Recent findings from Minneapolis Fed monetary advisors Jonathan Heathcote and Fabrizio Perri, along with UCLA consultant Andrew Atkeson, challenge the traditional view of U.S. stock market overvaluation. Their research, presented in Staff Report 682, "A Macroeconomic Perspective on Stock Market Valuation Ratios," argues that financial data alone can be misleading due to evolving corporate compensation methods for owners. Instead of relying on reported earnings, they emphasize "free cash flow" as a more accurate measure of investor value.
This new perspective suggests that persistently low earnings yields don't necessarily indicate mispricing or bubbles. The economists highlight a growing divergence between reported earnings and free cash flow, with investors appearing to prioritize cash flow. They note that while U.S. company valuations have surged as cash flow has increased, corporate output has grown at a much slower pace. This indicates a fundamental shift in company value generation.
The research also points to a significant decrease in measured capital as a share of enterprise value for U.S. companies, falling from 144% in 1980 to 44% in 2022. This suggests that corporations can achieve earnings growth without increasing measured capital investment. The economists propose that an increase in intangible capital, such as reputation or proprietary software, might partially explain this trend, as corporations reassure investors of future cash flow even if earnings and measured investment exhibit slower growth.
Historically, warnings about an expensive market have come from metrics like the Shiller CAPE ratio, which recently crossed 40 – a level previously seen only during major market bubbles like the late-1990s tech boom. The Buffett Indicator, measuring total stock market capitalization relative to U.S. GDP, has also climbed above 230%, signaling historical overvaluation. However, the new free cash flow perspective offers a counter-argument to these traditional indicators, suggesting the current market may not be as overvalued as these metrics imply.
