This issue's gibberish is one that seems to come back on a fairly regular basis and fits primarily into the second category, inappropriate comparisons, but it can also be used to create a misleading impression. It is also one that I have written about previously in a market perspective, but since the data keep being presented, I feel the "honor" of being discussed as gibberish is well deserved.

The culprit is the ratio of stock market capitalization to gross domestic product (GDP) and the inference that this relationship can tell us something about whether the market is overpriced or not. I have seen this twice recently. One is by Charles Allmon, the publisher of Growth Stock Outlook. He wrote "the world changed drastically on Sept. 11 and appears headed for the first major global crunch since the 1930s. Yet stock market capitalization today rolls along at 130 percent of GDP. This compares to 81 percent in 1929 (before the big crash), 183 percent in March 2000, and 79 percent in January 1973." (Quoted in the Washington Post on November 2, 2001.)

Notice how he combines two unrelated ideas, the terrorist attacks and the market cap to GDP ratio, and implies that somehow they are related with the significance of both being somehow increased by the juxtaposition. One needs to realize that Allmon became a "permabear" in the mid-1980s and still has not gotten over the fact that the market ignored his sage wisdom and is now many times higher than it was when he revealed his ursine nature. His newsletter has done reasonably well picking individual stocks, which has been fortunate for subscribers who have ignored his overall market outlook.

The other person to use the ratio canít be dismissed so easily as a stopped-clock looking for statistical justification because he is the "sage of Omaha," the legendary Warren Buffett. He wrote an article for FORTUNE magazineís 2002 Investorís Guide, which still should be available at forutne.com, making a thoughtful case that overall stock market returns over the next ten to twenty years will average about 7% annualy. I find that Buffett is always worth reading, and he seeks a method of quantifying extremes of "market irrationality." To that end, he proposes using the market cap to GDP ratio, and presents a graph of the ratio going back to 1924. He says "the ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment. And as you can see, nearly two years ago the ratio rose to an unprecedented level.(1) That should have been a very strong warning signal." Later he says that if the ratio "falls to the 70% to 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%-as it did in 1999 and a part of 2000-you are playing with fire. As you can see, the ratio was recently 133%."

So if Buffett likes the ratio, can it really be gibberish? It may be the best single measure of stock market valuation, but that doesnít necessarily make it a good one. There may not be any really good measure that works in "real time" as opposed to those that clearly identify the market peaks well after the fact. According to the graph accompanying the Buffett article, the market cap to GDP ratio never exceeded 100% before the mid-1990s. At that point, many pundits made a big deal about the fact and said that the market must therefore be overvalued and destined for a great drop in the near future. (That was the first time I wrote about this ratio.) That illustrates the first large problem with the use of the ratio: figuring out what the various levels mean. It is quite dangerous to make inferences from fewer than a large number of prior occurrences. Even when there are a large number of data points, one must be careful for several reasons. The level near 80%, that Allmon points to so ominously, was an effective maximum for many years. It marked the high water mark in the late 1930s and through the 1960s and early 1970s. However, what the ratio was mainly reflecting then, and what it still does now, are the recent trends in stock prices. It is interesting to note that the level Allmon implies is an indication of major market tops, about 80%, is one that Buffett thinks will indicate a great time to buy stocks. Is the current level around 130% excessive? We donít know because the only previous time we saw that level was in the 1990s when the ratio was headed up to its peak in early 2000. All the level really tells us now is that stock prices on the average are a lot lower than they were about two years ago, but I think we already knew that.

In addition to the problem of interpreting the value of the ratio, there is another reason I consider it to be gibberish. I think it is somewhat a case of comparing apples to oranges. Because both market capitalization and GDP are measured in dollars, it is tempting to divide one by the other and ascribe some significance to the ratio. Letís look at its two components to see if the ratio should have some meaning. Both are fairly easy to understand.

GDP is the total value of all the goods and services produced by the U.S. economy. As such it can be thought of as the analog of revenue if we think of the U.S. economy as a business. That reveals one of the weaknesses of the ratio. The overall level of stock prices is driven more by profits than revenues, which makes sense because most business owners are trying to make money rather than just have a certain level of sales. The two are definitely related, and profit margin expresses the relationship. Thus, revenue, and hence GDP, is a meaningful measure of business activity for stock valuation purposes only to the extent that overall profit margins do not vary by a large amount. However, in the 1990s technology drove profit margins higher for most industries. As one example, nearly instantaneous computer-to-computer communications enabled the use of just-in-time deliveries supporting manufacturing. That in turn led to a dramatic reduction of in-process inventories, which are a buffer against disruptions, but are generally an inefficient use of resources.

Now let's look at the numerator of the ratio, market capitalization. That is also easy to understand. It is the total stock market value(2) of all publicly traded companies. It is the public ownership aspect that makes the ratio an inappropriate comparison tool for different time periods. At the times of ratio peaks Allmon mentions, about 30 and 70 years ago, businesses were not as likely to go public as they have been for the past decade. There are a number of reasons for this including the nature of the financial culture and banking practices, public perception of stocks, and the potential for the first owners companies that go public to accumulate great wealth. As more companies decide to go public, as many did during the 1990s stock market boom, total market capitalization increases even if nothing else changes. This may be instructive in and of itself, but it says nothing about the relevance of the market cap to GDP ratio in 1929, or any other time for that matter.

In short, it is not clear what the ratio is really measuring, and moreover, there is no good way to interpret what the levels of the ratio mean. My contention is what the ratio mainly tells us is how stock prices have moved recently, which we already know. Rather than worry about the market cap to GDP ratio, we are better off trying to figure out what recent stock price movements tell us about future movements. That is well known to be a very difficult, if not impossible, problem to solve. The market cap to GDP ratio does not really help us in that quest, which is why I consider its use to be gibberish. Buffettís pronouncement can be "translated" into stock price terms as "stocks prices reached a record high about two years ago, and if they fall to under half of those levels, it will be a good time to buy stocks." I donít think too many will argue with that.


  1. The graph shows that the ratio first rose to an unprecedented level about six years ago, but then it continued to rise to even higher unprecedented levels.
  2. There are problems interpreting the meaning of market capitalization, which I discussed in a previous gibberish column. However, those are not relevant to this article.

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