7%
1935 2.3% 1.8% 0.1% 3.8% 4.0% -0.3% 4.2%
1936 5.7% 1.8% 0.1% 5.3% 5.7% 1.4% 5.7%
1937 7.6% -1.7% -0.2% 5.1% 5.3% 0.0% 6.0%
1938 2.5% 0.1% -1.4% 3.7% 2.3% 0.8% 4.6%
1939 5.0% 1.0% -1.1% 4.1% 4.2% 1.4% 5.6%
1940 8.2% -0.6% -1.5% 3.9% 5.2% 1.1% 6.8%
1941 14.0% -1.7% -1.0% 3.4% 10.3% 0.2% 6.3%
1942 15.5% 6.2% 0.1% 2.6% 19.2% -0.5% 5.7%
1943 14.4% 7.9% 1.0% 2.2% 19.0% -0.9% 5.3%
1944 11.6% 12.6% 0.9% 2.0% 18.9% 1.1% 5.3%
1945 6.4% 13.6% 0.6% 2.0% 15.4% 1.7% 4.3%
1946 5.3% 3.2% -2.2% 2.5% 8.6% 0.5% 4.0%
1947 5.5% -1.0% -3.7% 2.6% 4.4% 1.2% 5.2%
1948 10.0% -0.4% -0.9% 2.6% 6.3% -0.1% 7.0%
1949 6.6% 2.9% -0.3% 2.7% 5.0% 0.6% 7.0%
1950 11.5% -0.7% 0.6% 3.0% 6.7% 0.4% 6.1%
1951 12.9% -1.8% -0.3% 2.5% 7.5% 1.0% 5.4%
1952 11.2% 0.1% -0.2% 2.4% 7.6% 0.7% 5.6%
1953 11.2% 0.5% 0.3% 2.4% 7.5% 1.0% 5.2%
1954 9.6% 1.5% -0.1% 2.5% 7.2% 0.7% 5.7%
1955 11.6% -0.4% -0.1% 2.5% 6.6% 0.5% 6.7%
1956 11.3% -1.0% -0.6% 2.6% 7.7% -0.4% 6.3%
1957 10.1% 0.0% -1.0% 2.6% 7.8% -0.1% 6.0%
1958 8.5% 2.3% -0.2% 2.5% 8.1% 0.1% 5.3%
1959 10.8% 0.3% 0.2% 2.6% 7.1% 0.0% 6.3%
1960 10.1% -0.5% -0.6% 2.6% 7.0% -0.2% 6.0%
1961 9.9% 0.4% -0.7% 2.6% 7.9% -0.2% 6.0%
1962 10.8% 0.4% -0.6% 2.6% 7.7% 0.0% 6.7%
1963 10.9% -0.2% -0.8% 2.7% 7.4% -0.2% 7.1%
1964 11.1% 0.4% -1.1% 2.9% 8.1% 0.0% 7.5%
1965 12.1% 0.3% -0.8% 2.9% 7.9% 0.1% 8.0%
1966 12.6% 0.3% -0.5% 2.7% 7.6% 0.6% 7.9%
1967 11.3% 1.8% -0.4% 2.7% 8.5% 0.4% 7.3%
1968 10.9% 1.1% -0.2% 2.8% 7.7% 0.3% 6.9%
1969 10.6% 0.2% -0.2% 2.7% 7.5% 0.2% 6.0%
1970 8.7% 3.1% -0.3% 2.6% 9.1% 0.5% 5.1%
1971 9.1% 4.5% 0.0% 2.4% 9.6% 0.8% 5.6%
1972 10.0% 3.4% 0.3% 2.4% 8.7% 0.6% 6.1%
1973 10.8% 2.3% -0.6% 2.4% 9.5% 0.4% 6.2%
1974 9.3% 2.8% -0.4% 2.5% 9.5% 0.5% 5.1%
1975 6.1% 6.5% -1.2% 2.3% 9.7% 0.8% 5.5%
18
Net Government Foreign Net Personal Statistical Corporate

