The sig­nal in US mar­ket cap

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

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.

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