GDp vs. Market Cap
We were e-mailed the following note about our recent post on GDP.
“This graph looks interesting, but I am not sure that one can relate the capitalised value of publicly traded companies with GDP. Firstly, GDP of actual productive activity is in some sense lower than what is recorded because much of what passes as goods and services (particularly services) arises from government activity that would not be produced and would be over-priced and have very little if any real value.
“Secondly, the value of businesses participating in the economy is much higher when you count all those businesses that are not listed on the stock exchange or are run by government.
“Finally the capitalised value of publicly listed firms is some multiple of forward earnings with that multiple now around 16, and varying over time (from about 8 to 28 in the USA). If the multiple can be sustained by future earnings then share prices are OK. Also, it should be noted that value investors such as Buffett consider the residual value of firms after taking account of projected earning over a 10-15 year period. That residual value can be very substantial, and make the share price reasonable, even when the current PE looks excessive.
“I am not sure what is a reasonable level of total market capitilisation to GDP."
We are not sure what is reasonable either. But we do know what the historical market-cap to GDP ratio is. The average, according to the good folks at Bianco Research is about 60%. That is, the stock market’s total value is about 60% of national GDP (in the U.S.).In 2000, the ratio reached 183%, and then corrected down to 90% (largely the result of a loss of $7 trillion market cap from the Nasdaq tech wreck.)Today, the ratio is around 120%, with market-cap north of US$16.3 trillion and GDP around $13.3 trillion. That’s still high by historic standards. Twice as high as the historic average, in fact, suggesting that the stock market could lose another $5 trillion and still be above average in relation to GDP.
The story here in Australia is no better. The stock market has a total market cap of around $1.3 trillion. GDP, according to the latest World Bank Figures, is around $674 billion. That puts market cap at 92% higher than GDP. Does it really mean anything?
As our commenter pointed out, measuring GDP is an inexact science. It may be more. It may be less. The really important question is how much investors are willing to pay today for future earnings. The larger the market cap the number, the more we find investors are willing to pay for future earnings. It means they have confidence earnings will grow. The larger the market-cap-to-GDP ratio is, the greater the premium investors seem to be willing to pay.
The problem is that not much of the future is foreseeable…and that investors, in times of euphoria and easy money, pay far too much for average performance. So despite the real difficulties in measuring GDP, this market-cap-to-GDP ratio is more of a red-light indicator than an entire economy has become overly-financialized. It’s an indication of speculation, lack of judgment, and good old fashioned greed.
There are plenty of ways you might rationalize the discrepancy between what the economy is actually producing and what value the stock market is placing on it. But we’d submit that the debate over the economy’s production is a fairly simple one without major variations being possible. On the other hand, the value the investing public places on the stock market is entirely subjective, and hence, variable.
The market moves with the social mood and the social mood is improved by a rising market. And in the end, that’s what makes the study of markets the study of human behaviour. People are brilliant, and they are stupid. They are prudent, and they are foolish. They are fearful. And they are greedy. And they are all these things by turns, their prejudices moving with the cycles of the market and the economy.
It’s probably appropriate that we approach the year of the pig. An old investing aphorism goes that “Bulls make money and bears make money, but pigs get slaughtered.” Bring home the bacon while you can, dear reader. Oink.
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About the Author
Dan Denning is the author of 2005's best-selling The Bull Hunter (John Wiley & Sons). A specialist in small-cap stocks, Dan draws on his network of global contacts from his base in Melbourne, Australia and pens the small cap newsletter, The Australian Small Cap Investigator. He is also a contributing editor to the Australian resource investing publication Diggers & Drillers.
Comment by Ron Pylant on 8 July 2008:
Good discussion. I am not an economist, however I think it might be correct, and possibly valuable, to suggest that the GDP/Mkt Cap indicator is particularily long term, and the time and pain level between approaching an inflection point and reaching an inflection point under current circumstances might be considerable. I'm under the impression that the US market cap is at roughly 109% of GDP, and a correction to 90% of GDP (as in the post tech era) might cost something in the neighborhood of another $2.5 trillion market cap. The US dollar on a trade weighted basis is about as low as it's been in the last 30 years and would require something like a 42% rally to reach the levels of 2002. At what point might one consider that the US market has reached fair value - relative to the declining importance of the US in the world economy?