Date
Investment Debt Saving Dividends Savings Discrepancy Profits
1976 8.2% 4.6% -0.4% 2.4% 8.2% 1.1% 6.1%
1977 9.6% 3.5% 0.5% 2.4% 7.5% 0.9% 6.6%
1978 10.9% 2.4% 0.5% 2.5% 7.4% 1.0% 6.8%
1979 10.9% 1.8% 0.0% 2.5% 7.1% 1.7% 6.4%
1980 8.3% 3.3% -0.3% 2.7% 7.8% 1.6% 5.2%
1981 9.1% 3.1% -0.1% 2.7% 8.3% 1.2% 5.5%
1982 6.0% 5.7% 0.1% 2.8% 8.8% 0.3% 5.3%
1983 6.8% 6.2% 1.0% 2.7% 7.3% 1.6% 5.9%
1984 10.3% 4.9% 2.2% 2.6% 8.2% 1.0% 6.4%
1985 9.4% 4.6% 2.6% 2.7% 6.6% 1.3% 6.3%
1986 8.8% 4.8% 3.1% 2.7% 6.3% 1.7% 5.1%
1987 8.6% 3.7% 3.2% 2.7% 5.7% 0.9% 5.2%
1988 7.8% 3.3% 2.2% 2.8% 6.1% 0.1% 5.5%
1989 7.7% 3.2% 1.6% 3.2% 6.0% 1.2% 5.1%
1990 6.6% 4.0% 1.3% 3.2% 6.1% 1.6% 5.0%
1991 5.0% 5.0% -0.1% 3.3% 6.4% 1.5% 5.4%
1992 5.4% 6.2% 0.7% 3.2% 7.0% 1.8% 5.3%
1993 5.8% 5.6% 1.2% 3.2% 5.8% 2.3% 5.4%
1994 6.8% 4.4% 1.6% 3.5% 5.0% 1.9% 6.2%
1995 6.6% 4.1% 1.4% 3.7% 5.1% 1.2% 6.7%
1996 7.1% 2.9% 1.4% 4.0% 4.7% 0.7% 7.2%
1997 8.0% 1.6% 1.5% 4.2% 4.6% 0.1% 7.5%
1998 8.5% 0.3% 2.3% 4.2% 4.9% -0.6% 6.5%
1999 8.9% -0.3% 2.9% 3.9% 3.6% -0.3% 6.3%
2000 8.9% -1.1% 3.9% 4.0% 3.5% -0.9% 5.4%
2001 7.1% 1.0% 3.6% 3.8% 3.7% -1.1% 5.6%
2002 6.5% 4.2% 4.1% 3.9% 4.3% -0.7% 6.9%
2003 6.7% 5.1% 4.5% 4.0% 4.1% -0.1% 7.4%
2004 7.7% 4.5% 5.1% 4.8% 3.8% -0.2% 8.3%
2005 8.3% 3.1% 5.7% 4.6% 2.3% -0.4% 8.5%
2006 8.2% 2.3% 5.8% 5.5% 2.8% -1.5% 8.8%
2007 7.0% 2.7% 4.9% 5.9% 2.7% 0.1% 7.9%
2008 5.1% 5.8% 4.6% 5.7% 3.7% 1.2% 7.0%
2009 1.4% 11.0% 2.6% 4.3% 4.6% 1.3% 8.2%
2010 2.8% 10.9% 2.9% 4.3% 4.9% 0.4% 9.7%
2011 3.2% 9.8% 3.0% 5.0% 5.5% -0.3% 9.8%
2012 4.1% 8.4% 2.8% 5.9% 6.8% -1.5% 10.3%
2013 4.4% 5.4% 2.2% 6.0% 4.8% -1.0% 9.8%
2014 4.7% 4.8% 2.1% 6.3% 5.5% -1.7% 9.8%
2015 5.0% 4.3% 2.3% 6.4% 5.7% -1.4% 9.1%
2016 4.3% 4.9% 2.4% 6.3% 5.1% -0.7% 8.8%
2017 4.6% 4.9% 2.4% 6.2% 5.1% -0.7% 9.0%
Mar-18 5.0% 6.0% 2.6% 6.1% 5.5% -0.8% 9.8%
Jun-18 4.9% 6.1% 2.1% 6.0% 5.0% 0.0% 9.8%
Sep-18 5.3% 5.8% 2.6% 6.1% 4.8% -0.2% 10.1%
From the above charts, we can see that the 10-year average of corporate profits reached a peak,
until that time, of 7.0% in the latter 1960’s. That peak was not broken until 2006, but has steadily risen
19
since then to 9.3%, over 30% above prior peaks. It is also evident that the greatest historical contributors
to the increases in corporate earnings relative to GDP have been higher government debt and lower
personal savings. These changes—higher government debt and lower personal savings—are typically
considered negatives, not positives, for longer-term 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 Kalecki’s 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 𝑅 2 of 0.35, not only is the product of the above variables as effective on a standalone basis
as 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
20
support of the concept of “macro earnings negativity”, discussed in Section 4.2. While this 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 Kalecki’s 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
0.30
1955
1954
1957
1959
1960
1962
1964
1965
1967
1969
1970
1972
1974
1975
1977
1979
1980
1982
1984
1985
1987
1989
1990
1992
1994
1995
1997
1999
2000
2002
2004
2005
2007
2009
2010
2012
2014
2015
2017
However, the above earnings have not been adjusted for the extent they have been driven by
unsustainable components in Kalecki’s profit equation. Basing the components to historical norms adjusts
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, and thus demonstrate
the negativity of changes of earnings relative to GDP. Furthermore, the resulting steps yield a logical and
interesting conclusion. When taking the market value and dividing it by the historical norm of earnings
21
relative to GDP—such as Market Value/12.4% of GDP—as the appropriate measure of the components
of Kalecki’s profits equation, then adjusting that formula to historic norms results in “normalized”
earnings being a consistent ratio of GDP. Depending on the timeframe utilized, this ratio will likely vary,
just as historical norms of P/E10 or Tobin’s 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, due to
“macro-earnings negativity” the MV/GDP ratio has, ironically, better theoretical justification as a
price/sustained-earnings indicator than do earnings-based measures. This valuation measure, in black in
Figure 7, below, has also been, historically, much more effective at forecasting 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
0.30
1965
2014
1954
1955
1957
1959
1960
1962
1964
1967
1969
1970
1972
1974
1975
1977
1979
1980
1982
1984
1985
1987
1989
1990
1992
1994
1995
1997
1999
2000
2002
2004
2005
2007
2009
2010
2012
2015
2017
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 corporate profits/GDP have
averaged 9.3% over the past decade, vs. 7.8% in the first decade of 2000, 6.1% in the 1990’s, 5.6% in the
1980’s, 6.0% in the 1970’s, 6.9% in the 1960’s, and 5.8% in the 1950’s and the 1940’s. Therefore, the
evidence that MV/GDP is a better indicator—both theoretically and statistically—of future real equity
22
returns, and the fact that the ratio is near its greatest disparity ever relative to traditional ratios, should
raise investors’ attention. 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 1960’s, a time
which preceded flat real equity returns over the following 15 years.
With an R2 of 0.46 , 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 Kalecki’s 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 GDP—inflation, population growth, and productivity—are not directly affected by

