Total Market Cap To GDP Is Worthless As A Valuation Measure

|
Includes: DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, HUSV, IVV, IWL, IWM, JHML, JKD, OTPIX, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWM, RYARX, RYRSX, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, UWM, VFINX, VOO, VTWO, VV
by: Strubel Investment Management

Summary

Total market cap to GDP shows we might be in a bubble, but the measure is flawed.

Companies that make up the US market earn a substantial amount of profit overseas.

Corporate margins and thus profits as a percent of GDP fluctuate over time.

The proportion of public companies to private companies also fluctuates over time and impacts the total market cap calculation.

I've recently started to come across articles stating that one of "Warren Buffett's favorite" valuation indicators, total US stock market capitalization to US GDP, shows that the stock market is in or near a bubble. When looking at a chart of total market cap to GDP shown below, we do indeed see that we are approaching the previous highs (circled in red) seen during the tech bubble and the housing bubble.

The problem is that total market cap to GDP is a flawed way to determine whether or not we are in a market bubble. There are three main problems with using this indicator that I'll talk about below.

Problem 1

Probably the chief problem with the total market cap to GDP ratio is that we are comparing companies that earn money both domestically and internationally solely to US GDP. In 2017, about 44% of the revenue for companies in the S&P 500 came from overseas (yes, the ratio uses the entire stock market, but the S&P 500 accounts for about 80% of that, so it's a good proxy). Why are we comparing the capitalization of the US stock market to only US GDP? This ratio can vary from year to year based on exchange rates, where companies are headquartered, and how market indices determine what counts as a domestic company or an international company. There is no reason to expect a market index that includes a significant international component to have any stable relationship with US GDP.

Problem 2

The second problem with using total stock market capitalization to GDP is that it ignores the distribution of profits in the economy. If large corporations are earning higher profits and getting a larger slice of GDP, it makes complete sense for the stock market to be valued higher compared to GDP. The chart below shows after-tax corporate profit margins since 1947.

After-tax corporate profits are hovering around all-time highs. As long as higher valuations (i.e., a higher total stock market capitalization) are backed up by higher profits, it's hard to make the case that we are in a bubble. I've read arguments that if profit margins revert to the mean, then the market is overvalued, but I've yet to hear a compelling case on why corporate profit margins are mean reverting and what the catalyst for a reversion to the mean would be. Maybe they will, but then corporate profit margins, not total market capitalization to GDP, would be your valuation metric of choice.

Problem 3

The third and final major issue this valuation measure faces is that it ignores the public versus private composition of corporate America. The measure uses the total market capitalization of all publicly traded stocks. If the proportion of corporate profits earned by public companies and the proportion of profits earned by private companies changes over time, then this valuation metric will fluctuate as well.

Indeed, this is exactly what we've seen happen. Despite the number of public companies shrinking from around a high of 6,000 during the tech boom to a little more than 3,000, the proportion of corporate profits earned by public companies is still quite high. In 1957, the S&P 500 was valued at $172B and traded at a P/E of around 13.3. Using quarterly after-tax corporate profit annual run rate data from FRED, we find that this equates to public companies earning roughly half of all corporate profits. In 2017, the S&P 500 was valued at $23.9T and a P/E of 21.4, yielding implied profits of about $1.12T in total. The annual run rate of corporate profits for the entire economy was about $1.82T, so the S&P 500 accounted for about 62% of all corporate profits.

We used data for the S&P 500 rather than the entire market since it was much easier to access. It's also worth noting that S&P 500 profit figures obviously also include profits from international operations (as we pointed out in our first point). Therefore, using data for the entire market or trying to make adjustments for other factors could yield slightly different percentages, but that's the point. The percent of corporate profits that the market represents changes over time whether it's due to the mix of public versus private companies or because of the effect of international profits.

Summary

These are just three of the major problems with using total market capitalization to US GDP as a measure of whether or not the stock market is cheap. All of the changing variables that make up the measure mean there is no way to come up with a long-term fair value mean or median or some other method of determining when the ratio is too high (bubble) or too low (great buying opportunity). This doesn't mean you can't argue the market is a bubble or that the market won't go down. It just means that using this particular metric to make that point makes no sense.

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.