When Warren Buffett started his investing career, he would respond to general questions about whether the stock market was overvalued or undervalued by pointing to the ratio between the market capitalization of American stocks and America’s GDP. If the market cap of all publicly traded American stocks exceeded the gross domestic product of what the nation produced (i.e. was a ratio over 100%), then the stock market would be considered overvalued. And if the ratio was below 100%, the stock market would be considered undervalued. Right now, the market cap to GDP ratio is 147%, which would historically suggest that stocks in aggregate trade at 1.5x their overall value based on Warren Buffett’s historically used benchmark.
As you may have noticed, Warren Buffett has not cited this valuation benchmark in recent years.
I suspect there are at least two reasons why.
As an initial matter, Benjamin Graham introduced the concept in a pre-WWII America where it was taken for granted that every large business in the country would be public and generate nearly all of its profits in the United States. Those were the presumed and consistent conditions of the concept.
But over the past sixty or so years in general, and over the past twenty specifically, those assumptions are no longer true. The rise of cheap financing in the United States, along with automation that has facilitated the rise of vast fortunes in software and e-commerce, as well as historically low tax rates, enables private-market fortunes to ripen and grow without the need to raise capital through an IPO. As a result, private-market businesses now account for 19% of business activity for companies worth of $1 million in the United States, compared to only 4% in 1930. This affects the calculation because private industry contributes to GDP but is not part of publicly traded market calculations.
Secondly, and much more substantially, many multinationals in the United States have become just that–multinationals. Right now, Philip Morris International is headquartered in New York, but 100% of its profits originate outside the United States. So it contributes towards the market cap portion of the calculation, but it does not contribute towards the GDP portion of the calculation. A similar story occurs at Coca-Cola, where 81% of profits are created outside of America. GDP does not capture these profits, but they are part of the American market cap, distorting the ratio.
Fortunately, neither you nor I are required to make any conclusions about the market as a whole in order to build household wealth. You only have to find one business idea at a time that is offered on fair terms. If you are right about the business proposition you select, it doesn’t matter if the rest of the market is overvalued. On the other hand, if you choose an investment on poorly valued terms, it doesn’t matter if general conditions are favorable if you specifically choose the unfavorable proposition. Comparing market cap to GDP maybe had some historical value when the expectation of all large businesses being public and earning their profits in the United States was a given, but as those conditions have varied, the value of the formula as a useful comparison tool has diminished.