23
earnings; additional 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 evident that primary determinant of long-term real total equity returns is,
therefore, productivity. Also note that productivity, though important to GDP, does not have to result in
higher earnings, a fact which provides further support 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 Kalecki’s
profits equation is that, on a macroeconomic perspective, earnings are not so much produced by
corporations collectively as they are allocated to corporations 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 Kalecki’s 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, which are economic negatives.
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.
24
The Relationship Between Government Debt and 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 Kalecki’s 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, finds:
“. . . a non-linear impact of debt on growth with a turning point—beyond which the government debt-to-
GDP ratio has a deleterious impact on long-term growth—at 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 Kalecki’s 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) study—which 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.”
25
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
2017, as estimated the IMF13, are: Austria, 79%; Belgium, 103%; Canada, 90%; France, 97%; Germany,
64%; Greece, 182%; Ireland, 69%; Italy, 132%; Japan, 238%; Spain, 98%; UK, 88%; US, 105%.
While commenting on the current global situation, Reinhart and Rogoff 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: A History of Debt
Source: IMF
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.
26
2. Forecasting the Equity Markets: 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 Malkiel’s (1973) book, A Random Walk Down Wall Street.
The 1980’s, 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);
• 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);
27
• 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 Welch’s 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 Thompson’s 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).”
28
Both efficient market theorists and their critics have 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 (10-year) equity returns. Through our demonstration of “macro earnings negativity”, our above
research has verified how and why the MV/GDP variable is both statistically and theoretically better at
forecasting long-term equity returns than are earnings-based measures. We have found, however, that the
ability to forecast long-term equity returns can be significantly improved with the use of additional
variables.
5. Expanding MV/GDP into A Composite Model
The process of researching and demonstrating the concept of “macro earnings negativity” not
only led to the realization of the merits of the MV/GDP ratio to forecast equity market returns, but also
introduced us to additional metrics to forecast equity returns. From there, we considered combining
these metrics into a composite variable. 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
variables—both original and from prior research—to combine with MV/GDP to form a composite
model. The realization of “macro earnings negativity”, 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 Kalecki’s 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
29
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 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.
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 boomer’s earnings and investing
powers began to escalate in the early 1980’s, 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 also aging rapidly:
30
Figure 9: Global Aging Population Aged 65 and over (%):

