INTERNATIONAL EQUITY MARKETS 1. Differences and Instruments.
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Transcript of INTERNATIONAL EQUITY MARKETS 1. Differences and Instruments.
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INTERNATIONAL EQUITY MARKETS
1. Differences and Instruments
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General Overview and Differences
• Differences
- Macrostructure
- Liquidity
- Taxes
- Indexes
- Microstructure
- Organization
- Trading Procedures
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Liquidity
Liquidity
“Ability to buy or sell significant quantities of a security quickly, anonymously, and with minimal or no price impact.”
=> Most important attribute for an asset.
• Usual measures are:
1. Capitalization/GDP
2. Transaction size (market turnover)
3. Degree of concentration
4. Bid-ask spread
5. Number of non-trading days
6. Number of zero-return days
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1. Capitalization/GDP
Fact: U.S. stock market is very large compared to the U.S. economy. See figures in Dec. 2014 USD.
Market Market Cap (MC) GDP (nominal) MC/GDP
U.S. 26,240 B 17,416 B 151%
China 6,005 B 10,355 B 57%
Japan 4,378 B 4,770 B 92%
U.K. 6,370 B 2,847 B 224%
India 3,324 B 2,047 B 162%
Brazil 844 B 2,244 B 37%
But, this number may not be a good indicator: for South Africa, in 2009, the MC/GDP was over 170%.
Also, this figure changes a lot. The MC/GDP for Brazil in 2009 was close to 50% and in 2007 was close to 100%.
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• Some analysts (Warren Buffet included) see the MC/GDP measure as a valuation metric, useful to identify what markets are under-/over-valued. The higher the ratio, the more overvalued the market. For example, Swiss market => overvalued!
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2. Transaction volume
• Define turnover (T) as the total value of share trading. Not surprisingly, New York and Tokyo have the largest turnover (T) in USD (Dec. 2007).
NYSE 2,158.0 B
NASDAQ 1,187.3 B
London SE 441.4 B
Tokyo SE 440.5 B
Euronext SE 340.0 B
Shangai SE 272.4 B
• Turnover as a percent of market capitalization (T/MC) varies over time.
Example: From 1991 to 1995 annual turnover ranged:
U.S.: 55% - 74%
France: 33% - 140%
=> not very precise, if different years were observed.
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3. Degree of concentration found in the major markets
• Composition: many small firms vs. concentrated in a few large firms.
Institutional investors dislike small firms for fear of poor liquidity.
A concentrated market provides fewer opportunities for risk diversification and active portfolio strategies.
Example: Market share of the 10 largest companies.
U.S. 11.9%
Japan 20.2%
U.K. 23.2%
Germany 39.2%
Switzerland 67.0%
Netherlands 74.3%
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4. The bid-ask spread
Market maker buys shares (at the bid quote) and expects to sell those shares in the future (at the ask quote).
The longer it takes to receive a buy order The higher the required compensation Higher compensation => Higher bid-ask spread.
An average bid-ask spread is a useful market liquidity indicator.
Example: The average bid-ask spread in the U.S. is 0.6%, while in Thailand the average bid-ask spread is 5.14%.
Problem with this measure: Not easy to obtain –definitely, not in the WSJ.
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5. Non-trading days
Market may be seem liquid on average, but there is no volume during some days. The number of non-trading days gives us an idea of liquidity.
6. Zero-return Days
Two things behind a no change in the price –i.e., zero return:
- No information
- No trading (stale prices) => proxy for non-trading days
It is an easy measure to gather, just from stock prices.
Conclusion: Take a look at several liquidity indicators.
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Example: Liquidity -- The Case of Emerging Markets
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Taxes
Taxes on Investments
1. Capital gains,
2. Income (dividends, etc.),
3. Transactions.
• Key question for international investors:
Q: Do they tax foreigners? If so, what are the withholding taxes?
Two Tax principles
- Residence: Residents are taxed on their worldwide income.
- Source: All income earned inside the country is taxable in this country.
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When entire income is earned in the country of residence, both principles agree. Otherwise, the two principles have different (negative) implications.
Example:
Situation: A U.S. consultant works 3 months a year in Greece.
Residence principle: she pays taxes on her Greek income in the U.S.
Source principle: she pays taxes on her Greek income in Greece.
