Market Capitalization as a % of GDP
By Barry Ritholtz - August 24th, 2011, 1:35PM
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Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data, ability to repeat discredited memes, and lack of respect for scientific knowledge. Also, be sure to create straw men and argue against things I have neither said nor even implied. Any irrelevancies you can mention will also be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.
August 24th, 2011 at 1:42 pm
I used to really like this chart.. but it was pointed out to me that since so many of the big SPX companies do biz overseas now, and in increasing proportions, that this chart’s concept may be flawed in the current financial landscape… since those sales aren’t part of US GDP…
thoughts?
August 24th, 2011 at 2:04 pm
@ KidDynamite.
That’s a good point until you consider that most of the difference in the valuations is accounted for by the disappearance of the equity premium and a rise in P/Es that is partly masked by the huge cyclical increase in corporate profits as a proportion of GDP.
August 24th, 2011 at 2:05 pm
KidDynamite, dead on – correct.
The idea behind giving “trickle down” tax cuts to “job creators” was that they’d “create jobs” INSIDE America.
Those jobs, In turn, generate tax revenues & economic activity from workers.
As we now know, this “plan” was tragically flawed where it failed to incorporate globalization into the equation.
Using Apple supplier Foxconn as an example, where manufacturing is the biggest sufferer of jobs lost in the U.S., a Foxconn employee that just received a 50% pay raise now makes a whopping $0.49 per hour.
Meanwhile, the American consumer gradually increases debt to offset this lack of wage growth.
All the while executive salaries have exploded exponentially, from 50X the median wage to A current 500X the median wage, and we are borrowing to support those wages and lack of reciprocation for “job creating” tax losses.
We then get into a convoluted debate over the Constitution and the “financial liberty” of those executives.
For any and all answers to that debate, look no further than the “Powers of Congress” section of the U.S. Constitution.
It’s time we reset the wealth transfer & depletion that my favorite talk show pundit, Dylan Ratigan, speaks about so often.
It’s also time we take a long hard look at the Constitutions prohibition of bribery, categorizing it as a “high crime”…yet as I type Washington D.C. is being drowned in bribe money to buy laws and regulation.
August 24th, 2011 at 2:13 pm
Note that secular bears ended in 1941 and 1982 with MC at 20% and 30% of NGDP respectively. Similarly reasonable peaks occurred in 1932 at 62% and 1968 at 77% of NGDP. Joining the peaks and the valleys with trend lines we can project reasonable upper and lower bounds for secular bull tops and secular bear bottoms at 2016 of 95% and 50% of NGDP respectively. The average value trend goes from 42% in 1940 to 55% in 1972 and can be projected to 72% in 2016. The slope is 30 % in 76 years or 0.4 %age points per year. While this slope may still be valid it is likely that there have been structural changes in the economy that have offset the peak/valley or min/max bounds upwards.
What would cause the bounds to shift upwards? And by how much?
To get a better idea of what is happening to Market Capitalization (MC), we can pick off the year end values from Chart 1 and plot them on a linear scale as:
Chart 3
We can see abrupt changes in slope at 1980 and 1992. Did anything happen near those two years that could represent a structural change in the economy or in the way the market is capitalized? What major changes have taken place in this time frame?
Major changes:
1) The great divergence. Income equality converged from about 1930 to near 1980, when inequality started developing. Krugman puts the beginning of the great divergence at 1979. The divergence has put an increasingly larger share of income into the hands of the investing class, providing more money to chase existing shares, which should drive up price.
Chart 4
2) Personal indebtedness. Household debt to tangible assets took off about 1982. Mortgage debt to owner occupied real estate was the main vehicle. It flattened after 1995, and took off again in 2002.
Chart 5
Run up in personal debt corresponds with run-up in market capitalization
3) Taxation. In the early 1980’s Pres. Reagan lowered the upper marginal tax rate from 72% to 28% and the capital gains tax from 25% to 15%, again providing more income to the investing class.
4) Deregulation. Business deregulation started in the late 1970s under Pres. Carter, and accelerated in the early 1980s under Pres. Reagan. There is probably a considerable delay before deregulation effects the economy and MC, but it surely would have been felt by the mid ‘80s. Among other effects, Reagonomics began the deregulation of banks, loosened restrictions on mortgages, marked the beginning of the end of thrift in America and the growing of household debt (the debt growth rate exploded from 1983 to 1989), and started the creation of derivatives, all of which provided more money to chase existing shares.
The repeal of Glass Steagall in 1999 set the stage for the explosion of speculation in exotic derivatives after 2002, that finally led to the credit market crisis and collapse of 2008. Interestingly, testifying before Congress after the crisis, the heads of the 4 largest banks advised that “they made mistakes, but didn’t know how serious they were at the time”. One can probably trust unregulated financial institutions to make mistakes.
