Life’s experience is a template for recognizing life’s extremes. There are so many things out of place in U.S. financial markets that one almost doesn’t know where to begin. But here’s one that’s a good indicator that equity market valuation is way too high. Generally speaking, the growth in equity market capitalization – using the S&P 500 as the measure for market capitalization – should bear a relationship to the growth in the U.S. economy as measured by GDP.
Equity Market Valuation and Buffett’s Favorite Indicator
Warren Buffett called the relationship of market capitalization to GDP “the best single measure of where valuations stand at any given moment.” So let’s take a look at it through the lens of history.
Over the last two years, the relationship between S&P 500 market capitalization and GDP became unhinged. Market capitalization reached 110% of GDP in 2018. By the second quarter of 2022, the ratio exploded to almost 170% (the prior all-time high was 120% right before the dot-com crash over 20 years ago).
But then add the value of private equities to the S&P 500 market capitalization. Look at the ratio between this total equity valuation to GDP. What do we see? Previously, the all-time high in the ratio between total equity capitalization to GDP was 180%. This occurred immediately prior to the dot-com crash (data goes back to the early 1960s). In 2020, the ratio reached an all-time high of 200%. Now, that ratio is approximately 280% of GDP. It is 40% higher than the all time high.
The Federal Reserve shoulders most of the blame for equity market valuation reaching such lofty levels. There is a big price to pay for what the Fed has done over the last 14 years. That’s worth more than one other discussion.
But for now, a dramatic break to the upside in these ratios means this. Equity market valuation has grown much faster than the U.S. economy. In fact, it has de-coupled from the growth of the economy. That makes no sense. It can’t continue. And it won’t.