Can GDP data help us time the market, and what is it telling us about the London stock market today?
In my ongoing struggle to make sense of the markets, I stumbled across a new macro measure of market valuation: the total stock-market-capitalisation-to-GDP ratio.
When I say 'new', I mean new to me; the ratio has been in use for some time, but it's not one you come across every day.
The price-to-sales ratio
What I find interesting is that this is essentially a price-to-sales ratio (PSR), but for the whole market. A low PSR was identified by James O'Shaughnessy in his famous book, What Works on Wall Street, as one of the most reliable indicators of value.
The PSR divides the share price by the sales per share, to get measure of how much revenue your investment is delivering. Adding in debt, to give an enterprise-value-to-sales ratio is a logical refinement of that idea, as it accounts for differences in the way each company is financed. And even then the PSR is most useful when applied within a particular industry.
The market-cap-to-GDP ratio
The stock-market-capitalisation-to-GDP ratio does the same thing for the whole economy. Gross Domestic Product corresponds to all sales in the country, while total value of all companies on the stock market corresponds to the valuation of those businesses.
According to the theory, measuring this ratio over time should give us a feel for whether the market is undervalued or overvalued. Some analysts set a threshold of 100% -- where the value of all listed companies equals the annual GDP -- as the level above which the market is overvalued, but this seems very arbitrary to me.
One potential problem with this is that not all businesses are listed on the stock market, so this rule of thumb indicator is sensitive not just to frothy valuations, but also to the proportion of businesses that are listed. Arguably, though, this is not really an issue, as there is also a tendency for more businesses to list on the stock market when valuations are high, so we are still getting a usable result.
Perhaps a bigger concern would be changes in the proportion of revenue these companies generate outside the country. Many large companies operate globally, while others that are traded here make little or no contribution to British GDP.
What is it telling us?
With those caveats in mind, how does the market look now? Figures for the last ten years appear to indicate that equities are very undervalued. Now that £700bn has been wiped off the value of our shares, they equate to only 94% of GDP. Even at the last bear market low in 2003 they only fell to 108%.
| Date | Stock Market Cap to GDP |
|---|
| Apr '09 | 94% |
| Apr '08 | 132% |
| Apr '07 | 156% |
| Apr '06 | 155% |
| Apr '05 | 125% |
| Apr '04 | 122% |
| Apr '03 | 108% |
| Apr '02 | 150% |
| Apr '01 | 176% |
| Apr '00 | 194% |
Obviously this is a very blunt instrument, and in this case I'm just looking at the situation at one date each year. GDP data is available quarterly, but even that gives us a very coarse granularity; this is not a measure for day-traders.
Attempting to time the market in this way may be an exercise in futility, but I find it interesting to have tools like this available to help us triangulate where we are. It is questionable, however, whether historical patterns and norms have any relevance to the future direction of the markets -- Anthony Bolton maintains they do, Nassim Nicholas Taleb says otherwise. What do you think?
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