5) Derivatives. The beginning of over-the-counter derivatives and swaps, with speculation on interest rates and exchange rates as opposed to pure hedging, started in the 1980s, encouraged by deregulation. There were several side effects, but the pertinent ones were increases in money velocity, (velocity took off sharply in the mid 1980s, growing much faster than GDP, peaked about 1998 and stayed high until mid 2000), in commissions to traders and “quants”, and increases in financial institution profits, again providing more money to chase existing stocks. CDSs and CDOs were invented in 1995, driving velocity up and helping the second kink in the curve. After 2002 the ratio surged again, even with GDP artificially supported by the housing bubble. That surge must have been mainly derivatives fuelling an artificial multiple of capitalization. We still have derivative excesses
6) Globalization. Post WWII globalization can be said to have started in 1948 with the first GATT agreement to reduce tariffs. US multinational growth started in the early ‘60s with the advent of jet travel and accelerated after 1970 when the Boeing 747 was introduced, and again in the late ‘70s under Pres. Carter with airline deregulation sharply reducing air fares. The move of factories offshore, and/or subcontracting to low cost manufacturers grew seriously after China’s opening in ca 1978, but accelerated greatly after 1994 with the development of the internet. Globalization of business for American companies increases MC with little effect on GDP.
7) The digital revolution/Information technology. Started in the early ’60 as computers became affordable, accelerated about 1985 when the PC took off and again in 1994 with the internet. The early effects were accelerated productivity growth which improved MC, and then support of globalization and offshoring.
8) Irrational exuberance. Market capitalization in the relatively healthy periods since 1924 remained in a band between 30% and 80% of GDP, and only broke out of that band after 1994. From 1995 to 2000 the DJIA went up 2.9x, while the % of NGDP went up 2.6x. The break-out occurred while GDP was still growing nicely, so much of that surge is the dot com bubble when P/Es went through the roof. After tax corporate profits rose from a low since 1944 of 4.8% in 1980, to a high since 1929 in 2010 of 9.4%, fueling high P/Es.
The dot com bubble drove P/Es to absurd heights, starting about 1995, and drove the final steep climb in MC, which petered out with the deflation of the bubble in early 2000.
9) Interest rates. The last bounce in MC started in late 2002, when the Fed. dropped interest rates to combat the dot com recession, but also kicked off the housing bubble.
10) Productivity. Productivity growth was relatively slow from about 1973 to 1995, and then much higher to about 2006. The jump is generally attributed to computerization. The impact on MC was mainly through increasing the great divergence (see 1) above).
11) Stock repurchase. Share buybacks in total $ terms increased by a factor of 70 from 1980 to 2005, from $5B to $350B. A buyback of x% of outstanding shares will normally raise the price on the remaining shares by >x%, so there is some contribution to the steeper slope of the MC curve. However even $350B was only 2% of MC in 2005, so the impact is not very large.
12) Employment to population ratio – seemed to stay in a band between 55% and 58% for nearly 30 years after WWII and then broke out on the upside about 1977, probably with growth of women entering the work force, which started picking up about 1973.
13) Demographics “Professor Shiller and a few of his graduate students conducted a study to discover a data series that fits closely with the Shiller P/E ratio. The study revealed that demographics heavily determine stock market valuations. It compared the number of 40-year-olds with the number of 20-year-olds through time. If the number of 40-year-olds grows faster than the number of 20-year- olds, valuations rise. If the number of 20-year-old grows faster than the number of 40-year-olds, valuations fall. In statistics jargon, the “r-squared” of this variable, in explaining valuations, was 0.79. That’s very high, meaning the demographic trends are important in determining long-term stock market returns. Over the next several years, the number of 40-year-olds will decline, due to the lower birth rates between the Baby Boomers and the Boomers’ kids. So the Shiller P/E ratio is very likely to fall.”
14) Manufacturing capacity utilization is well below historic highs but has been on a downtrend since the end of the postwar secular bull market. Relationship to MC/NGDP is not clear, but it was mostly above 80% from 1984 to 2000. If we have a repeat of the ’66 to ’82 secular bear, we are poised for a sharp drop.
We can see from the above 14 points that there was a concatenation of events from near 1980 to 2008 that definitely made fundamental changes in the structure of market capitalization that accounts for the very steep increase in MC during this period, especially to 2000. Now the key questions are: how large and how permanent an impact would these changes make in terms of forcing a step function upward shift in the MC/NGDP ratio band, and what would be the significance of such a shift going forward?
