Over the past few months, many institutional investors have cited the U.S. market capitalization-to-GDP ratio, also known as the “Buffett indicator,” as an indicator that stocks may be overvalued. This metric was first described by Buffett in an interview with Fortune magazine 25 years ago. As of Friday, U.S. stocks had a market capitalization-to-GDP ratio of about 2.3 times, according to Bloomberg Research. At the time of the 2001 Fortune article, the ratio was about 1:1, down from just under 1.5 times at the peak of the tech bubble in March 2000. At the bottom of the global financial crisis in 2008-2009, the U.S. public stock market (as measured by the Wilshire 5000) was about half of U.S. GDP. To illustrate, we’ll estimate an average of about $14.50. Nominally trillion. Since then, GDP has more than doubled to about $31.5 trillion, while U.S. stock valuations have increased more than 400%. For perspective, consider that the market capitalization of today’s five largest publicly traded companies in the United States totaled more than $17.5 trillion as of Friday’s close, roughly equal to the nominal GDP of the United States 12 years ago. In fact, the market capitalization of the top 25 companies in the S&P 500 currently exceeds the GDP of the United States, totaling $32 trillion. However, before you panic and sell all your stocks, you should understand a little more background. First, the trend in recent decades has been that the largest publicly traded companies in the United States have become an increasingly large (and growing) part of the economy. Between 1980 and 1996, this relationship grew at a fairly steady rate from about 40% to about 75%, nearly doubling its share over that 16-year period. The tech bubble disrupted that trend, but by 2006 U.S. stocks returned to the long-term trend line and continued to follow it until around 2007, when it collapsed again due to the global financial crisis. Just before the pandemic, U.S. stocks were around 140% of GDP, again consistent with the broader trend of large corporations gaining a larger share of the economy, and still not that expensive, at least according to Buffett metrics. The fact that a trend exists suggests that there are underlying dynamics at play that cannot be captured by simplistic ratios, and to establish whether the 230% we are currently at is as extreme as it seems, we need to consider whether at least some of the underlying drivers of the trend have accelerated recently. What changes in the economy and public stock markets are likely to shift market capitalization and US GDP over the decades?Globalization is certainly a factor. Because a significant portion of the S&P 500’s sales come from outside the United States, U.S. GDP may underestimate the revenue base of U.S.-listed multinationals. JPMorgan points out that foreign countries account for about 28% to 30% of the S&P 500’s international sales, and the tech sector’s sales are much higher at 55%. The counter argument is that globalization cuts both ways. To be sure, U.S. companies sell far more foreign products overseas than they used to, but U.S. consumers also buy far more imported goods than they did in 1980, especially from China. A more compelling reason is that the largest companies are highly profitable, asset-light businesses. Today’s markets are heavily weighted toward businesses whose value is tied to intangible assets (software, IP, networks) and whose profitability can be structurally more profitable than the configuration of the old economy. If margins persist, market capitalization could be higher relative to GDP. The aforementioned S&P top 25 companies’ profits exceeded 3% of U.S. GDP over the past 12 months. Price is also important. If long-term real interest rates are lower than their historical averages, an increase in market capitalization/GDP is justified, suggesting that 1) the present value of each dollar of cash flows increases (higher multiple), and 2) the cost of capital/borrowing is lower, potentially accelerating growth. This is a difficult question because interest rates in the United States have been trending downward for decades since 1981. In response to high inflation, interest rates were very high from the late 1970s until 1981. The downward trend was decisively broken in 2022 as the worst inflation in 40 years occurred. If monetary policy contributed significantly to the slope of the trend line over the past 45 years, that could pose a problem. Borrowers (particularly governments) want interest rates to fall in order to maintain high levels of debt, but the Faustian bargain of money printing is beginning to become apparent. We should not hope or expect to return to anything beyond the 2% to 3% a year that policymakers have led people to believe is acceptable. JPMorgan outlined late last year that a high P/E ratio would lead to significantly lower returns over the next 10 years, but also noted that current levels are not far from the highest levels of the past 40 years. How do investors adjust their positions if they are concerned about overlapping indicators of the relative valuation of U.S. stocks? One way is to use a stock exchange strategy. For example, you can replace a long position in the S&P with a call spread to lock in profits while limiting the downside, such as by buying a call spread on the S&P 500 ETF or the S&P 500 Index. A diversified hedged portfolio can include reliable hedges like put spread collars. Downward put spread collars are financed by selling upward calls, reducing exposure to sectors trading at high multiples. Much of the sector rotation we’ve seen since December may be due to investors repositioning in exactly this way. Bloomberg’s research shows that gold could serve as a top performer when U.S. stocks eventually turn around, and that it can fall more than most risk assets in a deflationary cycle, so we feel that gold deserves a tactical allocation, but it’s also one of the assets that has significantly outperformed in recent years, and we think it’s contradictory to go after one of the most popular assets on a broader theory of mean reversion. Finally, if stock price growth slows, you might consider adding covered calls or other premium selling strategies to boost returns. In fact, a diversified basket of stocks with a call overwrite program can fund some index downside protection (such as put spreads on SPY and SPX) without the headwinds of negative carry. We don’t have a crystal ball, so we’re not prepared to answer the question, “Is the bull market over?” But stocks have come a long way, and a 20% year-over-year gain is not normal. said Herb Stein, former senior fellow at the American Enterprise Institute. “If something can’t go on forever, it will stop.” Disclosure: None. All opinions expressed by CNBC Pro contributors are solely their opinions and do not reflect the opinions of CNBC, its parent or affiliates, and may have been previously disseminated on television, radio, the Internet, or another medium. The above is subject to our Terms of Use and Privacy Policy. This content is provided for informational purposes only and does not constitute financial, investment, tax, or legal advice or a recommendation to purchase any securities or other financial assets. The content is general in nature and does not reflect your unique personal circumstances. The above may not be appropriate for your particular situation. 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