Hi guys,
I am getting hela confused about this. Topic referring to “On potential growth”. If anybody can help, much appreciated~~~
Equation: P=GDP(E/GDP)(P/E)
Why is P/E included in there? The text doesn’t speak a word about it.
Think about it conceptually rather than literally, and take another look at the equation.
In principle, broad earnings growth cannot outpace GDP growth in the long run. Earnings growth is a driver for price action in the markets. If earnings aren’t outpacing GDP in the long run, market prices aren’t either - they’re loosely tied to GDP growth and oscillate around it.
I hope that helps/makes sense.
The equation can also be expressed lograthimacally as
(1/T) % dP = (1/T) % dGDP + (1/T) % d(E/GDP) + (1/T) % d(P/E)
In other words, % change in equity price equals some of % change in GDP, % change in Earnings GDP ratio and % change in price earnings ratio, all over a time period T.
In short run % change in equity prices is dependent on all the three terms, ie, all the three terms in the right hand side contribute to the appreciation or depreciation of equity prices.
But in the long run, the second term tends to zero. It is because, earnings cannot outsmart GDP forever and hence the ratio E/GDP cannot rise forever. Think it this way; if there is a continued increase in profit growth rate that outsmarts GDP growth rate in a business, then more and more people would enter into the business which leads to increased output / supply and naturally earnings drop. It is essentially because of this concept that E/GDP cannot rise forever and in the long run this ratio becomes exactly 1 and the logarithm of 1 is zero and hence the second term wipes out. Also E/GDP cannot decline either, meaning earnings cannot continue to be lesser than GDP growth rate as those businesses would disappear in the long run and essentially the ratio in the long run becomes 1 (log 1 would be 0).
Similarly the P/E ratio cannot be neither greater than 1 nor lesser than 1 in the long run because investors neither would be willing to pay more price for lesser earnings nor will they allow a market with lesser price for more earnings. Hence the P/E ratio in the long run tends towards 1 and the lograthim of 1 is zero. Hence the third term also gets wiped out in the long run.
Hence the idea derived here is in the long run the % change in equity prices (either % change or logarithmic change) is only dependent on the % change in GDP (either % change or logarithmic change). In other words, drivers of potential GDP are the drivers of stock market price performance.