Greek income can be taxed twice. ¶
• Foreign investments may be taxed in two locations:
1. the investor's country,
2. the investment's country
Convention: make sure that taxes are paid in at least one country.
that is why withholding taxes are levied on dividend payments.
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Tax Neutrality
Tax neutrality: no tax penalties associated with international business.
Two approaches:
(1) Capital import neutrality
(2) Capital export neutrality.
(1) Capital Import Neutrality
- No penalty or advantage attached to the fact that capital is foreign-owned
- Foreign capital competes on an equal basis with domestic capital.
- Local tax authorities exempt foreign-source income from local taxes.
=> For a U.S. MNF: Exclusion of foreign branch profits from U.S. taxable income (exclusion method).
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(2) Capital Export Neutrality
- No tax incentive for firms to export capital to a low tax foreign country.
- Overall tax is the same whether the capital remains in the country or not.
=> Local authorities "gross up" the after-tax income with all foreign taxes; then apply the home-country tax rules to that income, and give credit for foreign taxes paid.
=> For a U.S. MNF: Inclusion of "pre-tax" foreign branch profits in U.S. taxable income. A tax credit is given for foreign paid taxes (credit method).
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Example: Bertoni Bank, a U.S. bank, has a branch in Hong Kong. Hong Kong branch income: USD 100.U.S. tax rate: 35%Hong Kong tax rate: 17%
Double Exclusion CreditTaxation Method Method
• Hong KongBranch profit 100 100 100(17% tax) (i) 17 17 17Net profit 83 83 83
• U.S.Net Hong Kong profit 83 83 83Gross up 0 0 17Taxable income 83 0 100(35% tax) 29.05 0 35Tax credit 0 0 (17)Net Tax due (ii) 29.05 0 18
Total taxes (i)+(ii) 46.05 17 35
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Organization
Three market structure types: ○ Public exchange
○ Private exchange
○ Banker exchange
The private exchange
Origin: XVII and XVIII century's European commodity markets.
- Private institution with some government supervision.
- Brokers are created by independent members.
- Brokers compete among themselves or enjoy monopoly.
Private exchanges may compete within the same country (U.S., Japan, China, India).
Commissions: negotiated or imposed by exchange or local law.
Example: U.S., U.K., Canada, Japan, Mexico, Argentina.
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The public exchangeOrigin: legislative work of Napoleon I.
- Public institution.- Brokers are appointed by the government.- Brokers enjoy a monopoly over all transactions.
Brokerage firms are private.New brokers are proposed to the state by the broker's association. Commissions: fixed by law.
Examples: Belgium, Italy, Greece, and some Latin American countries.
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The bankers exchangeOrigin: German tradition.
- May be either private or semipublic organizations.- Brokers are banks.- Members must deal through the exchange.
In some countries, banks are the major securities traders. In Germany the Banking Act grants a brokerage monopoly to banks.
Examples: German sphere of influence: Austria, Switzerland, Scandinavia and the Netherlands.
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Recent Trends 1) Deregulation: The private stock exchange is the norm.Many exchanges have become business organizations, listed in their own exchanges.
Example: Paris Bourse, Deutsche Börse, NYSE.
2) Consolidation: Competition has created consolidation: - OMX: OM & Stockholm Exchange (OMX) (1998); Helsinki (HEX)
(2003); Copenhagen SE (KFX) (2005); Oslo SE (2006); Iceland SE (2006); Armenian (Armex) (2007)
- NASDAQ buys PHLX and OMX (2007, 2008).- Euronext: Paris Bourse, Amsterdam (AEX) & Brussels (BXS) (2000);
LIFFE (2002); Lisbon (BVL) (2002).- NYSE buys Euronext (2006).- CME buys CBOT (2006)- Toronto (TSX) & Montreal (MX) (2007)
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Differences in Trading Procedures
The most important differences are in the trading procedures.
(1) Cash versus futures markets
(2) Fixed versus continuous quotation
(3) Computerization
(4) Internationalization
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(1) Cash versus futures markets
• Cash markets
Stocks are traded on a cash basis (settlement within a couple of days).
For more leveraged investments: margin trading is available.
Margin trading: Investors borrow money from a broker.
a cash market transaction: a third party steps in.
Note: Margin trading is costly and, sometimes, difficult.
• Futures or forward stock markets
Provide an organized exchange for levered stock investment.
Forward stock markets compete with cash stock markets.
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(2) Fixed versus continuous quotation
• Continuous market: transactions take place all day.
