Introduction to the Stock Market Capitalization-to-GDP Ratio
The Stock Market Capitalization-to-GDP Ratio is an insightful metric used to evaluate whether an overall market is undervalued or overvalued compared to historical averages. This ratio can be useful for focusing on specific markets, like the U.S. market, or can be applied on a global scale depending on the values utilized in its calculation. The formula for this ratio involves dividing the stock market capitalization by the gross domestic product (GDP). It is widely known as the Buffett Indicator, a term attributed to the renowned investor Warren Buffett, who popularized its use.
Formula and Calculation
The calculation of the Stock Market Capitalization-to-GDP Ratio is straightforward and can be expressed using the formula:
[ Market Capitalization \to GDP = \frac{SMC}{GDP} \times 100 ]
Here’s what these terms mean:
- SMC – Stock Market Capitalization
- GDP – Gross Domestic Product
Significance of the Ratio
- The ratio serves as a gauge to determine if the market is undervalued or overvalued compared to historical norms.
- A value between 50% and 75% suggests a market that is modestly undervalued.
- A ratio between 75% and 90% indicates fair value.
- Current ratio between 90% and 115% suggests modest overvaluation.
Understanding Its Meaning
This ratio gained prominence after Warren Buffett appraised it as potentially the best measure available to determine where market valuations stand at any given moment. It presents a comprehensive measure by comparing the total value of publicly traded stocks to the economic output represented by the country’s GDP. Analysts often use the Wilshire 5000 Total Market Index for U.S. stocks and quarterly GDP data for these calculations. Traditionally, ratios above 100% suggest overvaluation, while 50% is considered closer to the historical U.S. average indicating undervaluation.
Global Application
The ratio isn’t restricted to national markets. It can be applied globally by using the World Bank’s data, which releases figures such as the Stock Market Capitalization to GDP for the world, which was 92% in 2018. Global market cap to GDP ratios are influenced by trends in the initial public offering (IPO) markets and the proportion of publicly traded entities versus private entities. A significant rise in publicly traded companies would naturally increase the metric, independent of actual valuation shifts.
Practical Example
Consider calculating the ratio for the U.S. market for the quarter that ended on September 30, 2017. For this period:
- The stock market’s total value (measured by the Wilshire 5000) was approximately $26.1 trillion.
- U.S. GDP for the third quarter was reported as $17.2 trillion.
Using these figures, we have:
[ Market Cap \to GDP = \frac{26.1 \text{ trillion}}{17.2 \text{ trillion}} \times 100 = 151.7% ]
A ratio of 151.7% indicates a significant overvaluation of the market. Historically, peaks, such as during the dotcom bubble in 2000, showed a 153% ratio signaling an overvalued market. However, ratios have shown variability over time. For instance, in 2003, a 130% ratio still led to subsequent market highs. By 2020, the ratio hovered around 150%.
Conclusion
The Stock Market Capitalization-to-GDP Ratio offers a meaningful lens through which investors can view market valuations, aligning historical data with current market conditions to make informed decisions. As with any metric, it’s crucial to consider it alongside other indicators and understand that market predictability based on this ratio has its limitations.
Related Terms: Stock Market, Gross Domestic Product, Market Valuation, Buffett Indicator, Publicly Traded Companies.
References
- Fortune. “Warren Buffett On The Stock Market”.
- The World Bank. “Market Capitalization of Listed Domestic Companies (% of GDP)”.
- Yahoo! Finance. “Wilshire 5000 Total Market Inde (W5000”).
- Bureau of Economic Analysis. “Gross Domestic Product: Fourth Quarter and Annual 2017 (Third Estimate) Corporate Profits: Fourth Quarter and Annual 2017”, Page 8.
