One way to check if the market cap of American publicly traded companies has not disconnected altogether from their real incremental value is comparing their market cap to the total GDP.
This ratio can be used to understand whether the market is overvalued – in the U.S, the lion share of the companies are publicly traded, at least the big ones, thus we can expect to find a correlation between both the movement and the size of the stock market and the GDP.
The market cap to GDP indicator has become extremely popular in recent years, thanks to Warren Buffett, which believes that “it is probably the best single measure of where valuations stand at any given moment.”
In the third quarter of 2017, the indicator showed that the market cap is 134% of the U.S GDP. This ratio has steadily increased in recent years from a very low level of 59.5% during the Sub Prime crisis. The all-time high was above 151% in 2000, just before the Dot-Com bubble collapsed.
Bigger than the GDP?!
First, we need to ask how can the market capitalization of all stocks be higher than the GDP.
The most common explanation is the cyclical one – in times of economic growth, companies’ profits are growing. The investors are expecting this growth to continue, and thus are ready to pay more for the stocks. These expectations are driving the companies’ valuations higher. The opposite happens in times of recession – the investors expect to see shrinking profits (or even losses) and sell their stocks. By doing so, the stocks prices are few steps ahead of the GDP.
Another key factor is the increase of the indicator is the globalization, which plays an important role in the change of this indicator over time. Until 1997, the indicator has never risen above 100%. But an important shift has happened to the economy in recent decades – a big portion of American companies’ revenues is not generated from the U.S, and therefore does not necessarily account as a part of the GDP. For example, an American company can have a local subsidiary in a foreign country with local employees and customers. The effect on the American GDP will be limited but the effect on the company’s stock will be significant as some of the profits will flow to the American mother company.
So, what is the right number?
The main problem with the indicator is that we do not really know what are the numbers we should aspire to in the long run. A ratio of 100% between U.S equities and the GDP seemed incredibly high 50 years ago, but today this ratio seems quite reasonable. As the world becomes more globalized and the economy grows, it makes sense to see this indicator rising – at least as long as the American economy remains so dominant in the world. However, the fact that we are on historically high level suggests that we might have reached too high of a ratio, and probably too fast. Even if the historically high prices of the market are not quite as high in today’s perspective, they definitely suggest that the upside of the market is limited in these levels, because there has to be a correlation between the GDP and the market performance. And of course, the downside is still there.