GDPRank Country: 1950 2000 2050 2100
1 United States 8.3% 12.4% 21.4% 26.7%
2 China 4.5% 6.9% 23.9% 28.2%
3 Japan 4.9% 17.2% 36.5% 35.7%
4 Germany 9.6% 16.3% 32.7% 34.2%
5 France 11.4% 16.0% 25.5% 30.0%
6 United Kingdom 10.8% 15.8% 24.7% 29.6%
7 Brazil 3.0% 5.5% 22.5% 32.6%
8 Italy 8.1% 18.3% 33.0% 32.9%
9 India 3.1% 4.4% 12.7% 23.9%
10 Canada 7.7% 12.5% 24.7% 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
ratio of those aged 40-49 divided by those aged 60-6915. Their study identifies the ratio as a good indicator
of the market’s 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

31
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
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

Adj R2 t Stat
7 6 18 17
Log (Market Value /GDP *(# aged 55-64) /(# aged 35-44) ) .61 -32.2
This represents an 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 .35, and
32
they reduce the remaining unexplained volatility of the composite model by almost 70% (by increasing
the Adjusted R2 from .61 to .88).
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 (3-Year Average) and

2. Change in Personal Consumption21/Personal Income10 (3 Yr. Avg.)
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 indicator has been shown
to be beneficial for the economy, the Change in Personal Consumption/Personal Income indicator appears
33
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 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
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:
34
Figure 12:
Breakdown of DAMA’s Forecast
(Based on data available on 12/31/2018, when the S&P 500 closed at 2507)
Multiple R Adj. R2
DAMA Composite Model: .94 .88
Components: t Stat Coefficients

Intercept (I): 15.1 0.1317
Personal Income12/Book13, 3Yr.Avg. (PI/B): -19.8 -0.1596
∆Pers. Cons. 14/Pers. Income12, 3Yr.Avg. (PC/PI): 24.5 1.3064
Log MV7/GDP6*Demographics O/M Ratio16: -45.8 -0.2458
Real GDP 10-Year Prior Growth (RGDP): - 9.8 -0.8920
Calculation of 12/31/2018 Forecast:

= 0.1317 -0.1596*PI/B +1.3064*PC/PI -0.2458*Log MV/GDP*O/M -0.8920*RGDP
= 0.1317 -0.1596*(0.7007) +1.3064*(-0.3280) -0.2458*Log((1.308)*(1.016)) -0.8920*(1.6573)
= 13.17% -11.48% -1.46% -3.04% -1.48%
= -4.29%
In Figure 13, below, we compare the market’s actual real 10-year-forward total returns to the
forecasts created by the DAMA model, the Market Value/GDP measure, Tobin’s q, and the 10-year P/E,
or CAPE, variable.
Figure 13:
DAMA’s Performance & Forecast vs. Other Valuation Measures:
Mean Absolute Current 2028 S&P

