The stock market capital-to-GDP ratio measures the size of the equity market compared to the so-called Buffett indicator-economy. Since the growth of the corporate sector depends on economic growth, the two inputs of the indicator are expected to run concurrently in the long run.
So what’s the trend in the United States?
The trajectory of the Buffett indicator over the last 50 years shows two basic features:
1. A Rising Trend
The curve has grown fairly steadily in recent years with a pronounced acceleration. What is the explanation for this behavior? The growth of the private sector as a proportion of the economy is probably a culprit. This is because the government’s contribution to GDP has been steadily declining over the last half century.
US stock market capitalization-to-GDP ratio
US stock market capitalization vs. nominal GDP, in USD billion
The increase in money supply has also fueled this acceleration. The US Federal Reserve has consistently lowered interest rates since the early 1980s, and the introduction of additional currencies into the system has helped keep the stock market afloat. With the onset of the Global Financial Crisis (GFC) in 2007, the Fed launched its Quantitative Facilitation (QE) program. Then, the growth of equity market capitalization is much higher than GDP. In other words, QE has helped the stock market more than the economy.
US Stock Market Capitalization vs. Money Supply, in USD billion
2. The duration of sharp peaks and holes
The curve shows four sharp peaks in the last half century. A burst stock bubble before the first three and a recession before hitting down:
- 1972-1974: The Buffett indicator reached 0.85x in 1972 and then fell until 1974. This coincides with the recession of 1973-1975, which was due to the first oil shock and the stock market crash of 1973-1974.
- 1999-2002: The market cap-to-GDP ratio 1 rose to 1.43 in 1999 and then declined in 2002. What happened? The dot-com bubble burst, and the economy plunged into recession in 2001. The stock market peaked in 2000 and did not reach its lowest ebb until 2002. By then, the Fed had lowered interest rates, which helped revive the economy and also contributed to the start of a real estate bubble.
- 2007-2008: Between GFC and the 2007-2009 recession, the Buffett indicator flattened at 1.03x in 2007 before falling to its peak in 2008. The equity market peaked in 2007 and did not begin to recover until 2009, when the Fed’s Kiwi program began.
Today, we are in the middle of the fourth peak. The only question is when it will reach its peak and start its descent.
Current deviation from the trend
Since the inception of Kiwi in 2009, the equity market cap has risen against nominal GDP. Covid-1 – The current round of induced Kiwi has widened this deviation. The Buffett indicator moved into the overvalued area when it crossed the 1.0x line in 2013. This effectively implies that publicly traded companies were more valuable than total economic output. Or that the market expects extremely high economic growth over the next few years.
At the end of 2020, the market cap-to-GDP was about 1.86x. This indicates that public companies are now almost twice the size of the economy. The current imbalance between equity market cap and GDP is the highest and longest in the last 50 years.
The faster the market cap deviates from GDP, the faster it retreats. Therefore if there is any suggestion in the past, we can expect a rapid decline in the equity market. While no one can call the summit, possible triggers for the recession could be the surprising policy coming out of the Joseph Biden administration, the new Fed taper, the deteriorating Covid-1 development, or the global economic downturn.
Setting market time is always a fool’s errand, but the Buffett indicator is blinking red and has been around for some time now, so caution is a precaution.
If you liked this post, be sure to subscribe Entrepreneurial investors.
All posts are the author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
Image Credit: © Getty Images / Ionis Totras
Professional education for CFA Institute members
Members of the CFA Institute have the ability to earn self-assessment and self-reporting professional education (PL) credit, including content Entrepreneurial investors. Members can easily record credit using their online PL tracker.