The market capitalization/GDP ratio — the so-called Buffett indicator – measures the size of stock markets relative to the economy. Since the growth of the corporate sector depends on economic growth, the two inputs of the indicator should move in sync in the long term.
So, what is the trend in the United States?
The trajectory of the Buffett indicator over the past 50 years has two main characteristics:
1. An upward trend
The curve has seen a fairly continuous rise, with a pronounced acceleration in recent years. What explains this behavior? The growth of the private sector as a proportion of the economy is likely one of the culprits. This happened as the government’s contribution to GDP has gradually declined over the past half century.
Market capitalization to GDP ratio in the United States
US market capitalization to nominal GDP, USD billion
Money supply growth also fueled this acceleration. The US Federal Reserve has been steadily cutting interest rates since the early 1980s and the extra money this injected into the system helped propel the stock market. With the onset of the Global Financial Crisis (GFC) in 2007, the Fed instituted its Quantitative Easing (QE) program. Thereafter, the growth of stock market capitalization largely exceeded that of GDP. In other words, QE has helped stock markets more than the economy.
US market capitalization relative to money supply, in billion USD
2. Periods of sharp highs and lows
The curve shows four cases of sharp peaks over the past half-century. Each of the first three preceded the bursting of a stock market bubble and a recession before hitting bottom:
- 1972-1974: The Buffett indicator peaked in 1972 at 0.85x and then fell until 1974. This corresponds to the recession of 1973-1975, partly due to the first oil shock and the stock market crash of 1973-1974.
- 1999–2002: The market cap-to-GDP ratio peaked at 1.43x in 1999, then declined to a low in 2002. What happened? The dot com bubble burst and the economy fell into recession in 2001. The stock market peaked in 2000 and did not bottom out until 2002. By then the Fed had cut interest rates. interest, which helped revive the economy and also contributed to the start of a real estate bubble.
- 2007–2008: The Buffett indicator peaked in 2007 at 1.03x before falling to its nadir in 2008 amid the GFC and the 2007-2009 recession. The stock market peaked in 2007 and only began to recover in 2009 when the Fed’s quantitative easing program began to take effect.
Today we are in the middle of the fourth peak. The only question is when it will peak and begin its descent.
Current deviation from trend
Market capitalization skyrocketed relative to nominal GDP after QE began in 2009. The current COVID-19-induced QE cycle has widened this gap further. The Buffett indicator entered overvalued territory in 2013 when it broke through the 1.0x line. This effectively implied that publicly traded companies were worth more than total economic output. Or that the market was expecting extremely high economic growth for the next few years.
At the end of 2020, market cap to GDP was around 1.86x. This suggests that state-owned enterprises are now nearly twice the size of the economy. The current mismatch between market capitalization and GDP is the highest and most enduring in 50 years.
Each time the market capitalization has deviated so strongly from the GDP, it has rebounded just as quickly. So if the past is any prologue, we can expect a rapid drop in stock markets. While no one can call the peak, possible triggers for a downturn could include the Joseph Biden administration’s surprise policies, the Fed’s further taper, worsening COVID-19 developments, or an economic slowdown. global.
Timing the market is always a wild ride, but the Buffett indicator has been flashing red and has been for some time now, so caution is the watchword.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
Image credit: ©Getty Images / Ioannis Tsotras
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