Barry Ritholtz offers this graph (courtesy of The Chart Store).
Barry offers no further comment with the graph, but I started to wonder if the "bubble" in capitalization could be explained by the increase in business done outside the country by U.S. corporations. I have read that about half of the earnings of the S&P 500 companies are derived from activities outside the U.S. It may be that smaller companies do a smaller percentage of business outside the U.S., but let’s use the same 50% estimate for all U.S. firms on average, large and small.
Next, we need to make two additional estimates:
- What was the average capitalization to GDP ratio prior to the globalization era, say before 1992. From the graph I estimate that the ratio from 1924 to 1992 was about 50% (area under the curve method).
- What was the average percentage of business by U.S. corporations done outside the country from 1924 to 1991? That is the second factor that needs to be estimated and I have not at, this point, thought of a good way to get that number. Therefore, I have decided to draw conclusions based on four possible ratios: 40%, 30%, 20% and 10%. I am biased to think that 40% is too high and 10% is too low, but they are included to give outside brackets.
Now we can do some calculations to decide if we actually are in a valuation bubble for U.S. stocks based on historical comparison to GDP.
First half of current earnings are from within the U.S. so half the current total market cap to GDP ratio (~110%) is the reference for "domestic" market cap to GDP ratio, or 55%.
The possible average ratios for 1924 to 1991 are shown in the following table:
It is clear that the ratio of market cap to GDP is currently significantly above historical averages, even when adjustments are made for increased foreign income for U.S. corporations in recent years.
I am not sure what significance to give to this observation. I will make one statement, though: This data should not be put on the list of reasons why the U.S. stock market is undervalued today.