Adj. R2 Error Forecast* Target**
P/E10: .36 3.4% 2.6% 3230
Tobin’s q: .46 3.3% -0.5% 2400
Figure 14:
Market Value/GDP: .42 3.2% -2.0% 2060
DAMA: .88 1.5% -4.3% 1620
*Based on data available as of 12/31/2018, when the S&P 500 closed at 2507. Projected average annual real returns.
**Calculations are based on the assumption that the impacts of dividends and inflation offset each other.
35
Comparison of Predicted vs. Actual Performance of DAMA and

Other Common Metrics
13.0%
8.0%
3.0%
P/E10
-2.0% MV/GDP
DAMA
Actual
-7.0%
Tobin's q
-12.0%
1974
1999
1954
1955
1957
1959
1960
1962
1964
1965
1967
1969
1970
1972
1975
1977
1979
1980
1982
1984
1985
1987
1989
1990
1992
1994
1995
1997
2000
2002
2004
2005
2007
2009
2010
2012
2014
2015
2017
In Figure 13, above, DAMA’s projections of 10-year-forward real total annual returns have
historically averaged 4.6% and ranged from -7.0% to 16.0%, making DAMA’s current projection for
annual real declines of 4.3% nearer its most bearish level than its historical average.
6.1. Implied Cyclical Forecasts

