J The Domestic Macroeconomy

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The macroeconomy is the environment in which all firms operate. The importance of the macro-economy in determining investment performance is illustrated in Figure 11.2, which compares the level of the S&P 500 stock price index to estimates of earnings per share of the S&P 500 companies. The graph shows that stock prices tend to rise along with earnings. While the exact ratio of stock price to earnings per share varies with factors such as interest rates, risk, inflation rates, and other variables, the graph does illustrate that, as a general rule, the ratio has tended to be in the range of 10 to 20. Given "normal" price-to-earnings ratios, we would expect the S&P 500 Index to fall within these boundaries. While the earnings-multiplier rule clearly is not perfect—note the dramatic increase in the P/E multiple in the 1990s—it also seems clear that the level of the broad market and aggregate earnings do trend together. Thus, the first step in forecasting the performance of the broad market is to assess the status of the economy as a whole.

The ability to forecast the macroeconomy can translate into spectacular investment performance. But it is not enough to forecast the macroeconomy well. One must forecast it better than one's competitors to earn abnormal profits.

In this section, we will review some of the key economic statistics used to describe the state of the macroeconomy.

gross domestic product

The market value of goods and services produced over a period of time.

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