- Large market-makers assure liquidity.
- In some markets, the market maker has a monopoly for a given security, as is the case for the specialist on the NYSE.
- In other markets, the market makers (dealers or jobbers)
compete to provide the best quote.
• Fixed market: transactions take place only at specific times.
- Call or fixing market: a single price applies to all transactions.
- Auction market: an asset is traded only few times per day and its price is determined through a competitive auction system.
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(3) Computerization
• Traditional trading method: floor trading.
- Traders meet on a floor to trade and to execute orders according to a set of pre-specified rules.
- Floor trading has been greatly influenced by computers: computers help to make floor trading cheaper, with fewer mistakes and faster.
• New trading method: computerized trading.
- A computer executes orders according to a set of pre-specified rules.
- Computerized trading allows the automated execution of orders entered by traders in their office.
- Best known system: Computer Assisted Trading System (CATS) -TSE.
- CATS eliminated the need for a floor where participants meet.
• Mixed system: NASDAQ.
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(4) Internationalization• Traditional internationalization: International network of offices.
• New trend: Electronically access foreign markets. cheaper alternative.
Key to this new trend: Harmonization of electronic trading platforms
Examples:
(i) OMX: OM Stockholm Exchange (SSE), Copenhagen SW (CSE), e Helsinki SE (HSE), the Iceland SE. (September 2006).
(ii) Euronext: Amsterdam SE, Brussels SE and Paris Bourse (Sep 2000)
(iii) NYSE Euronext: NYSE and Euronext (April 2007)
(iv) NASDAQ OMX: NASDAQ and OMX (February 2008)
International Exchange of the Future: Stock exchanges with their own automated trading system available worldwide on a 24-hour basis.
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Practical Aspects
Dual Listing
Fact: Some firms are traded on more than a dozen markets.
Implication: Shares should sell at the same price all over the world, once adjustment for exchange rates and transactions costs are made.
Procedures for admitting foreign stocks to local markets:
Montreal: Listed by simply by meeting the same regulatory requirements as those in its own jurisdiction.
U.S.: Must satisfy the local exchange and regulatory requirements.
Q: Why do companies double list?
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Advantages of double listing:
- easier access to foreign capital.
- diversified ownership reduces the risk of a domestic takeover.
- fragmented markets.
- advertising.
Main disadvantage: Increase volatility.
Example: Situation: Bad political news in Chile.
Foreign investors tend to immediately sell their shares, driving domestic share prices down in this illiquid stock market.
Chilean investors have a less volatile behavior: they are not as shaken by domestic news, and have few investment alternatives. ¶
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American Depositary Receipts (ADRs)• Special shares for foreign company: depository receipts.
Many DR programs around the world
U.S.: American depository receipts (ADRs).
U.K: Global DRs (GDRs).
Singapore: Singapore DRs.
Simple process: (1) Foreign shares are deposited with a trust company.
(2) Trust issues DRs.
To avoid unusual share prices, ADRs may represent a combination or a fraction of several foreign shares.
Example: Petroleo Brasileiro (Petrobras) ADR (PBR)JP Morgan has a 10 million shares of PBR in deposit. JP Morgan issues 5 million depository receipts (DR). Each DR represents 2 Petrobras shares. ¶
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• Trading in ADRsTrading in ADRs avoids delays of trade settlement, problems with safeguarding, and making currency transactions.
Note: ADRs do not eliminate currency risk or country risk.
Example: BRL depreciates sharply, Petrobras (PBR), USD returns decrease
Petrobras ADRs will decline.
• There are more than a 2,700 ADRs available to U.S. investors. Representing over 80 markets. China has 124 ADR programs.
• ADRs account for more than 15% of the entire U.S. equity market.
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ADRs Trading Volume: Exchange Listed ADRs
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• Types of ADRs(1) Listed ADRs (Level II and Level III): companies should meet all the exchange requirements. In December 1995, there were 316 Listed ADRs: 199 traded on the NYSE, 7 on the American Stock Exchange, and 110 on the NASDAQ.
(2) Unlisted ADRs: The rest of the ADRs trade on the OTC market (OTC level I), or privately placed (ADR Rule 144-A, or RADR).
- OTC Level I (pink sheets): Simplest way to access capital in the U.S. A Level I DR programme does not have to follow U.S. GAAP, nor it has to make a full disclosure to the SEC.
