Reading the GDP Leaves

What trader does not wish for a quick and easy signal for fair valuation  -  the trader’s silver bullet.  Some like a measure used by Warren Buffet that compares Total Market Capitalization to the Gross Domestic Product.  The fact that he is impressively successful as an investor probably adds to the credibility of any measure that he admits using.  

At the heart of the ratio is the view that stock prices and therefore market value revert to mean in the long term.  Profits can be realized in the reversion.  It is quite logical.  If total market capitalization is too low, that is the market is undervalued, the excess capital in the economy be attracted to cheap stocks. The resulting demand will cause stock prices to rise.  On the other hand, when GDP is low, the economy cannot support continued investment in stocks at the prevailing price levels.  This is especially the case if the stock market is priced high.  Investment in stocks will diminish and stock prices will decline as supply from sellers outpaces demand. 

The Wilshire 5000 Index has been most popular as a proxy for market capitalization.  It is a broad collection of about 3,600 stocks actively traded in the U.S. markets.  Of course, the U.S. Bureau of Economic Analysis calculates Gross Domestic Product. 

As of January 12, 2017, the ratio was 148.30%.  The lofty figure signals frothy overvaluation.  The only time the ratio has been higher was during the Dot.com bubble in March 2000, when it was 148.50%.  The ratio sank to 57.00% in March 2009 during the Great Recession.  A similar low point occurred in 1982 during an earlier recessionary period.

Ratio Value	Equity Market Indication
Ratio Value  <  50%	Significantly Undervalued
50%  <  Ratio Value  <  75%	Modestly Undervalued
75%  <  Ratio Value  <  90%	Fair Valued
90%  <  Ratio  <  115%	Modestly Overvalued
Ratio Value > 115%	Significantly Overvalued

Advisor Perspectives, a publisher of content for registered investment professionals, provides an excellent review of alternative calculations for the Market Cap/GDP ratio.  A clear upward trend can be observed in the ratio over time that results from a long-term change in the mean.  ‘Detrending’ with regression analysis removes the effects of accumulating data in a time series.  Absolute changes in values are left that can reveal clearer cyclical patterns. 

After completing the detrending step, the resulting ratio in early January 2018 still reflects an overvalued market.  Although with the impacts of the long-term upward bias removed, it is clear the market is not as overvalued as was experienced during the Dot.com Bubble in 2000.

Unfortunately, the ratio says little about how quickly the market will respond to overvaluation or undervaluation.  The impressively high Market Capitalization-to-GDP ratio of 148.30% does not signal an impending stock market crash.  However, a correction in pricing appears more likely than not.  Stock prices revert to the mean in the long-term.  Thus investors need to temper buy/sell/hold with some prudence.

Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.