October 11, 2018
In assessing valuation of US equities, there is a school of thought in which it is opined that the total market capitalization of US equities should grow roughly in line with that of US GDP (the “Buffett Indicator”).
The premise is that if US market capitalization substantially outpaces that of US GDP, equities (in aggregate) are considered over-valued. Conversely, if market capitalization lags that of US GDP, equities are considered under-valued.
This intuitive concept may be simplified by comparing the value of the S&P 500 index itself to that of US GDP (divided by a constant). Since the S&P 500 is a reasonable proxy for the majority of market capitalization of US equities (the calculation of the S&P index ensures that it remains proportional to the market capitalization of its constituent components), this assumption would seem reasonable, especially for large-cap stocks. We employ this formula to compute the value used in our model:
RGDP = (INDEX VALUE / GDP) * 100
Quite simply, RGDP is the ratio of the index to the latest GDP, multiplied by 100.
Let’s have a look at how RGDP performed historically.
The 1973-1974 Recession
In early 1973 the RGDP ratio peaked at nearly 10:
[The lower plot encapsulates the RGDP ratio, in green]
Once the recession took hold and equities retreated through 1974, the RGDP declined substantially, finally bottoming out under 5.
The early 2000’s “Tech Wreck”
Here is what the market looked like in the 1999-2001 lead-up to the Tech Wreck and the ensuing recession:
As the market peaked, you will observe the RGDP ratio hovered near 15. As the recession commenced, RGDP started to decline, finally bottoming at about 7:
The 2008-2009 Financial Crisis and Great Recession
Taking another example, during the lead-up to the financial crisis, the RGDP ratio peaked at just over 10. However, once the market deteriorated in late 2008 / early 2009, the RDGP ratio bottomed out about 5:
Finally, looking at the current picture, we see the RGDP ratio stands again at almost 15:
All things being equal, our ratio at just under 15 appears to be at an elevated level at the present time.
There are several points to note.
- As mentioned, the RGDP ratio takes into account the market capitalization of S&P 500 companies. It does not take into account the entire market capitalization of all equities in the United States. This simplifying assumption is introduced to make RDGP easy to calculate and is believed to be a reasonable proxy of the Buffett Indicator. Nevertheless, readers may find RGDP is more aptly suited to large-cap equities (since it is based on the S&P 500)
- Readers should keep in mind that market conditions vary over time. For example, the RDGP ratio tended to peak around 10 in the 1970’s – whereas, more recently, it seems to peak about 15. It is difficult to explain with certainty the underlying cause, but it may be due to a number of factors, including:
- The 1970’s was a highly inflationary environment; recent times have seen inflation remain low and stable
- The 1970’s saw bond yields in the high teens; recent times have seen yields extraordinarily low
- Trading in the 1970’s was still a very manually-driven process, with some automation largely assisting human traders. Conversely, technology and automated trading today is extraordinarily widespread, with the majority of trading being done in milliseconds by specialized software
- Quantitative Easing programs recently introduced by the Fed and other central banks may have skewed normal market forces which did not exist in earlier times
- All of that to say, readers are advised not to adapt a hard-and-fast approach, such as “buy when RGDP falls to 5 and sell when it rises to 15”. Readers would be better served by comparing RDGP values today to observed ranges in the recent past (say, the last 10 years)
- RGDP is a market valuation tool – it is not a market timing tool. Although RGDP seems to indicate with some degree of precision whether a market is over-valued (under-valued), it cannot forecast when the downturn (upturn) will occur
- As with any model, readers are advised to employ RGDP simply as one tool among many. The idea is to use RGDP, along with other models, to get an overall impression of market valuation – any one model should never be used alone.
The Relative to GDP (RGDP) model is a simple model (based on principles similar to the Buffett Indicator) which compares the S&P 500 index value to US GDP. It provides a rough sense of equity valuation, especially as applied to large-cap stocks.
With a value of nearly 15 today, the RGDP is suggesting that equities have reached valuations close to that of where they were just prior to the “Tech Wreck” bear market and recession of the early 2000’s.
Market Cap to GDP: And Updated Look at the Buffet Valuation Indicator, https://www.advisorperspectives.com/dshort/updates/2018/10/02/market-cap-to-gdp-an-updated-look-at-the-buffett-valuation-indicator, retrieved October 11, 2018
Stock Market Capitalization to GDP Ratio, https://www.investopedia.com/terms/m/marketcapgdp.asp, retrieved October 11, 2018
How is the value of the S&P Calculated?, https://www.investopedia.com/ask/answers/05/sp500calculation.asp, retrieved October 11, 2018
The above discussion of financial conditions represent the opinion of the author and should strictly be used for educational purposes only. It is not an endorsement to buy or sell any security whatsoever, and does not constitute investment advice. Individual security prices fluctuate and may result in financial loss.
While data contained therein is believed to be accurate, no express or implied warranty is provided with respect to data accuracy.
Always consult your professional investment advisor prior to making any investment decision.