- RADR: They are privately sold and bought by qualified institutional buyers (QIBs). QIBs include institutions that manage at least USD 100 million.
Example: KIA Motors, LG Electronics, Samsung are all 144-A ADRs
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Examples ADRs in the U.S.:
AUSTRALIA: BHP (NYSE), Foster’s (OTC), Qantas (OTC)
BRAZIL: AES Tiete (OTC) AMBev (NYSE), CVRD (NYSE), VIVO (NYSE)
CHINA: Air China (OTC), Agria Corp. (NYSE), Baidu (NASDAQ)
CHILE: Concha y Toro (NYSE), LAN Airlines (NYSE), Enersis (NYSE)
EGYPT: Orascom Construction (OTC), Orascom Telec (OTC), Suez Cement (OTC)
FINLAND: Neste Oil (OTC), Nokia (NYSE), Stora Enso (OTC), UPM (OTC)
FRANCE: GDF Suez (OTC), France Telecom (NYSE), L’Oreal (OTC)
GERMANY: Allianz (NYSE), BMW (OTC), SAP (NYSE)
GREECE: Alpha Bank (OTC), Hellenic Petrol (NYSE), Hellenistic Telecom (NYSE)
JAPAN: Canon (NYSE), FujiFilm (NASDAQ), Hitachi (NYSE)
KOREA: Korea Electric Power (NYSE), Pohang Steel (NYSE), SK Telecom (NYSE)
MEXICO: Am Movil (NASDAQ), Cemex (NYSE), Femsa (NYSE), Telmex (NYSE)
NETHERLANDS: AKZO Nobel (OTC), ING (NYSE), Crucell (NASDAQ)
RUSSIA: Gazprom (OTC), Lukoil (OTC), Mechel (NYSE), Mosenergo (OTC)
TURKEY: AKBank (OTC), Koc Group (OTC), Petrol Ofisi (OTC), Turkcell (NYSE)
UK: Barclay’s (NYSE), BP (NYSE), British Airways (OTC), Imperial Tobacco (OTC)
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Financial Analysis and Valuation
• Nothing unique to financial analysis in an international context.
Example: The methods and data required to analyze U.S.-, Mexican, or Malaysian-type manufacturers are the same. ¶
A research report on a company should include:
(1) Expected return.
(2) Risk sensitivity.
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The information problemA firm is typically valued in two steps: (1) Forecast future earnings (EPS -expected earnings per share)(2) Assessment of how the stock market will value these forecasts.
(PE -price-earnings ratio)
InformationU.S.: Firms publish their quarterly earnings.
Europe and Far East: Firms only publish their earnings once a year. • Quality of the disclosed information: Varies from country to country. There is a market for companies "interpreting" for international investors the local books of companies:
Many international brokerage houses provide analysts' guides.
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Comparative analysis.Another difficult problem due to:
- Different accounting principles- Different cultural, institutional and tax differences
Example: Swiss firms stretch the definition of a liability. They tend to overestimate contingent liabilities when compared to U.S. firms.
Example: German firms create hidden reserves often equal to 100% of fixed assets. Inventories tend to be understated.
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Major differences in international accounting practices:
* Publication of consolidated statements* Publication of accounts corrected for fiscal distortion* Inflation accounting* Currency adjustment* Treatment of extraordinary expenses* Existence of "hidden" reserves* Depreciation rules* Inventory valuation
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Company Valuation
(1) Discounted Dividend Model (DDM)• DDM is used to estimate the expected return on an investment:
• The value of an asset is determined by the stream of cash flows it generates for the investor. • DDM: Stock price (P) = stream of discounted forecasted dividends.
P = D1/(1+r1) + D2/(1+r2)2 + D3/(1+r3)
3 + D4 /(1+r4)4 + ...
• A typical DDM approach is to decompose the future in three phases. - Near future (next two years), earnings are forecasted individually.- Second phase (years two to five), a general growth rate for the company's earnings is estimated. (revert to industry?)- Third phase, the growth rate in earnings is supposed to revert to the average of all firms in the market.
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Dt-forecast's and P are known solve for the expected return (r).
Problems: - Companies have discretion over their dividend payments.- International comparisons are difficult:
Payout ratios vary considerably. The U.S. has a much lower payout ratio than the U.K.
Note: We might also need an accurate forecast of currency movements.
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Example: Using DDM to calculate the fair value of YPF ADRsIt is December 1995.
