Shares: Market Cap/GDP

Shares are undervalued when the orange line is above the yellow and dear when the opposite applies

This investment tool is especially relevant for identifying major stock market bubbles or depressions, by looking beyond 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 indexes 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 main explanatory variable, the ratio of market cap/GDP, is shown as the thin yellow line using the left hand axis, while the series representing the level at which this ratio represents Fair Value is shown as the thin orange line on the same axis.

This tool overcomes the problem of PE ratios in validating cyclical extremes in profitability. When profit margins (E/S) are cyclically depressed, price earnings multiples (P/E) should be abnormally high and vice versa. This ratio eliminates profits (E) from both equations as follows: P/E x E/S = P/S, where P is Price, E is Earnings and S is Sales. The whole market calculation is derived by substituting Market Capitalisation for Price and GDP for Sales.

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 from or to the unquoted sector and state-owned sectors, without corresponding changes in GDP. Such changes include new issues or stock repurchase schemes and is especially significant in an era of widespread privatisation.

A Fair Value series has been fitted to the ratio to indicate that changes in inflation justify fluctuations in the ratio of market cap/GPD. In as far as a fall in inflation generates a corresponding fall in long-term bond yields, it also justifies higher price earnings ratios, and thus a higher ratio of market cap/GDP. Mathematically this is 1/(CPI + k) = P/E where CPI is the Consumer Price Index (smoothed), k is the equity risk premium (historic global average) and P/E is the PE ratio. The resulting series has been adjusted to give the best fit to the Market Cap / GDP series of each country. Thus periods of over-valuation can be identified when the ratio of Market Cap/GDP is above the Fair Value level and conversely for periods of under-valuation. To examine the underlying elements of this ratio in greater depth, study the Valuation tools for both bonds and shares.

Please note that comparisons between countries are not meaningful for several reasons. The extent to which companies are publicly quoted. The amount of overseas assets owned by publicly quoted companies. Differences in the weighting of highly rated sectors

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