The US economy is facing a growing disconnect between financial markets and real economic capacity, creating an over-financialized system that may be unsustainable. With US equity market valuations reaching record highs compared to private sector GDP, and private assets growing at an extraordinary pace, the strain on the underlying economy is mounting. Corporate and government debt has ballooned, while rising interest rates are pushing the cost of capital to new heights. As financial markets expand far beyond the economy’s productive capacity, the risk of a major correction looms ever larger. Let’s dive into this topic.
1. Stock Market Valuation vs. Economic Capacity
A critical examination of the US stock market reveals a striking disparity between its capitalization and the underlying economic capacity, particularly when viewed through the lens of the famous Warren Buffett indicator. This metric compares the total market value of a country’s stock market to its gross domestic product (GDP). Currently, US equity valuations have reached an unprecedented high relative to GDP. The nominal GDP of the United States stands at approximately $29 trillion, but around $11 trillion of this is government spending. Subtracting government expenditures leaves a private sector GDP of roughly $18 trillion. Against this backdrop, the total market capitalization of US-listed equities is a staggering $54 trillion, creating an enormous gap between asset valuations and the economy’s productive output.
Using the historical average return of 11% on equities, as demonstrated by the S&P 500 over the past 50 years, the US stock market would need to generate returns equivalent to nearly one-third of the private sector GDP. This raises concerns about the sustainability of such valuations. The Warren Buffett indicator, though widely used, is not without its flaws. Comparing a stock (market cap) with a flow (GDP) presents an intellectual challenge. Furthermore, GDP includes government spending, which is often funded by debt and may not reflect the true productive capacity of the private sector. Some argue that it would be more accurate to compare the stock market to private sector GDP alone.
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