The table below lists the total market cap to GNI (GDP) ratios of the largest economies in the world. Comparing the current market cap-to-GNI ratio (also known as the Buffett Indicator) of a country to its historical average can be used to estimate the current valuation and expected returns of a nation’s stock market. The current cap-to-GNI of the United States is 156.66% (Jan 1st, 2023).
Note that we are using GNI (Gross National Income) instead of GDP (Gross Domestic Product) in our calculations. GNI represents an economy’s total income, including all income received from investments abroad. The table below also shows the historical correlation between the ratio and the subsequent 3-year stock market returns. Negative correlation means that a lower-than-average ratio is correlated with higher-than-average returns.
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Total Domestic Market Cap to GNI Ratio
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The total value of domestic stock market & nation’s economic output
The total market cap (TMC) to GNI ratio, commonly known as the Buffett Indicator, was popularized by Warren Buffett when he described it as the single best measure for the overall stock market valuation level at a given time. In the article published in the Fortune magazine, Mr. Buffett was only talking about the U.S. economy but the same ratio can be applied successfully to almost every other nation in the world.
The ratio is calculated by dividing the total value of a country’s domestic public companies by the nation’s Gross National Income (or GNI).
The ratio can’t be used to directly compare the valuation levels of different nations. Some countries are characterized by a higher portion of publicly listed corporations when some have a larger portion of private or state-owned companies. The current TMC-to-GDI of a country’s stock market needs to be compared to the historical average value of the nation.
TMC-to-GNI & stock market returns
The table above lists the correlations between a country’s monthly TMC-to-GNI ratios for the past 20 years and the corresponding 3-year forward stock market returns. 3-year forward return means the return on investment generated during the following three years starting from the day the investment is done. The returns are based on the most followed stock index of a country’s exchange. The correlations suggest strong negative relationship between the ratio and stock market returns for almost all of the countries: when the cap-to-GNI is higher than historical averages, the stock returns are going to be lower. This would suggest that TMC-to-GNI ratio is a powerful indicator of market valuations even though it offers no insights for short-term market movements.
However, a word of caution is in order. The correlation calculations include the period of the 2008 financial crisis when both the stock returns and GNI of practically all of the nations in the world were plummeting and the after-crisis period of fast recovery of both economic activity and share prices. If these periods are excluded, the correlations are slightly weaker but still more than significant. It is highly recommended for every investors to pay close attention to the cap-to-GNI ratios.
Shortcomings of the Buffett Indicator
Dr. Ed Yardeni has pointed out some possible shortcomings of using the ratio to estimate the current market valuations. One potential problem is that Buffett Indicator does not take account structural changes in profit margins caused by e.g. changing tax rates, lower interest rates or technological innovations. Especially technological advances have often been expected to lift corporate profits to a entirely new level but the evidence for this has remained mixed. As Dr. Yardeni states, there is no perfect indicator and stock valuation is always somewhat subjective. The best option is to follow multiple metrics and make your own conclusions about them.
Gross Domestic Product, Gross National Income & Gross National Product
The most common practice is to use GDP when calculating the cap-to-economy ratio but using Gross National Income (GNI) gives more accurate results. GDP takes only account the domestic economic activity inside a country. GNI also includes interest & dividend payments and profits from assets received outside of the boarders of a country.
GNI = GDP + Net Income from Abroad
In majority of the cases, the difference between GDP and GNI is quite minor. In 2014, the GNI of US was $17,813 billion and GNP was $17,419. This means that the outflow and inflow of income is balanced. The same is true for majority of the nations but there are exceptions. One notable case is Ireland that used generous tax policies to lure many multinational corporations to set up their headquarters to the country. The GNI of Ireland is 20% lower than its GDP.
Gross National Product (GNP) and GNI are quite similar concept and there are only small differences in the way they are calculated. The main difference is that GNI takes account income and taxes earned also by citizens permanently living abroad while GNP only measures the earnings of domestic citizens. The GNI has largely replaced the use of GNP since the World Bank begin calculating and publishing GNI figures instead of GNP numbers.