In a 2001 Fortune article, Warren Buffett described his favoured valuation indicator for the US stock market, namely total market capitalization to GDP. This ratio measures the total stock market value of all listed companies to the overall wealth created by the United States. Buffett’s main point was that there should be a direct relationship between the two: the better the economy the better the stock market. "It is probably the best single measure of where valuations stand at any given moment," Buffett wrote back in 2001.
Over the years, this measure has been commonly accepted by the investment community to a point that it is computed by and commented on by central bankers, namely by the St Louis Fed as can be seen in the graph below :
Source: St Louis Fed
Based on this measure, the US stock market looks totally overvalued especially in a pandemic hit economy. However, as our colleague Michael Gielkens from Vimco rightly pointed out in a recent Linked-in post, it would be premature to jump to conclusions as this valuation measure is far from perfect.
Indeed, stock markets are driven by earnings and earnings multiples and not by GDP trends. The percentage of corporate profits to US GDP has doubled since the 70’s. In other words, the US corporates became much richer than the overall economy and represent now 10% of overall US GDP versus 5% in 1971.
The reasons for this trend are multiple:
- US consumers have seen their employers cutting costs and seen pressure on their wages. This was good for the profitability of the companies but less good for the consumer.
- Globalization has not only let to cheaper sourcing by US corporates but also to more profits generated overseas that are less dependant on the overall state of the US economy.
Each aggregate market valuation measure has its limitations. Yet, we cannot think of one valuation measure ( Cape PE, P/CF, rel P/E, ... ), except relative to bond yields, that makes the US equity market look attractive. In the Shiller CAPE graph shown below, using normalized earnings over a 10 year business cycle, the US market is now at the third highest level seen over the last 150 years.
Shiller CAPE US equity market
Source: Toroso Asset Management
One reason for this is the high weight in the broader stock market indices of a few technology leaders. Apple, Microsoft, Amazon, Facebook and Alphabet represent now 22% of the S&P 500 and contributed the major part of the ytd performance of the S&P 500. The phenomenon has been so extreme that tech has become the most crowded trade in the most recent Bofa global fund managers survey ( even more crowded than the long gold trade ):
If history can be any guide, this spells trouble for some names that appear priced to perfection. As European Value investors, you sleep better far away from the hyped glamour stocks.