Are U.S. Stocks Fairly Valued?

August 22, 2012 | Nat Kellogg, CFA, President

There are a variety of methods to measure market valuation but one of the simplest is to compare market capitalization to GDP. Investors can think of this as a price-to-sales multiple for the macro economy. For U.S. stocks over the last 50 years this ratio has averaged 0.76x (U.S. Market Cap/U.S. GDP). The gold line on the chart shows this ratio over the last 50 years and the dotted gold line shows the average. This simple valuation metric clearly shows the market was overvalued in 2000, and given that the market is currently valued at 1.07x U.S. GDP, stocks also look pricey today.

However, this valuation tool ignores the increasing importance of global sales and profits to U.S. firms. As many investors are aware, almost 40% of S&P 500 company profits come from overseas. The blue line shows the U.S. share of global GDP. Over the last 50 years, and particularly over the last decade, the U.S. share of global GDP has fallen to record lows, currently at just 21.5%. As the U.S. accounts for less of global GDP, U.S. GDP becomes a less relevant metric to value firms with a global reach.

As a result, global GDP may be the more relevant metric to follow. The dark gray line looks at the ratio of U.S. Market Cap to global GDP. The dotted dark gray line shows the long term average. Based on this metric, stocks were clearly cheap in the late 1970’s and early 1980’s, and expensive during the dot-com years around the turn of the century. Currently, based on global GDP, stocks do not look nearly as expensive today. In fact, stocks look fairly valued compared to their long term average.

While these metrics can act as a useful guide to broad over and under valuation in markets, they tell investors very little about where markets are headed in the short-term. However, as U.S. company sales and profits become more global, investors will increasingly want to focus on global benchmarks when looking at valuation.