Stock Markets: Market Capitalisation / GDP

 Buy when the orange line is above the yellow line

Sample chart showing the market cap / GDP ratio adjusted for new issues. Markets are undervalued when the yellow line (actual value) lies below the orange line (fair value).

This strategy is especially relevant for identifying major stock market bubbles or panics, by disregarding the current level of company profitability. The market capitalisation/GDP ratio is intended to perform for whole markets a similar role to that performed by Price / Sales ratios for the analysis of individual companies. It may also be helpful in identifying cyclical swings in valuation. For comparability, stock market indices have been rebased to set year-end 1994 at 100.
 
In each chart the stock market index is shown as the thick white line on the right hand axis. The explanatory variable, the ratio of market cap/GDP, is shown as the thin yellow line using the left hand axis, as also does the series representing the level at which this ratio represents Fair Value, which is the thin orange line on the same axis.
 
This strategy overcomes the counter-productive problem of PE ratios in making shares seem cheap in economic booms market peaks and dear in recessions. When profit margins are cyclically depressed, price earnings multiples should be abnormally high and vice versa.
 
The market capitalisation data has been adjusted to eliminate distortions created by capital issues among quoted companies. This is necessary to take account of changes caused by transfers of productive capacity to or from the unquoted sector and state-owned sectors, without corresponding changes in GDP. Such changes include new issues or stock repurchase schemes. This can be especially significant in an era of widespread privatisation.
 
A Fair Value series has been fitted to the ratio of Market Capitalisation / GDP so as to indicate what changes in valuation are justified by changing rates of inflation. In as far as a fall in inflation generates a corresponding fall in short term interest rates and long-term bond yields, it also justifies higher price earnings ratios, and thus a higher ratio of market cap/GDP.
 
Please note that comparisons between countries are not meaningful for several reasons. a) Differences in the proportion of companies that are listed on exchanges. b) Differences in the overseas assets owned by publicly quoted companies. c) Differences in the weighting of highly rated sectors.
 
Generally speaking, valuation strategies are more helpful in minimising risk than in maximising gains, and should not be used as market timing indicators.