Using Market Capitalization / GDP as a Valuation Metric

Whenever Warren Buffett gives us insight on how he invests, we listen. One point Buffett made recently was to look at the total stock market capitalization compared to GDP. In recent years, the market has done better when this ratio is in the 80% range than when stocks are valued above GDP. This showed itself to be true most prominently during the dot com bubble.

One point I would make is that whatever the correlation there, we also need to factor in government’s percentage of GDP.

Since GDP is calculated as Consumption + Investment + Government + Net Exports, simply increasing the Government component will increase GDP, but that won’t necessarily increase corporate profits. At the extreme, an example would be a completely communist country where there are no corporate profits (no stock market in general) as they would all be seized by the state. Of course, the country still has GDP, since the government spends money. We would expect that countries with a higher percentage of GDP from government contribution to have a lower stock market capitalization/GDP compared to more capitalist countries.

In short, all GDP isn’t created equal when it comes to corporate profits. An increase in GDP due to consumption/investment bodes well for stock profits, whereas one driven by government does not.

I assembled some data from the CIA world factbook comparing the total stock market capitalization/GDP. Since the data is at the end of 2007, valuations were obviously much higher then:

USA: 137%

Japan: 92%

France: 68%

UK: 143%

Germany: 55%

There’s a wide variation, but with the exception of the UK, the trend is clear. Out of these, our situation most resembles Japan, in terms of corporate taxes, debt/GDP, and the ultimate amount of government spending will be a part of GDP.

Let’s make a rather bold assumption and assume that our market and Japan’s market was about equal in terms of accuracy of valuation at the time. Given that, we would ultimately expect the market’s capitalization/GDP to be about 33% less on average than it was during Reagan/Bush/Clinton years after Obama and Congress are through with their stimulus plans and tax hikes.

Comments

[PitbullsAre...:]

he didnt make it rain, he made it drizzle

Mar 02 04:04 PM

[LILLANEY:]

IF IN A COUNTRY LIKE INDIA IF GDP IS GOING TO GROW AT 7 TO 9% MARKET CAPITALIZATION WILL HAVE TO FACTOR INTO THIS GROWTH PLUS INFLATION(4-6%) AND IT IS ALWAYS FOUND THAT IN EUPHORIA MARKE DISCOUNTS THE FUTURE EARNINGS AND HENCE IT IS POSSIBLE FOR THE MARKET CAPITALIZATION TO BE MORE THAN GDP BY A WIDE MARGIN OF 20 TO 25% AS IT HAPPENED IN 2007 WHEN HOUSING BUBBLE BURST IN U.S.

Nov 07 12:02 AM