What is the Stock Market Capitalization-to-GDP Ratio?
The stock market capitalization-to-GDP ratio refers to a metric that is used to evaluate whether or not a given market is valued accurately in accordance with its historical average. The ratio can be calculated for a specific market, such as the London Stock Exchange (LSE), or can even be applied to the global market. It is calculated by dividing the stock market capitalization of an economy by the gross domestic product of that area.
The term was popularized by a veteran investor and one of the richest people in the world, Warren Buffet, and subsequently came to be known as the “Buffet Indicator.” He claims that it is the best measure of where the valuation of a given security stands at any given point in time.
The stock market capitalization-to-GDP ratio refers to a metric that is used to evaluate whether or not a given market is valued accurately in accordance with its historical average.
The formula for the same is: Market Capitalization to GDP = (SMC/GDP) * 100
The value of the market cap-to-GDP ratio is affected by the fraction of companies that are public as opposed to the number of private companies and IPO trends in an economy.
Mathematical Expression for Stock Market Capitalization-to-GDP Ratio
The stock market capitalization-to-GDP ratio is expressed in a ratio or a percentage form and is calculated using the following formula:
Market Capitalization to GDP = (SMC/GDP) * 100
SMC – Stock market capitalization
GDP – Gross domestic product
The total value of all the publicly-traded stocks in the US can be calculated using the Wilshire 5000 Total Market Index. The index represents the total value of all the stocks in US financial markets. The GDP number used is one that is reported on a quarterly basis.
Inferences from the Stock Market Capitalization-to-GDP Ratio
The stock market capitalization-to-GDP ratio is a technical measure of the value of all the publicly listed stock of all companies in a given economy divided by the gross domestic product of that economy. The ratio enables a comparison of the value of an economy’s stocks, on average, to the value of the total output produced by that economy in a given time period. It gives that percentage of GDP that is representative of the value of the stock market.
Generally, in a situation when the ratio is greater than 1, or 100%, it implies that the market is currently overvalued. On the other hand, when the ratio is lesser than 0.5 or 50%, it shows that the stock of that economy is undervalued. The historical average of the US market is 0.5.
In a situation where the ratio falls anywhere between 0.5 to 0.75, or 50% to 75%, it is said that at the current moment, the market is accurately or modestly valued. If the ratio falls between 0.75 to 0.9, or 75% to 90%, it is said to be modestly valued or valued fairly. Lastly, if the ratio falls within the range of 0.9 to 1.15, or 90% to 115%, it is considered to be a modest overvaluation of the market.
Factors that Impact the Stock Market Capitalization-to-GDP Ratio
The value of the market cap to GDP ratio is affected by the fraction of companies that are public as opposed to the number of private companies in the economy. Moreover, trends in the initial public offerings (IPOs) of newly public companies also impact the value of the ratio.
Consider an example where the total value of the US stock market is $15 trillion, and the country’s real quarterly GDP is $26 trillion. The market cap to GDP ratio would be approximately 1.66 (25 trillion/15 trillion). It would mean that the stock market is currently overvalued, given that 166% of the GDP represents the stock market value.