For the past several months, many institutional investors have cited the U.S. stock market capitalization-to-GDP ratio, also known as the “Buffett Indicator,” a metric he first described 25 years ago in an interview with Fortune, as an indication that equities may potentially be overvalued. According to Bloomberg Research, as of Friday U.S. equities are currently at a market-cap-to-GDP ratio of approximately 2.3x. The ratio was ~1:1 at the time of the Fortune article in 2001, having descended from just under 1.5x at the tech bubble peak in March 2000. In the 2008/2009 GFC trough, the U.S. publicly traded equity market (as measured by the Wilshire 5000) was ~half US GDP, which, for illustrative purposes, we’ll estimate averaged about $14.5 trillion nominal. GDP has since more than doubled, to ~$31.5 trillion, but U.S. equity valuations have increased more than 400%. For perspective, consider that the five largest publicly traded U.S. companies today have a combined market capitalization of over $17.5 trillion as of Friday’s close, approximately equal to the United States’ nominal GDP twelve years ago. In fact, the combined market cap of the top 25 companies in the S & P 500 exceeds U.S. GDP at the moment, totaling $32 trillion. Before panicking and selling all your stocks, though, a bit more context is necessary. For one thing, the trend for decades has been that the largest publicly traded companies in the U.S. have represented an ever larger (growing) share of the economy. Between 1980 and 1996, the relationship grew at a fairly steady rate from ~40% to ~75%, nearly doubling its share over that 16-year stretch. The tech bubble disrupted that trend, but by 2006, U.S. equities were back on the long-term trendline and continued to follow it until 2007 or so, when it was disrupted once again by the GFC. Just prior to the pandemic, US equities were around 140% of GDP, but again, that was consistent with the broader trend of large companies growing the share of the economy, so still not hugely expensive, at least by the Buffett Indicator. The fact that there is a trend at all suggests there is an underlying dynamic at work that a simplistic ratio doesn’t capture, and to establish whether the 230% where we find ourselves now is as extreme as it might sound requires that we at least think about whether some potential drivers of the trend have accelerated recently. What changes in the economy and the public equity markets plausibly make market cap/U.S. GDP migrate over a few decades? Globalization certainly is a factor. A meaningful share of S & P 500 sales comes from outside the U.S., so U.S. GDP can understate the revenue base of U.S.-listed multinationals. JPMorgan notes that the S & P 500 generates roughly 28%–30% of sales overseas, and tech is much higher at 55%. A counterpoint is that globalization cuts both ways, yes, US companies sell far more overseas than they once did, but so too do US consumers purchase significantly more imported goods, particularly from China, than they did in 1980. A more compelling reason is that the largest companies are very high-margin, asset-light businesses. Today’s market has a larger weight in businesses where value is tied to intangibles (software, IP, networks) and where margins can be structurally higher than in old-economy mixes. That can support a higher market cap relative to GDP— if margins persist. The profits of the aforementioned top 25 companies in the S & P exceeded 3% of US GDP over the past twelve months. Rates matter too. If long-run real rates are lower than historical averages, a higher market cap/GDP is justifiable, 1) it increases the present value per dollar of cash flow (higher multiples), and 2) it suggests the cost of capital/borrowing is lower, possibly fueling faster growth. This is a tricky one, because US rates had been in a multi-decade-long down trend since 1981. Rates were very high from the late 1970s through 1981 in response to high inflation. That downtrend was definitively broken in 2022 as the nastiest bout of inflation in 40 years took hold. If monetary policy contributed materially to the slope of the trend line over the past 45 years, that could spell trouble because, although borrowers (most notably governments) would like lower rates to sustain their high debt loads, the Faustian bargain of money printing has begun to reveal itself. One should neither want nor expect us to return to it, beyond the 2%-3% or so per year that policymakers have convinced folks is acceptable. JPMorgan outlined late last year that high PE ratios are associated with much lower returns over the subsequent 10 years, while also noting that current levels are not far from the highest levels in the past four decades. How might investors adjust their positions if concerned about the confluence of measures of relative expensiveness for US equities? One way would be to use stock replacement strategies; for example, one could replace long S & P positions with call spreads to lock in gains while limiting downside, such as buying call spreads in the S & P 500 ETF or S & P 500 Index . A diversified hedging portfolio can include reliable hedges like put spread collars, where a downside put spread is financed by selling upside calls, and reducing sector exposure to those that are trading at rich multiples. Much of the sector rotation we’ve seen since December may be investors repositioning in exactly this way. While Bloomberg research indicated that gold may act as a top performer when U.S. equities eventually revert, potentially falling less than most risk assets in a deflationary cycle, and we do feel gold deserves a tactical allocation, it is also among the assets that have significantly outperformed in recent years, and we would observe it’s inconsistent to chase one of the hottest assets on a thesis of broader mean reversion. Finally, one might look to enhance returns if stock price appreciation slows by adding covered calls and other premium-selling strategies. In fact, a diversified basket of stocks with a call overwriting program could finance some measure of downside index protection (such as SPY or SPX put spreads) without the headwind of negative carry. We don’t possess a crystal ball, so we’re ill-prepared to answer the question: Is the bull market over? But equities have come a long way, and 20% YoY appreciation is not the norm. As Herb Stein, former senior fellow at the American Enterprise Institute, famously observed: “If something cannot go on forever, it will stop.” DISCLOSURES: None. All opinions expressed by the CNBC Pro contributors are solely their opinions and do not reflect the opinions of CNBC, or its parent company or affiliates, and may have been previously disseminated by them on television, radio, internet or another medium. THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSTITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. THE CONTENT IS GENERAL IN NATURE AND DOES NOT REFLECT ANY INDIVIDUAL’S UNIQUE PERSONAL CIRCUMSTANCES. THE ABOVE CONTENT MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. BEFORE MAKING ANY FINANCIAL DECISIONS, YOU SHOULD STRONGLY CONSIDER SEEKING ADVICE FROM YOUR OWN FINANCIAL OR INVESTMENT ADVISOR. Click here for the full disclaimer.
Trending
- Cuba appears to hold speedboat suspects in provincial hospital
- Block plans to lay off nearly half its staff in ‘deliberate and bold’ embrace of AI
- Ocado failing to deliver on its potential as one of UK’s great technology hopes | Ocado
- Grant Cardone plans to tokenize his firm’s $5 billion real estate portfolio
- Nvidia Hit by Profit Taking but $300 Target Still in Sight
- Syfe Brings J.P. Morgan’s Active ETF Strategy to Singapore Investors
- US weekly jobless claims rise slightly; unemployment rate likely unchanged in February
- Yields in a crucial part of the Treasury market keep falling — and it may have something to do with AI
Thursday, February 26
