At the quarter ending March 31, US annual GDP is estimated at $15.3 trillion. At quarter-end, the S&P 500 Index constituent companies had a combined market value of $12.7 trillion, or 83% of GDP. Many thanks to Ned Davis Research, who computes this for us on a regular basis.
For US stock market investors, this 83% number is significant. Let’s cite some references. At the bear market bottom in March of 2009, this number was 47%. That is about the same as the level that prevailed in the early 1990s.
At the 2007 stock market top, the ratio of S&P market cap to GDP was about 98%. The all-time high was about 129% in millennium year 2000 when the tech stock bubble was about to burst.
Implied in this ratio is that it tells investors how the market is valuing the profit share of these 500 companies in relation to the economic output of the United States. A great deal of the profits of American business are earned in the United States. The rest is earned outside the US but is influenced by the momentum of the US. Furthermore, those companies with large overseas exposure are valued in the US capital markets.
Using GDP as a reference, about half the business economy of the US is privately owned. Many smaller business are in sub-S form. The publicly traded and shareholder-owned companies use the C-corp. or corporate form.
When we look at the profit share of the GDP going to US business, we are seeing an aggregate number that includes both the publicly traded companies and the privately owned companies. Right now, that profit share is at the highest level we have seen in many decades. Publicly traded and privately owned American business is very profitable. Remember, we are looking at an aggregate number. The government’s statisticians compute these estimates from tax return information, thus the profit series of the GDP accounting tends to be consistently calculated and is a reliable indicator of the economically derived profits of the US.
One can derive estimates of the earnings of the publicly traded companies by using the GDP accounting for guidance. Note that the reported earnings of companies differ from the profits calculated by using the tax returns. But the trends in those earnings and those profits run together over time. Right now the trend is toward higher earnings, and that reflects the large profit share that business is achieving from the GDP.
2012 earnings estimates for the S&P 500 seem to be centered in the $100 to $105 range. That would put the stock market at a valuation of about 13 times earnings. Many forecasters are ratcheting down the growth rate of earnings for 2013. We agree with that approach, since the profit share is so high and is not likely to go much higher. In fact, there are many estimates that suggest the profit share may actually start to decline from its lofty level. We are among those who think that will be the case.
So our assumptions are that the GDP continues to grow at a moderate rate, say 5% nominally or about 2.5% real growth and 2.5% inflation. And we assume that the profit share from the GDP stays high but not as high as the peak it achieved last year. In two years these assumptions lead us to a US GDP of about $16.5 trillion to $17 trillion.
The reason that the profit share will decline can be found in the changes in the cost of labour. The annualized rate-of-change to unit labour costs in the US was about plus 3% prior to the Lehman-AIG meltdown and the recession. The recession took this from plus 3% to minus 3%. This was the reason the profit share was so high coming out of the recession. That has now changed. The annualized unit labour costs rate-of-change is now nearly back to its pre-recession plus 3% level. (hat tip Steve Leuthold) Therefore the labour share will eat into the profit share even as the GDP grows.
Using that GDP number, the growing labour share and assuming a gradual change in the profit share, we can see S&P 500 earnings in 2014 of $115 to $120. If we use 13 times those earnings as an assumed fair price of the S&P 500, we get a 1550-1600 price target for the S&P 500 index, and that would equate with about an 85%-to-90% ratio for the market cap-to-GDP ratio. This is neither overvalued nor undervalued. It is more or less smack in the middle of the last 20 years of US stock market history. Note that the stock market peak was 1565 on the S&P 500 Index. By the method outlined herein, we are still two years away from a new high.
Lots of assumptions go into this broadest of measures of the valuation of the US stock market. Any number of things can derail the outcome or make it better than this baseline. But the baseline gives us some comfort. It suggests that the S&P 500 Index can appreciate in price at the rate of about 6%-to-7% per year and that it can pay out about another 2% in dividends while that occurs. That total return is not bad when compared with near-zero per cent on cash equivalents and with low single-digit interest rates on higher-grade bonds.
At Cumberland, our equity accounts remain fully invested using ETF strategies. Of course, we reserve the ability to change this at any time. There are many potential shocks, and any one of them could alter this sanguine view.