The signal in US market cap
The ratio of US stock market capitalisation to US gross domestic product has long been a favourite indicator for many investors. The great Warren Buffet himself endorsed it in 2001 as “probably the best single measure of where valuations stand.” But we think we can improve on it. Recent history has shown that it is more appropriate, and more useful, to value US stocks against global GDP. Looking at this measure today we find one more reason to doubt any further multiple expansion in the US.
The US equity market is now valued at around 155% of US GDP. Is that too high? It is hard to say. Over the last 65 years this particular indicator has failed to offer ‘sell signals’ with any reliable consistency. In 1969, the ratio topped out at 100% of GDP, suggesting this might be the level at which to sell. But then the market went on to hit 180% in 2000, 150% in 2007, and 155% today. In fact, since 2000, that 100% level has acted more like a floor than a ceiling; more a signal to buy than to sell.
The US market cap to US GDP indicator has proved a moving target because the world has changed. Starting in the early 1990s US companies began to make much of their money from foreign operations. Today they make more than a third of their profits abroad. With US companies operating in a global marketplace, it now makes far more sense to compare their equity valuations to global GDP.
This not only makes logical sense, it has also worked in the past. While the US market cap to US GDP measure has failed to establish a consistent ceiling, US market cap to global GDP has repeatedly shown resistance at around 35-40%, or at one standard deviation above its historical mean. This level held on numerous occasions throughout the 1960s, then again in 2004-2007. Today we are at that resistance level once more.
This does not necessarily mean US equities are set to sell off. If the global economy grows, asset values can rise along with GDP. But it does suggest there is limited potential for a further multiple expansion. After all, this ratio is effectively an estimate of price to potential earnings. In 1980, the indicator showed fantastic potential for a rerating of US equities; a rerating which duly played out in the secular bull market of the following 20 years. Similarly, the 2008-09 sell-off left a lot of room for multiples to rebound-and, sure enough, they did.
Granted, it is possible that from here onward this ratio could break out on the upside, much as it did in 2000. The US economy could outpace the rest of the world, US companies could gain market share from global peers, and easy monetary policy around the globe could boost asset prices everywhere more than would normally be justified by the prevailing rate of global growth. These are all plausible reasons why our US market cap to global GDP metric could rise above one standard deviation. However, the stronger US dollar is no longer helping US companies to gain market share. The Fed is not as dovish as formerly. And US equity valuations are already pushing against the upper limits of recent experience. Consequently, we think the odds are turning against further multiple expansion and further outperformance from the US stock market.
As a result, we no longer suggest being overweight US equities in general. We continue to see strength in the US economy, so we remain in favour of US domestics over multinationals. But it may now make more sense to look for ways to play the strong US consumer from the outside, from a region offering better value-namely Asia.