Practical analysis for investment professionals
02 February 2021

Beware the Bubble? The US Stock Market Cap-to-GDP Ratio

The stock market capitalization-to-GDP ratio — the so-called Buffett Indicator — measures the size of the equity markets relative to the economy. Since corporate sector growth depends on economic growth, the indicator’s two inputs are expected to move in sync over the long term.

So What’s the Trend in the United States?

The Buffett Indicator’s trajectory over the last 50 years displays two primary characteristics:

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1. A Rising Trend

The curve has been on a fairly continuous upswing, with a pronounced acceleration in recent years. What explains this behavior? The private sector’s growth as a proportion of the economy is probably one culprit. This has occurred as the government’s contribution to GDP has gradually decreased over the last half century.


US Stock Market Capitalization-to-GDP Ratio

Chart showing US Stock Market Capitalization-to-GDP Ratio
Sources: All charts derived from St. Louis Fed, BEA, and Earthen Street Capital data.
Notes: Q3-2020 GDP is used as a proxy for 2020 GDP; Wilshire 5000 Index is used as a proxy for the total equity market.

US Stock Market Capitalization vs. Nominal GDP, in USD Billions

Chart of US Stock Market Capitalization-to-Nominal GDP Ratio

The growth of the money supply has also fueled this acceleration. The US Federal Reserve has steadily reduced interest rates since the early 1980s and the added currency this has injected into the system has 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 in equity market capitalization far outpaced that of GDP. In other words, QE helped the stock markets more than the economy.


US Stock Market Capitalization vs. Money Supply, in USD Billions

Chart showing US Stock Market Capitalization vs. Money Supply, in Billions

2. Periods of Sharp Peaks and Troughs

The curve displays four instances of sharp peaks over the last half century. Each of the first three preceded a burst stock 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 with the recession of 1973–1975, which was due in part to the first oil shock and the stock market crash of 1973–1974.
  • 1999–2002: The market cap-to-GDP ratio crested at 1.43x in 1999 and then declined, bottoming out in 2002. What happened? The dot-com bubble burst, and the economy fell into recession in 2001. The stock market crested in 2000 and didn’t reach its lowest ebb until 2002. By that time, the Fed had slashed interest rates, which helped revive the economy and also contributed to the start of a real estate bubble.
  • 2007–2008: The Buffett Indicator summited in 2007 at 1.03x before falling to its nadir in 2008 amid the GFC and the recession of 2007–2009. The equity market peaked in 2007 and did not start to recover until 2009, when the Fed’s QE program began to kick in.

Today, we are in the midst of the fourth peak. The only question is when it will reach its summit and begin its descent.

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Current Deviation from Trend

The equity market cap spiked versus nominal GDP after the start of QE in 2009. The current round of COVID-19-induced QE has widened this deviation even further. The Buffett Indicator went into overpriced territory in 2013 when it crossed the 1.0x line. That effectively implied that publicly traded companies were worth more than the total economic production. Or that the market expected extremely high economic growth for the next several years.

At the end of 2020, market cap-to-GDP stood at approximately 1.86x. This suggests that public companies are now almost twice the size of the economy. The current mismatch between equity market cap and GDP is the highest and longest lasting in the last 50 years.

Expectations

Every time the market cap has deviated so sharply from GDP, it has snapped back just as rapidly. So if past is any prologue, we can expect a swift fall in equity markets. While nobody can call the peak, among the possible triggers for a downturn could be surprise policies coming out of the Joseph Biden administration, renewed Fed tapering, worsening COVID-19 developments, or a global economic slowdown.

Timing the market is always a fool’s errand, but the Buffett Indicator is flashing red and has been for a while 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, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images / Ioannis Tsotras


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About the Author(s)
Dhruv Goyal, CFA

Dhruv Goyal, CFA, is the founder of Earthen Street Capital. He specializes in global macro research, and sovereign bond and currency investments. He has more than 15 years experience in the industry and has previously worked with Nationwide Insurance, Wisconsin Alumni Research Foundation, and CUNA Mutual Group in the United States. He holds an MBA from University of Wisconsin-Madison and is a CFA charterholder.

8 thoughts on “Beware the Bubble? The US Stock Market Cap-to-GDP Ratio”

  1. Emile Bouchard says:

    I would be interested to see the impact of globalization on this ratio. Before the 90s, more US companies were generating business within their borders, today many US companies are generating a significant portion of their revenu outside the US.

    1. Dhruv Goyal, CFA says:

      I am not sure if my previous reply got posted, so replying again.

