Episode summary
The Big Macro Force That's Been Driving Stocks Higher for Years | Odd Lots
Odd Lots
· · 36 min · Hosts: Tracy Alloway, Joe Weisenthal · Guests: Jonathan Heathcote
Summary
Jonathan Heathcote argues that the long run-up in U.S. equity valuations looks less mysterious when stocks are compared to free cash flow rather than earnings. In his view, the classic price-to-earnings ratio has drifted above history because firms have been able to grow profits without commensurate capital spending, so more of each dollar of output has been left available to owners.
Heathcote links that pattern to two macro trends: labor’s share of income has fallen over time, and investment as a share of firm value has also declined. That combination helped cash flow grow faster than earnings, which makes the market look less stretched on a cash-flow basis than on a traditional earnings basis. He says the aggregate data do not show a long-run upward drift in the market-to-free-cash-flow ratio, even though it has risen recently.
The conversation turns to AI, where the host and Heathcote both see a possible turning point. Big tech firms are now spending heavily on data centers, chips, and energy capacity, which could reduce free cash flow in the near term. Heathcote says the key question is whether that investment pays off through higher future profits, and whether AI further shifts income away from labor and toward capital.
Key takeaways
- Heathcote says the market looks much less extreme when valued against free cash flow instead of earnings, because firms have not had to invest much.
- Heathcote says labor’s share of corporate income has fallen by about eight percentage points since 1980, helping profits and cash flow rise.
- Heathcote says the aggregate value-to-free-cash-flow ratio was about the historical average in 1980 and the second quarter of 2022, though it has moved above average more recently.
- Heathcote says the biggest U.S. firms have seen value and cash flow grow roughly in lockstep, with about 50 firms driving much of the market’s gains.
- Heathcote says AI could support valuations if it lowers labor’s share further, but heavy capital spending could also pressure free cash flow in the short run.
Notable quotes
“if you look at that ratio, the value of all the firms in the US relative to the total cash flow they're generating it bounces around a bunch over time”
“it doesn't have like a long a long-term drift. It's not like it's kind of systematically moving up over time”
“cash flow has grown even faster, and cash flow has grown even faster because firms have been able to generate these extra earnings without doing a lot of extra investment”
“that's eight percentage points of GDP. That's a big change”
“those 50 firms are the same firms that have had the the fastest growth in cash flow”
How the episode opens
Bloomberg Audio Studios podcasts, radio, news.
Hello and welcome to another episode of the Odd Lots podcast. I'm Joe Weisenthal. And I'm Tracy Alloway.
So Tracy, one of the things that we've been talking about a fair amount everyone's talking about it, I guess is how the biggest, most profitable companies in America, they're still really big, they're still really profitable, but they've switched from being throwing off tons of free cash flow to big investors spending a lot of money. Yeah, that's right. So we've had years and years and years of big tech basically I guess generating infinite amounts of cash it feels like.
Uh and now they're switching to actually spending some of that cash to build very expensive data centers and things like that. And you're right, it is kind of a change for the market.
Yeah. Right? Like we haven't seen that scale of investment for a very long time.
Certainly not I don't think in our lifetimes, have we? I don't know. No, I it doesn't feel like it.
I mean you know, I guess maybe we'll get into this in the conversation. You know, I think if you go back to like pre-GFC era when a lot of the really big companies in the index were like, you know, Exxon was the biggest company in the world for a long time. So they would have always been having to like spend because you can't just sort of like passively collect oil etc.
But it does seem generally true that the big theme both with financials and tech is this incredible ability to generate huge returns with fairly modest capital outlays whether we're talking about equipment, plants, or even human labor. Well, the other big switch is just, you know, if you look at it just at the tech sector basically which has been, you know, the dominant force in our equity markets for a while now.
From the episode’s captions: roughly the first two minutes, lightly cleaned. Keep watching on YouTube →
Topics
- stock valuation ratios
- free cash flow
- corporate earnings
- labor share of profits
- ai capex
Watch the episode
Watch “The Big Macro Force That's Been Driving Stocks Higher for Years | Odd Lots” on YouTube
Summary, takeaways and quote selection by Octagon. Quotes are short excerpts; the full conversation is in the episode.
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