Stock Market Exuberance
Valuations have risen much faster than earnings
The ratio of the market capitalization of all stocks to GDP, sometimes called the Buffett Indicator, has risen from 41.9 percent in 1981 to 205.6 percent most recently. Forty years ago, nominal GDP was $3.12 trillion. Most recently, it was $21.5 trillion. Multiplying, the market capitalization in 1981 was $1.31 trillion, and today it stands at $44.2 trillion.
Arithmetically, the increase in the ratio of stock market values to GDP has two sources. One is an increase in the ratio of corporate profits to GDP. The other component is the ratio of stock prices to profits, what we might call the valuation ratio. I think of it as measured in years, meaning the number of years it will take for companies to earn the profits to justify their share values.
In 1981, corporate profits were $0.245 trillion. More recently, they were $2.35 trillion. In 1981, profits were 7.84 percent of GDP. More recently, profits were 10.93 percent of GDP.
In 1981, the valuation ratio was $1.31 trillion/ $0.245 trillion, or 5.35 years. More recently, the valuation ratio was $44.2 trillion/$2.35 trillion, or 18.8 years. Had the valuation ratio remained at 5.35 years, the market capitalization of stocks today would be only $12.6 trillion. Imagine your favorite stock index at less than 1/3 of its current level.
In short, most of the increase in the market capitalization of stocks over the past 40 years does not come from higher overall profits. Most of the increase comes from extending the number of years that investors are willing to pay for profits.
Does the spectacular rise in the valuation ratio, from 5.35 years in 1982 to 18.8 years today, mean that it is too high? If you think that it will revert to some historical mean value, then you would say yes. But if you compare it to the way that real interest rates have behaved, then you would say no. In 1981, the inflation-adjusted interest rate on the 10-year U.S. Treasury bond was at least 2-1/2 percent. Today, this inflation-adjusted interest rate is below zero. At such an interest rate, stocks are cheap as long as corporations are earning any profits at all.
I think that negative real interest rates are a sign that financial markets are out of whack. If I am right about this, then at some point interest rates will climb, and this may finally put in an end to forty years of increasing stock market valuations. If I am wrong about this, and low or negative real interest rates are with us indefinitely, then stock market valuations ought to be even higher than they are today.
We've trained the population to expect that prices will increase at 2% annually, while a diversified portfolio will increase 6+% (with little risk and a central-bank safety net). I believe this creates the perception that utility of saving exceeds that of consumption.
Add government and central bank backstops to financial asset values and you end up with a stock of "wealth" that greatly exceeds the size of the economy. This creates negative real rates, pushes down future returns on all financial assets, etc. The big losers will be those just beginning to accumulate assets - we've essentially engineered a massive one-time wealth transfer to people who accumulated assets years/decades ago.
With $2.35T in profits (likely to grow as the economy ramps back up) and a market price of $44.2T you have an earnings yield of 5.3%. Compared to the 1.24% yield on a 10 year U.S. bond, that doesn't seem all that crazy.