Worth noting is that forecasts of simple valuation measures, like P/E10, Tobin’s q, and MV/GDP,
largely rely on reversion to the mean; however, such forecasts have, historically, underestimated the
tendency for reversions to continue well past the mean. DAMA’s greater accuracy is partly due to the
influence of the demographic and consumer trends we highlighted earlier. DAMA is not designed to
forecast cycles; therefore, analysis of the issue is perhaps more speculative and most appropriate for
additional research. However, a portion of DAMA’s forecasting accuracy does come from its implied
forecasts of cycles, and the cycle it appears to be forecasting is of interest. Figure 14, below, compares the
actual S&P level to the level which DAMA had forecasted 10 years earlier. If one looks closely, DAMA
did well at forecasting the current bull market cycle, even though its forecast of a peak of 2300 in 2016
was not spot on. Also of interest is that DAMA suggests a significant market decline to below 1000 near
2024, before rebounding strongly to the 1620 target it has for 2028.
36
Figure 14:
S&P vs DAMA Projections 10 Years Prior
10000
1000
100 DAMA Forecast S&P
10
1964
1977
2019
1965
1967
1969
1970
1972
1974
1975
1979
1980
1982
1984
1985
1987
1989
1990
1992
1994
1995
1997
1999
2000
2002
2004
2005
2007
2009
2010
2012
2014
2015
2017
2020
2022
2024
2025
2027
A close look at Figure 14, above, shows that the model was somewhat successful at foreseeing the
cyclical equity-market ups and downs since the year 2000. Of course, the large cycles in the past may not
repeat, but, historically, reversions from extreme high or low levels, as we are experiencing at present,
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 how the record levels of stimulative monetary policies over the
past decade will affect this current cycle; however, DAMA suggests that there is significant downside to
come. The peak valuation levels reached in 2000 substantially exceeded the prior peaks in the later 1960’s
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 reversion
to historical norms the market experienced in early 2009. If one assumes that the impact of inflation on
real returns over the next 10 years is offset by the impact of dividends, DAMA’s projections would
position the S&P near 1620 in 2028. This forecast initially appears quite bearish; however, as indicated in
Figure 15, below, any decline over the next 10 years to the historical bear-market bottom line would see
the market plummet below 600.
37
Figure 15:
Historical S&P, Inflation Adjusted
1000
100
10
1871
1874
1978
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
1982
1986
1989
1993
1997
2001
2005
2009
2012
2016
2020
6.2. 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:
Most Accurate 2nd Most Accurate
Forecast Forecast
Actual
Date: S&P Return: DAMA MV/GDP Tobin's q PE-10
Sep-02 815 5.3% 5.5% 2.9% 3.9% 3.1%
Aug-00 1518 -4.1% -6.5% -21.8% -18.1% -14.3%
Oct-90 304 16.3% 9.6% 9.7% 8.4% 6.6%
May-90 361 14.1% 7.3% 6.7% 6.8% 4.3%
Nov-87 230 14.7% 11.2% 10.5% 5.4% 8.1%
Aug-87 330 10.0% 5.7% 4.4% 6.1% 4.0%
Jul-82 107 14.8% 15.0% 17.0% 16.5% 19.2%
Nov-80 140 8.2% 7.9% 11.5% 13.1% 16.2%
Feb-78 87 10.1% 10.1% 15.5% 13.7% 19.0%
Dec-76 107 6.6% 5.6% 10.9% 10.6% 14.5%
Sep-74 64 7.3% 7.7% 14.4% 13.3% 18.1%
Dec-72 118 -2.0% -2.1% 3.8% 0.3% 6.2%
38
Figure 17:
Cumulative Out-of-Sample (OOS) Results:
5.0%
DAMA MV/GDP Tobin’s q P/E10 Solution
Adjusted R2 0.64 0.59 0.54 0.41 nmf
Avg. Abs. Error 3.1% 5.3% 6.0% 7.0% 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. DAMA’s performance clearly stands out, and the results
appear to contradict Goyal and Welch’s 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, DAMA’s 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 market’s peak in August, 2000,
and was the most bullish and most accurate of the models at the market’s recent low in September, 2002,
the most accurate at the market’s 2007 peak, and the most accurate model at the market’s 2009 low. As
such, DAMA’s recent bearish stance merits special attention.
7. Conclusion
This work introduces four major issues. The first is the introduction of “macro-earnings
negativity” to identify the problem with using combined corporate earnings as an indicator of broad
corporate or economic success. With the use of Kalecki’s 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. While we did provide support for the notion of causality in
39
Kalecki’s profit identity, we noted that, regardless of causality, the factors in Kalecki’s identity are at least
largely negative, and that they are inherently identified with earnings.
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 an optimal individual 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 Kalecki’s profits equation, and with the
understanding that the ideal gauge of a measure’s true weight is its percentage to GDP, we explain why—
due to “macro-earnings negativity”—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 Kalecki’s profit identity, which links corporate profits with economic variables.
Our work clarifies the causal the nature behind Kalecki’s identity and, by doing so, indicates the extent to
which macro-level earnings are negative, and how individual companies compete for a level of earnings
that have been largely been predetermined by the factors in Kalecki’s 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.
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 an optimal 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 DAMA’s 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.
40
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 Kalecki’s profits
equation makes the point quite conclusively. Kalecki’s 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
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 surprising—given the extensive amount of research
on individual drivers of the equity market—that 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 two—it may be difficult to show the extent to which the relationship is causal or coincidental.
Our unique combination of a demographic variable with a market valuation variable is an important
contribution to obtaining the effectiveness of the composite model.
41
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, 3-Year Average.
This is, to our knowledge, the first use of this variable to forecast equity 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 public that could coincide with this
variable’s change. The nearly 60-year history in our model provides strong support, relative to the
above variables we have, of the indicator’s ability to forecast equity returns.
7. Creation of the Personal Income/Book Variable, 3-Year Average. 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. The variable appears to significantly benefit our model’s forecasting accuracy.
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 Kalecki’s 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.
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 model’s forecast statistics or total returns:
momentum is one obvious example; however, we have chosen to restrict ourselves to broad fundamental
measures.
42
7.2. Closing Comments