August 24th, 2011 at 2:14 pm
I have a list of 14 factors that have affected the ratio, but can’t seem to post them.
August 24th, 2011 at 2:16 pm
The other question is whether increased market cap simply reflect that the economy has developed such that more an more of the activity is done by the big incorporated businesses.
August 24th, 2011 at 2:54 pm
Small businesses in the U.S. contribute about 50% of U.S. GDP. U.S. small businesses derive the vast majority of their revenues domestically.
August 24th, 2011 at 3:05 pm
The chart is based on July’s Market Capitalization. How different does it look at the August lows?
August 24th, 2011 at 4:11 pm
–delurking–
KidDynamite, is there any chance you got that from me?
I remember posting that in response to this graph the last time I saw it. Global corporations, traded on the NYSE will have value only partially reflected in US GDP. Not that I was first, just wonder if you recall one of my infrequent posts. scant notoriety.
I have moved most of my assets to prwbx, as I think that the high yield bond market is a proxy for all things financial — in a credit crisis. I don’t think this is usually the case, but when credit is the toxin, High Yield corp bond price – is the canary. I’m not as nimble as BR, or many here, as I just try to make my rollover IRA perform for me. a couple moves a year.
My strategy is Hussman + Ritholtz + 200D MA of PRHYX. The first two for tone, the last for timing.
I’m sticking with it til something actually gets fixed, or I give my assets to Hussman and Ritholtz. :)
and calc risk for news without the spin.
I am going to make a prediction, dated 8/23. Equity markets will buy the rumor and sell the fact on QE3. markets up all week. then down on Bernanke’s appearance, regardless of what he says. (not investment advice.)
Best of luck to all.
cjc
–relurking—
August 24th, 2011 at 4:22 pm
@murrayv – thanks for the list. This is why I’ve adopted a “trader” approach for my retirement portfolio.
I have no confidence in buy/hold or other investment strategies that rely on ever increasing market cap until AFTER most baby boomer have retired.
My net strategy — assuming the indexes are range bound for another 10 or 15 years
1 – be patient looking for obvious opportunities to buy low
2- be aggressive building positions
3 – then be quick to sell higher.
Repeat.
August 24th, 2011 at 4:39 pm
@cjcpa:
Why PRHYX?
@murrayv:
Impressive. Thanks for taking the time.
But concatenation? Dog, I had to look it up.
August 24th, 2011 at 6:02 pm
@CJC – sorry, no, it was a buddy of mine who pointed it out… it’s important though, to realize that this chart isn’t quite as useful for showing proper equity valuations in the Age of Globalization
August 24th, 2011 at 6:14 pm
A more interesting graph would be to add (1) “market cap” (proxy for equity) and (2) debt (both govt & household) to get to an ‘enterprise value’ for the economy. Then compare the resulting EV to GDP and see how far that is out of whack on a historical basis…
August 24th, 2011 at 11:09 pm
So this is kind of like a PE ratio for the economy… Market Cap being Price and GDP being Earnings. At least that would make sense of comparing a stock and a flow.
Of course, some a large portion of the economy’s equity is private, so it’s not like taking the PE ratio of the companies that make up the stock cap.
August 25th, 2011 at 9:36 am
molesworth — just cause I own it.
just an update — as the equity market has an up-week, lending to businesses (corp bonds) is having a down week.
Again, I am no sage, and no pro, but I have watched the credit market be a proxy for much more during this crisis.
I imagine that in normal times, the cost of borrowing does not affect the entire economy. But anybody remember when calculatedriskblog started posting the TED spread? It’s not a normal time indicator, like, say GDP or employment. But at some points, it is the headline. It is the story.
I just use prhyx as an indicator of investors’ willingness to a) lend to business and b) pay for yield. I guess you could add a + b = risk appetite.
To agree with Gordo, a good move over the last few years would just be– follow the 200day moving average. Get in when it is going up, get out when it is going down. Not very nimble, but not very heartbreaking either. (Disclosure — I did not follow my own rule in spring ’09 b/c I thought the move up was based on bogus FASB rule changes and not any substantive fix. Thus did not want to get on the ship of fools. I therefore missed most of the move up b/c I did not *believe* it. But I tell myself I believed Hans Blix more than Rumsfeld, but guess who our nation believed? Do you want to be right or do you want to make money? Turns out “our country embarks on a 600 billion dollar search for WMD on the other side of the planet” was the right answer. I didn’t pick that one either. I hate politics, [prefer solving problems] but these days, politics does matter.)
Ship of Fools would be my blog if I had time to run one. I believe Mr. Hoffer says sheeple.
What other people do – IS the market. Therefore, what they think, right or wrong, matters.
cjc