I’ve been reading a lot of arguments lately in favor of using the ratio of the total market capitalization of publicly-traded equities in a given country to that country’s GDP as a measure of potential under-/overvaluation of that country’s stock market.
This idea comes in two flavors: measurement across countries at a given time, and examination of historical experience in a given country. There’s a potentially interesting recent article in the Journal of Financial Economics on this topic–I say “potentially” because I’ve only skimmed it
…which probably already tells you where this post is going.
Japan in 1985: across countries
In 1985, the rest of the world decided that the big reason–or at least the main one they could easily do something about–that Japan was eating everyone else’s economic lunch with its exports was that the yen was seriously undervalued, at about 240/$US 1. After a severe bout of arm-twisting of Japan in the 1985 Plaza Accords, the yen started a rapid rise to around 130/$ US 1, a mind-boggling 85% gain over three years.
In the Japanese stock market, exporters, formerly the bluest of blue chips, were crushed. But perennial-laggard domestic firms, especially those using dollar inputs, shot through the roof. The net result was that from 1985 until the Japanese central bank began to raise interest rates in 1989, the Topix index tripled in local currency terms.
US and European strategists were by and large perplexed by all this, despite the elementary economics behind it, and began to argue that the Japanese market was wildly overvalued. How so? …the man argument they came up with was that the total equity market cap of Japan was 2x GDP, while the US, the other contender for world’s largest stock market, only traded at 1x. Therefore, short Japan and buy the US.
The oddest part of this argument, to my mind, was that the stock market of the largest economy in Europe, and third-largest in the world back then, Germany, was only trading at 0.2x GDP. And the UK, stuck in neutral and lost in dreams of past glory, was trading at 1x, just like the US. Yet, none of the US bulls were arguing that Germany was a far better bet than anything else, and the UK a viable alternative to the US.
A much better performance indicator–then and now–would have been interest rates.
the US now: relative to one country’s past
In 2021, the market cap/GDP metaphor was revived, unbeknownst to me, in the argument that a total market cap of 2x GDP for the US market–twice the typical past value–was a signal of substantial overvaluation.
To my mind, this application makes somewhat more sense. It’s a pretty blunt tool, however. In theory, the first thing I would try to do to sharpen it a bit would be to separate corporate earnings derived domestically from those derived abroad–and see if there’s a trend to be found. Yes, there’s an SEC requirement that firms break this out, but sort of like product line information, companies seem to me to make a special effort to disclose as little as possible.
Anyway, a better rule would have been: in a period of rising interest rates, don’t hold unprofitable “story” stocks whose valuation is based on the promise of earnings in the far future.