S&P 500 / Gross Domestic Product
S&P 500 / Gross Domestic Product
A classic valuation indicator
Since I started this newsletter a few weeks ago, I’ve focused on Gross Domestic Product (“GDP”) and the stock market. (Okay, yes AND a lot on the coronavirus since it’s such an important current issue.)
Potential pandemics aside, they are two of the most important metrics in the world of finance and economics. Given their importance, it would be useful if there were an easy way to create a comparative relationship between both metrics that could serve as an informative indicator. Well, I’ve set myself up nicely here because that’s exactly what we have in the following chart below:
This ratio is created by simply taking a stock market benchmark (in this case the S&P 500) and dividing it by Nominal GDP.
Now, this is a really popular indicator. I’ve heard some people knock it though - which is fine. But there is one particular argument against it that drives me crazy. It’s basically, “you can’t divide something like a stock price by a number like GDP, which represents a flow of production.”
I don’t usually say things like this - but that is just a straight up dumb argument. I’m not even sure what it means. Like, what does “can’t” mean? Illegal? When I calculated the ratio in excel, I didn’t get my door kicked in by the police or anything.
I think what people might mean to say is that it’s like dividing apples by oranges. That makes a little more sense. Except, if you look at lots of famous equations in the sciences, there are plenty of ratios comparing things that aren’t the same. So, I stand by my assessment that this ratio is definitely fine to use.
Okay, now that I’m off my soapbox, let’s talk about what this (very legal!) ratio means.
In a simple way, stocks represent financial expectations. Maybe stocks go up one day just because everyone in the market is feeling good and thinks “yeah, I’ve got high expectations - let’s pump this market up and let the good times roll!”
On the other hand, you have GDP which represents actual stuff, like the cost of a burger. If someone is super excited at the drive-through window and is like “yes these burgers are awesome - let the good times roll” it’s not like burger prices are suddenly going to skyrocket.
So, we are taking something based on fuzzy feelings, expectations, and speculation (the stock market) and grounding it in something more tangible (GDP). That is why this is a good metric for valuation. If this ratio is high, it means stock market prices are high relative to tangible production as measured by GDP.
And, the data confirms what we would expect to see. In particular, we can clearly see the dot-com bubble, which ran from about 1994 to 2000 before exploding and leaving everyone who owned gems like pets.com and eToyz.com feeling really sad. We can also look back to 1929 and see the stock market bubble that makes even the dot-com bubble jealous, the great speculative bubble of the roaring twenties, which was so absurd that, when it burst, stocks didn't recover for almost thirty years.
Those two bubbles preceded some pretty not-fun times, which makes the current ratio levels just a tiny bit concerning. When people say, “the stock market seems kind of frothy”, this is definitely one of those metrics that supports that.
Obviously, looking at one simple ratio isn’t enough to prove things are out-of-whack in the market. But, it provides some evidence for a hypothesis that valuations could be considered elevated to historical norms.
As people who write about the market usually caveat their writing, I will do so here as well: this is not investment advice. I have no clue what is going to happen because, as I often say, the future is impossible to predict. Even though the ratio is high now, maybe everyone will continue the party and just say “this is awesome, let the good times roll!”
Perhaps, this metric will help confirm or disprove your own assumptions about what the stock market is doing right now. After all, it’s basically just a bunch of made up expectations, yours included, right?
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