      This is a good point. Logically, there should be an influence of US companies’ foreign business in their market cap, which would contribute to upward drift in Market cap to GDP ratio. However, I suspect it is not a significant driver of the trend.

      One can look at it in two ways –
      1. Using US GNP instead of GDP in the ratio, to account for foreign income of US firms. Over last 20 yrs US GNP has been approx. 1% higher than GDP. Thus, Mkt cap/GNP ratio shows very similar trend and values as Mkt cap/GDP.

      2. US Mkt cap to World GDP trend, as a rough way of assessing influence of global GDP growth on US mkt cap. This ratio also shows very similar trend as US Mkt cap/ US GDP (0.39 in 2019). This suggests that either US firms are rapidly gaining share in World economy (at the cost of all other countries), to currently be worth 39% of World GDP, or the markets are overvalued (more likely). This, at a time when US GDP has been falling as a proportion of World GDP.

      Thus, one can see that the markets are overvalued even with these metrics.

    2. Adam Jones, CFA says:

      My thoughts exactly!

  2. Juan Pablo says:

    GDP is estimated with a fair degree of accuracy in G20 countries… but those same countries have very old demographics (lower growth). In most of the world GDP is at best a rough guess. Black markets and barter systems dominate more than half the globe, while VAT taxes encourage under-reporting throughout the EU.

    Many industries have been nationalized in countries that are supposedly private capitalism. The US government controls 95%+ of the US mortgage market, while government sponsored entities (utilities, telecom, money center banks, defense contractors, universities, hospitals) are officially private but are completely controlled by government… these entities tend to over-report their GDP contributions. Bureaucrats the world over are judged by how much money they spend (or report spending), never for efficiency.

    GDP numbers may be significantly over or under estimated— and as the share of private vs public economic activity changes, the measuring error is not consistent even within a given country.

    In G20 GDP estimates, the noise is almost as big as the signal. In emerging markets (where most of the growth is today) the noise is bigger than the signal. This makes market cap to GDP ratios highly inaccurate— maybe too high, maybe too low— and over time probably both.

    An economic model is only as good as the data going into it, and GDP is poorly measured.

  3. Adam Jones says:

    This article ignores that the historical geographic source of the S&P 500’s profits have drastically changed over the past 50 years. What does the S&P relationship with US GDP really tell us if a large and growing portion of the profits are derived from outside the United States?

    1. Dhruv Goyal says:

      As mentioned in my reply to a similar question above, the inclusion of foreign business estimates does not alter the conclusion that the market is currently overvalued.

      1. JATINDER says:

        Not a good idea to pronounce the market as ‘overvalued’ based on 1 or 2 indicators. GDP & earnings can grow faster than currently estimated. Buffett’s own performance vs S&P500 has been subdued ovr past 10+ yrs. Ppl especialy Buffett & Finance professionals hav been calling TSLA overvalued since 2013, they were wrong n will be proved wrong again soon. So no point in following such useless indicators, as the dunamics of economy & markets keep changing ovr time.

        1. Wizard says:

          Bro… the author isn’t discussing one stock, his article is about the entire stock market being overvalued. Whereas, in your comment, you’re looking at an individual stock: TSLA. This is not a fair comparison.

          Furthermore, the Buffet indicator doesn’t have anything to do with the Buffet’s performance vs S&P over the past years. The Buffet indicator is the ratio of stock market cap to GDP. It’s an indicator that companies, at this moment in time, are selling shares at a price way more than the value they’re producing.

          Moreover, you’re confusing speculated stock value, which doesn’t have much relevance to the author’s article. There’s a big difference here that you’re missing. Let’s say there’s a company XYZ that makes $1 in profit per share per year. Then, let’s say the best bond available gives me a 1% APY. Then, it only makes sense for me to buy stock of XYZ at $100/share.

          However, others might think that XYZ will revolutionize the car industry and they might think that in the future, XYZ will generate $100 in profit per share per year. They want to get in on it RIGHT NOW. This urgency in time creates a high demand for the stock, while the stock supply is fixed. This drives the stock prize up, purely based on hope that XYZ will achieve something. This is called speculation. It’s called speculation because there are lots of ‘what if’s’ and there is no analysis known that can predict this.

          TSLA is great example of speculation. For years, Musk has been promising things that have not been delivered (full self-driving since ~2016, Tesla robo taxis, etc.). Yet, the mass still hopes and believes that he will deliver. This belief with FOMO raises the stock price. Remember the time frame of the urgency is important, because the demand has to be greater than the supply.

          What the author is talking about has nothing to do with speculation. His article is about the present reality. The stock market is overvalued.

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