Co-Authored by Michelle Kangas & Dr. Bryan Taylor
Warrant Buffett once said that the stock market capitalization to GDP Ratio (MC/GDP) is “probably the best measure of where valuations stand at any given moment.” Global Financial Data has decided to follow in Warren Buffett’s footsteps and has added data on the ratio of stock market capitalization to GDP for all the stock markets in the world. GFD has the most extensive historical data on stock market capitalization and GDP available anywhere. This enables us to provide data on Buffett’s favorite indicator going back centuries, not decades. MC/GDP data for the United States begins in 1792 and data for the United Kingdom begins in 1688.
There are several factors which influence the ratio of stock market capitalization to GDP. First, countries with more multinational companies have a higher ratio than countries without. The MC/GDP ratio is particularly high for Switzerland and Hong Kong because those countries have numerous multinationals listed on their exchanges. Switzerland’s MC/GDP ratio is over 200% and Hong Kong’s ratio is over 1000%. Second, interest rates influence the ratio. Bond yields provide an opportunity cost for investing in the stock market. The higher bond yields are, the lower will be the MC/GDP ratio. The lower bond yields are, the higher will be the ratio. Third, government ownership of major industries, banks and utilities reduces the MC/GDP ratio because these industries are publicly owned rather than privately owned. Fourth, industrialization of the economy increases the MC/GDP ratio and has generally increased over time. Fifth, whether a country relies more on markets or banks to direct capital to industry affects this ratio. Anglo-Saxon countries generally rely more on stock markets than continental European countries and tend to have a higher MC/GDP ratio. Sixth, wars tend to redirect capital to funding government bonds and increases regulation of industry. This tends to reduce the MC/GDP ratio. All of these factors should be taken into consideration when trying to analyze whether the MC/GDP ratio indicates that the stock market is overvalued or undervalued for any country.
GFD has created a simple mnemonic that enables subscribers to quickly find data for the country they are interest in. The ticker begins with “SC”, then adds the ISO code, then adds “MPC” at the end, so the symbol for the market cap of the United States as a share of GDP is SCUSAMPC and for Canada it is SCCANMPC.
There are many things that subscribers can do with this information. Figure 1 compares the stock market capitalization of the United States with the outstanding government debt as a share of GDP. Several of the factors mentioned above are clearly visible. The inverse correlation between war, stock market capitalization and debt is visible during World War I and World War II. The impact of rising interest rates in the 1970s and falling interest rates since 1981 have clearly impacted the MC/GDP ratio. Since 1980, both the debt/GDP and the MC/GDP ratios have risen. Over the past 50 years, the United States has deregulated many markets which has contributed to the increase in the MC/GDP ratio.
Figure 1. United States Government Debt and Stock Market Capitalization to GDP, 1792 to 2018
Global Financial Data provides data on the MC/GDP ratio for every major stock market in the world. GFD provides more history for this ratio than any other data vendor. The MC/GDP ratio in the United States is around 164% today. This is one of the highest ratios in history; however, bond yields are also at their lowest levels in history. Could the MC/GDP ratio be headed to 200% as in Switzerland, or does the high ratio portend a crash as occurred at previous peaks in 1999 and 2007? Time will tell.
The equity-risk premium (ERP) is one of the most important variables in finance. In theory, riskier stocks should provide a higher return than risk-free government bonds, but unfortunately, this is not always true. Different factors drive return to stocks and bonds. Bond returns are driven by inflation; stock returns are driven by corporate cash flows. The two will vary independently of one another. It is not risk alone that determines the equity-risk premium. Any review of the equity-risk premium shows that its value is not constant, and even if you average returns over 10 or 20 years, the premium can vary dramatically. Using GFD’s data, analysis of the evolution of the equity-risk premium over the past 300 years is possible. . Information on the Equity Risk Premium in 20 countries can be found in the GFD Guide to Global Stock Markets.
The US Takes a Wild Ride on the ERP
Figure 1. 10-year Returns to Stocks and Bonds in the United States, 1792 to 2023
The 10-year return to stocks and bonds in the United States is illustrated in Figure 1. The black line represents the return to stocks, and the green line, the return to bonds. The 10-year return to stocks between from 2012 to 2022 was 12.45%. An investment in bonds returned 0.20% during the same time period and the equity premium would have been 12.25%.
As Figure 1 illustrates, the return to stocks is more volatile than the return to bonds. The 10-year return to stocks fell from 19.87% in 1999 to -2.34% in 2009. During that same period the return to government bonds fell from 7.98% to 6.40%. The return to stocks greatly influences the equity-risk premium as can be seen by the volatile returns in Figure 1 relative to the slower change in the return to bonds.
There is a strong correlation between the current yield on government bonds and the total return over the subsequent 10 years. Few people realize that you can use the yield to predict the future return on government bonds. The market would predict that investors will receive about a 4% return on government bonds between 2023 and 2033.
The black line shows the yield in 2022 and the green line shows the return to bonds between 2012 and 2022. As bond yields declined between 1981 and 2019, fixed-income investors received capital gains that largely offset the decline in bond yields. Although yields fluctuate up and down from year to year, bond yields can trend up or down for decades. Bond yields generally declined from 1920 until 1945, rose until 1981 and declined until 2021. They have increased from a low of 0.5% in 2020 to over 4% now.
Figure 2. United States 10-year Government Bond Yield and Returns, 1920 to 2023
Now Trending 100 Years
Unfortunately, there is no similar indicator to predict future returns to stocks. Dividend yields don’t change very much, but the price of stocks do. Nevertheless, using a 10-year average return shows that the return to stocks does trend over time; however, the trends are shorter than the trends in risk-free bonds. During the past 100 years, 10-year peaks in the return to stocks occurred in 1928, 1958 and 1999. Peaks in the return to bonds occurred in 1930 and 1991. 10-year bottoms occurred in stocks in 1938, 1974 and 2009 and in bonds in 1959 and 2018. There have basically been three market cycles in stocks over the past 100 years and two in bonds. Currently, the return to stocks is in an uptrend that began in 2009 while bonds are trading in a downtrend that began in 1991. Both of these trends should reverse soon, but the 10-year ERP will probably remain positive for the rest of the decade because it will take time for these two trends to once again converge.