We need input values for Dt, rt, and St. t = 1996, 1997, 1998, ....
PYPF-ADR = USD 20.53. (Market price at NYSE)
St= 1 USD/ARS.
Dt = ? t = 1996, 1997, 1998, ....
D1996F = ARS .84.
dtF = 9.1% t = 1997, 1998, 1999.
dt is low for international standards dt should increase in the future:
dtF = 15.7% t = 2000, ...
• rt = ? t = 1996, 1997, 1998, ....
According to CAPM, we should estimate:E[rYPF] = rf + E[rm-rf] ßYPF.
Inputs: ßYPF=.91; rf =.085; E[rm]=.18.
E[rYPF] = .085 + (.18-.085) x .91 = .17145.
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Example (continuation): YPF ADR Valuation • St = ? t = 1996, 1997, 1998, ....
st = -1% t = 1997, 1998, 1999.
st = -2% t = 2000, ....
• Valuation Process: (1) Determine the USD PV of CF from 1996 - 1,999 (year 4), P1-4.
- Effective USD rate of return from 1997 until 1999 is: [(1.091)x(.099) - 1] = .08009.
- P1-4 = .84/(1.17145) + .84(1.08009)/(1.17145)2 + .84(1.08009)2/(1.17145)3 +
+ .84(1.08009)3/(1.17145)4 = USD 3.5559.
(2) Determine the USD PV of CF from 2000+ (year 5+), P5+.
- The discounted dividends per share in year 4 will be:USD .84[(1.091)x(.99)]3/(1.17145)4 = USD .56204.
- The effective USD rate of return is [(1.157)x(.098) - 1] = .13386.- The USD PV of all futures cash flows after year 5 is given by
P5+ = USD .56204 x (1.13386)/[(.17145 - .13386)] = USD 16.9533
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Example (continuation): YPF ADR Valuation
(3) Add (1)+(2) -- Present value of a YPF ADR is:- P = P1-4 + P5+ = USD 3.56 + USD 16.95 = USD 19.50.
The December 1995 price of USD 20.53 indicates that the YPF ADR was slightly overvalued, given our estimates from the DDM. ¶
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(2) Valuation by Multiples
Calculation of the fair value of a company: Need rj = discount rate.
rj = bond yields (risk-free) + risk premium.
Example: For well-established markets, real bond yields are about 3%. No consensus about the risk premium: from 0 to 8%.
Alternative method: discount free cash flows (CF) (CF derived from ordinary after-tax earnings).
CF: after interest, tax, and capital expenditures, but before depreciation and amortization.
Assumptions:
(A) Two downward adjustments (1/3 of earnings, E):
(1) cost of replacing worn-out assets is higher than original (10)
(2) Companies invest also to expand (25%).
(B) Corporate earnings grow with trend economic growth (g).
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• Now, we can calculate fair value stock prices:
P = CF1/(1+r) + CF2/(1+r)2 + CF3/(1+r)3 + ....,
where CFt = 2/3 Et.
Et = E (1+g)t
P = 2/3 E(1+g)/(1+r) + 2/3 E(1+g)2/(1+r)2 + 2/3 E(1+g)3/(1+r)3 ..
This formula simplifies to:
P = 2/3E [(1+g)/(1+r)] / [1 -(1+g)/(1+r)].
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Example: It is 1994. Calculating the steady state P/E for the U.S.
Data:
(1) Real economic trend growth (g) is 2.5% a year.
(2) Real bond yield is 3%
(3) Risk premium is 3%.
From (2) and (3) r = discount rate = 6%.
Recall: CF = 2/3 E
P = 2/3E [(1+g)/(1+r)] / [1 -(1+g)/(1+r)].
Then,
P/E = 2/3 [1.025/1.06]/[1 - (1.025/1.06)] = 2/3 (.96698)/(.0330189)
= 19.52 (equal to the P/E for 1994). ¶
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Problem: Global economy is not in a steady state. Growth rates change over time: Over the business cycle, profits take different proportions of the GNP.
Example: When countries are in the advanced stages of the business cycle, wages rise at a faster pace. P/E ratios have to be adjusted.
Example: Ad-hoc adjustments.
U.S. economy: late stages of the business cycle.
Adjust steady state P/E by .80.
Asian Pacific Countries: room for improving the efficiency of firms.
Adjust steady state P/E by 1.10. ¶