Warren Buffett called the ratio of total stock market to US GNP "probably the best single measure of where valuations stand at any given moment." I respectfully disagree. I think it is one of the worst possible valuation metrics for the market. In fact, I think it is basically useless and tells investors nothing.
In this article, I'll go over three important factors that make this metric useless. We will skip the inherent problems of measuring a stock (market capitalization) versus a flow (GNP or GDP) and focus on just the fundamental underlying issues the metric has.
Before we go into the problems with the metric we can see why it's being talked about more and more. The chart below taken from the Federal Reserve data site shows the stock market capitalization compared to GDP (a close approximation of GNP). We can see that the measure is near times highs.
Using another data source, investing website GuruFocus.com, we see a similar pattern with the ratio approaching all time highs.
So it's natural that investors might be worried. But here's why you shouldn't be.
Ignores Foreign Earnings
The biggest issue with the market cap to GNP/GDP ratio metric is it ignores the growth of foreign earnings. From post WW2 to about the 1970s foreign profits made up about 5% of the earnings for S&P 500 companies. However, as the forces of globalization began to take hold the share of profits S&P 500 companies earned overseas began to increase. The graph below from BusinessInsider.com shows the jump.
The percent of foreign income has continued to increase and in 2015 about 33% of after tax profits for the S&P 500 came from overseas.
What this means is that the value of the S&P 500 and the stock market as a whole represents not only profits in the US but also overseas. Comparing the stock market to the size of the US economy at this point just doesn't make any sense.
Ignores Corporate Consolidation
The second problem for the market capitalization to GDP metric deals with industry consolidation. Let's say we have an economy that contains four companies, publicly traded ABC Corp and privately held X Corp, Z Corp and Y Corp. All are worth $5B. Let's assume that GDP is $20B. The public market cap to GDP ratio would be 25% ($5B ABC Corp divided by $20B in GDP). Now let's say we have the same economy but ABC Corp has increased its market share at the expense of X Corp and forced X Corp out of business. Now ABC Corp is worth $10B. The new market cap to GDP ratio is 50% ($5B original ABC Corp plus $5B in new market share from X Corp divided by $20B). Nothing about the economy changed but the valuation metric doubled!
In the US we are seeing something similar. We are seeing a larger share of corporate profits accrue to the largest companies, almost all of which are publicly traded. The chart below from The Economist shows how almost every industry in the US is becoming increasingly consolidated.
This means that the percentage of corporate profits that publicly traded stocks represent is increasing. That means that the value of the stock market can grow at a rate faster than overall GDP if those public companies are taking market share from smaller, private competitors.
Without accounting for the distribution of profits between public companies and private companies, the market cap to GDP ratio becomes meaningless.
Ignores Corporate Profit Share
The final problem with the market cap to GDP valuation metric is that it ignores the composition of GDP. If capital (i.e. corporations) are taking a higher share of GDP compared to labor then it would be natural to see the value of those corporations rise. Indeed, we can see that is the case by looking at corporate profits as a percent of GDP.
While I've seen many people claim that corporate profits are mean reverting I've never seen any complete argument that attempts to explain why corporate profit levels will revert and what the true, appropriate mean level actually is. The economy is an incredibly dynamic entity has seen decades (or longer) periods of time when labor has the upper hand and when capital has the upper hand. Absent large political or social changes, I don't see why a significant shift in share of GDP would occur.
In summary there are many flaws with using market cap to GDP (or GNP) as a valuation metric. The metric simply has no way of accounting for underlying changes in the structure of the economy and the public markets. The metric really has no redeeming qualities and investors are simply better off ignoring it and concentrating on the underlying fundamentals of the economies and companies they are interested in investing in.
Disclosure: I/we 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.