When we try to express our views on DAMA’s quite dire projections, we can’t help but recall
Shiller’s 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 DAMA’s forecast; however, hopes do not alter statistical
significance, and we find DAMA’s 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 DAMA’s 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
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 DAMA’s 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 Kalecki’s profit identity. While
Minsky’s 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.
43
Appendix: Deriving Corporate Profits from the National Income and Product Accounts (NIPA)
This table, and our use of Kalecki’s Profit Equation in general, is based on Laramie and Mair’s
(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 Data FRED Series ID
Table Line Annual Quarter
GDP 1.1.5 1 GDPA GDP
Corporate Profits 1.12 15 A551RC1A027NBEA CPATAX
+ Gross Domestic Investment 5.1 21 W170RC1A027NBEA W170RC1Q027SBEA

- Consumption of Fixed Capital 5.1 13 GDICONSPA COFC
= Net Domestic Investment 5.1 49 W171RC1A027NBEA W171RC1Q027SBEA
Government Net Saving (Borrowing) 3.1 31 A922RC1A027NBEA TGDEF
Foreign Savings (Current Account Balance) 4.1 33 A124RC1A027NBEA NETFI
Net Dividends 1.12 16 B056RC1A027NBEA DIVIDEND
Personal Savings 5.1 9 A071RC1A027NBEA PSAVE
Statistical Discrepancy 5.1 42 A030RC1A027NBEA A030RC1Q027SBEA
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1
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.
4
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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 Shiller’s website. We changed his month-average S&P prices with month-end prices,
available from yahoo.com. Shiller’s data can be downloaded at: www.econ.yale.edu/~shiller/data/ie_data.xls
10
As determined by Kalecki’s profits equation. See Appendix 1.
11
Tobin’s 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 Tobin’s q. However, book value, the denominator of Tobin’s 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).
49
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. Tobin’s 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. Tobin’s 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.
50

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Macro vs.

Micro Earnings, “Macro-Earnings Negativity”, and an Introduction to a Composite Valuation Model

Macro vs. Micro Earnings, “Macro-Earnings Negativity”, and an

Stephen E. Jones, CFA*

Macro vs. Micro Earnings, “Macro-Earnings Negativity”, and an

1. The Questionable Use of Earnings as an Indicator of Stock Market Value

2. The Preference for Earnings-Based Measures

2.1. Verifying a Variable’s Theoretical Fundamentals

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:

3.5. Using Multiple Years of Earnings to Value Individual Companies

4. What Are Earnings?

4.1. Where Do Earnings Come From?

4.a. Kalecki’s Profit’s Equation:

4.2. Normalized Earnings, and the Negativity of Increases in Macro Earnings

4.3. 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,”

4.4. Historical Evidence

Historical Profits, as a Percent of GDP

Figure 5: Corporate Profits as Percent of GDP:

Net Government Foreign Net Personal Statistical Corporate

Corp. Profits10/GDP (5 Year Avg.) * Market Value/GDP

between the MV/GDP ratio and a P/E (price/“normalized” earnings) ratio.

traditional, valuation indicators.11

1.80 Relative Tobin's q

price/sustained-earnings indicator than do earnings-based measures. This valuation measure, in black in

4.5. Market Value/GDP and Price/Sales:

4.6. Additional Implications

components of GDP—inflation, population growth, and productivity—are not directly affected by

GDP, of personal and government debt, which are economic negatives.

The Relationship Between Government Debt and GDP Growth

Reinhart and Rogoff (2010), also point out:

Figure 8: A History of Debt

2. Forecasting the Equity Markets: Literature Review

forecasted. The research supported a variety of variables:

5. Expanding MV/GDP into A Composite Model

variables14 has been used before to forecast future equity returns.

developed and analyzed by others in prior research.

of their assets, and thus depress equity values.

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

of creating a demographic variable for use in a composite model.

Figure 11: Combined MV/GDP and Demographic Variable

the Adjusted R2 from .61 to .88).

5.2. The Other Earnings: Bringing it Home and Making it Personal

Specifically, these factors are:

1. Personal Income19/Book20 (3-Year Average) and

forecast future equity returns.

5.3. Real 10-Year Historical GDP Growth

6. Composite Model Results

Components: t Stat Coefficients

Calculation of 12/31/2018 Forecast:

Mean Absolute Current 2028 S&P