Using Market Cap To GDP To Evaluate Global Markets

by: Jason Tillberg

One valuation metric for identifying what markets are cheap and what markets are expensive is to compare the market cap of the country's entire stock market relative to the same country's GDP. This article attempts to observe not just the U.S. stock markets, but global markets as well.

Warren Buffett had this to say about using this kind of metric in an article he wrote that was published in Fortune in 2001.

Below is a chart, starting almost 80 years ago and really quite fundamental in what it says. The chart shows the market value of all publicly traded securities as a percentage of the country's business--that is, as a percentage of GNP. The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment. And as you can see, nearly two years ago the ratio rose to an unprecedented level. That should have been a very strong warning signal.

The chart he's referring to is similar to the chart below.

He goes on to say:

If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%--as it did in 1999 and a part of 2000--you are playing with fire.

Here is a chart showing the market capitalization of U.S. equities as a percent of GDP since 1954:

Note: Quarterly Average

By observing this chart, we can appreciate the long term trends of secular bull markets and secular bear markets over given time periods.

Here is a chart of the S&P 500 (NYSEARCA:SPY) from 1957-1980:

The great bull run in the U.S. stock markets began around 1980. Things got crazy from 1995-2000 bringing the aggregate U.S. stock market capitalization to its highest level to GDP in this post WWII period. Here is the chart of the S&P 500 index from 1980 to the present:

Warren was right. Buying stocks when we hit that 70%-80% area proved to be good times to buy U.S. stocks this past decade.

The World Bank has data on these figures for all countries around the world. Let's begin with the world's market capitalization relative to world GDP for context:

Note: Data goes out to 2011

This shows that basically, between 1989 and 2011, the global stock market capitalization relative to the global GDP was between about 45% and 120% on average. In 2011, it stood at 68.76%. The average % between these years was 78.52%.

Let's take a look at the following 4 countries or regions:

U.S: Green

China: Blue

EU: Orange

Japan: Red

One observation we can make from this chart is that the U.S. is the most expensive of these four at just over 100% of market cap to GDP as of 2011. It may well prove worthy of being patient and waiting for that chance to buy U.S. stocks when the ratio gets to the 70% - 80% again.

China's stock market is the most interesting. While throughout the 1990's, China's stock market was only just beginning to develop, by 2000, their stock market reached 48.48% of GDP. It then sank to just 31.85% in 2002. From there, it didn't do much at all but suddenly beginning in 2005 staged a huge rally up to 2007. It peaked in 2007 averaging 178.2% of GDP only to crash the following year down to 61.78% in 2008.

Since then, China's economy has been under explosive growth, mainly due to infrastructure and gross capital formation spending prompting high labor productivity growth. But profits in China's companies have not kept pace with their GDP growth, so stocks sank to just 46.31% of GDP in 2011. In 2012, profits continued to fall and Chinese stocks continued to suffer despite GDP per capita rising 12% in 2012.

There is a bottom forming in Chinese equities I believe. With GDP expected to continue to grow in at least the mid to upper single digits over the next 3-5 years, improvements in the stock market cap relative to GDP could either prove to be explosive to Chinese equity share prices in a short period of time, or Chinese equities could simply experience a long term bull market in the years ahead.

One fund that U.S. investors can buy to participate in a rise in Chinese equities, when they believe the time is right, is iShares Trust China 25 Index Fund (NYSEARCA:FXI):

Both Japan and the European Union look cheap in historical context of market cap to GDP, but both areas are dealing with poor growth prospects on account of both demographics and more important, poor rates of productivity growth. Both also have to deal with sovereign debt issues in the near future that should have negative impacts on their GDP growth as well as their social fabric.

Here is an ETF for Japan, iShares MSCI Japan Index Fund (NYSEARCA:EWJ):

Vanguard has an index fund that holds 400 stocks across Europe, Vanguard European Stock Index Fund (MUTF:VEURX):

The equity markets in both Europe and Japan have proven to be more or less poor places to park funds for long term investment, however both could be bottoming soon too.

Where are the extremes? To start with the least expensive side, Greece looks cheap but perhaps for good reason.

Here is a chart of Greece's stock market capitalization as a percent of their GDP out to 2011:

In 2011, it reached just 11.62% of GDP. The Dow Jones Greece Total Stock Market Total Return Index looks like this:

One ETF that investors could buy to participate in any kind of growth in Greece's stock market is Global X FTSE Greece 20 ETF (NYSEARCA:GREK):

Note the extreme volatility however.

For kicks, look at Iceland's stock market cap relative to GDP:

Three countries stand out as having stock market capitalizations that are a high percent of their countries GDP. These include Malaysia, S. Africa and Singapore.

Here is their corresponding chart in 1 graph:

An ETF for Malaysia is iShares MSCI Malaysia Index Fund (NYSEARCA:EWM):

An ETF for S. Africa is iShares MSCI S. Africa Index Fund (NYSEARCA:EZA):

Singapore has two ETFs: iShares MSCI Singapore Index Fund (NYSEARCA:EWS) and iShares MSCI Singapore Small Cap Index Fund (NYSEARCA:EWSS).

Here is a chart for iShares MSCI Singapore Index Fund:

Of course this metric is not the end all be all to make investment decisions, but it's certainly a good tool to help identify extremes for long term value investors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.