The capitalization-to-GDP ratio of the stock market, often referred to as the Buffett Indicator, compares the size of the equity markets to the overall economy. Considering that corporate sector growth is tied to economic growth, these two components are expected to move in tandem over the long term.
Key Points
- The Buffett Indicator has shown a continual upward trend over the past 50 years, with a notable acceleration in recent years.
- The growth of the money supply, alongside decreasing government contribution to GDP, has been a significant driver of this acceleration.
- Sharp peaks in the indicator have historically preceded stock market bubbles and subsequent recessions.
- The current deviation from the long-term trend, particularly post the COVID-19-induced QE, suggests a significant overpricing of publicly traded companies.
- Historically, sharp deviations from the trend have been followed by swift corrections.
So What’s the Trend in the United States?
Over the last 50 years, the trajectory of the Buffett Indicator reveals two primary characteristics:
1. A Rising Trend
The curve has shown a consistent upward movement, with a significant acceleration in recent times. One probable explanation for this behavior is the increasing proportion of private sector growth relative to the economy, as the government’s GDP contribution has steadily diminished over the last five decades.
US Stock Market Capitalization-to-GDP Ratio
US Stock Market Capitalization vs. Nominal GDP, in USD Billions
The increase in the money supply has also contributed to this surge. The US Federal Reserve has consistently lowered interest rates since the early 1980s, injecting additional currency into the system and propelling the stock market. Following the global financial crisis (GFC) in 2007, the Fed implemented its quantitative easing (QE) program, leading to a surge in equity market capitalization that far outpaced GDP growth. Essentially, QE supported the stock market more than the overall economy.
US Stock Market Capitalization vs. Money Supply, in USD Billions
2. Periods of Sharp Peaks and Troughs
The curve indicates four instances of sharp peaks over the past half century. Each of the first three peaks was followed by a burst stock bubble and a subsequent recession:
- 1972–1974: The Buffett Indicator peaked in 1972 at 0.85x before declining until 1974, corresponding with the 1973–1975 recession, partially attributed to the first oil shock and the stock market crash of 1973–1974.
- 1999–2002: The market cap-to-GDP ratio reached 1.43x in 1999 before declining to its lowest point in 2002. This period saw the burst of the dot-com bubble and the subsequent 2001 recession. The stock market peaked in 2000 and bottomed out in 2002, coinciding with the Fed’s significant interest rate cuts, which stimulated economic recovery and contributed to the onset of a real estate bubble.
- 2007–2008: The Buffett Indicator peaked in 2007 at 1.03x, falling to its lowest point in 2008 during the GFC and the 2007–2009 recession. The equity market peaked in 2007 and didn’t begin to recover until 2009, coinciding with the initiation of the Fed’s QE program.
Currently, we are amidst the fourth peak, prompting the question of when it will reach its pinnacle and start declining.
Current Deviation from Trend
The equity market cap surged in relation to nominal GDP following the start of QE in 2009. The current round of COVID-19-induced QE has further widened this disparity. The Buffett Indicator entered overpriced territory in 2013 when it crossed the 1.0x mark, implying that publicly traded companies were valued higher than the total economic production, anticipating exceptionally high economic growth for several years.
By the end of 2020, the market cap-to-GDP stood at approximately 1.86x, indicating that public companies now nearly double the size of the economy. This discrepancy between equity market cap and GDP is the highest and longest-lasting in the past 50 years.
Expectations
Historically, significant deviations from the trend in the market cap have been followed by rapid corrections. The current overextended situation suggests a looming swift decline in equity markets. While predicting the peak is highly unpredictable, potential factors triggering a downturn could include unexpected policies from the Joseph Biden administration, renewed Fed tapering, deteriorating COVID-19 developments, or a global economic slowdown.
Timing the market is always challenging, but the Buffett Indicator has been signaling caution for a considerable duration. Caution is advised.
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The opinions expressed in all articles are solely those of the author and should not be considered as investment advice. They do not necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©Getty Images / Ioannis Tsotras
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