UPDATE* Stock Market Capitalization to GDP

While rummaging around for Buffett quotes, I ran into this 2002 interview with Buffett on the stock market. Besides an overall interesting perspective on the markets, one particular thing I noted:

On a macro basis, quantification doesn't have to be complicated at all. Below is a chart, starting almost 80 years ago and really quite fundamental in what it says. The chart shows the market value of all publicly traded securities as a percentage of the country's business--that is, as a percentage of GNP. The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment. And as you can see, nearly two years ago the ratio rose to an unprecedented level. That should have been a very strong warning signal.
For investors to gain wealth at a rate that exceeds the growth of U.S. business, the percentage relationship line on the chart must keep going up and up. If GNP is going to grow 5% a year and you want market values to go up 10%, then you need to have the line go straight off the top of the chart. That won't happen. For me, the message of that chart is this: If the percentage relationship falls to the 70% or 80% area,
buying stocks is likely to work very well for you. If the ratio approaches 200%--as it did in 1999 and a part of 2000 -- you are playing with fire.
As you can see, the ratio was recently 133%. Even so, that is a good -sized drop from when I was talking about the market in 1999. I ventured then that the American public should expect equity returns over the next decade or two (with dividends included and 2% inflation assumed) of perhaps 7%. That was a gross figure, not counting frictional costs, such as commissions and fees. Net, I thought returns might be 6%...

Now this isn't the first time we've seen someone make this argument. Prem Watsa has been making this case too:

The U.S. market capitalization is still at about 120% of GDP, down from over 170% in
2000 but way above its 80-year average of 58% and even higher than its 1929 high of 87%!!

This was from the 2005 Annual Shareholder Letter. Since then he has also made the point in several investor presentations, which I don't have readily available. Still two great investors like to look at this measure, so it is worth understanding what it means and the possible flaws.

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*Update
Here is the original Warren Buffett on the Stock Market, 1999.

As you can see, corporate profits as a percentage of GDP peaked in 1929, and then they tanked. The left-hand side of the chart, in fact, is filled with aberrations: not only the Depression but also a wartime profits boom--sedated by the excess-profits tax--and another boom after the war. But from 1951 on, the percentage settled down pretty much to a 4% to 6.5% range.
...
Today, if an investor is to achieve juicy profits in the market over ten years or 17 or 20, one or more of three things must happen. I'll delay talking about the last of them for a bit, but here are the first two:

(1) Interest rates must fall further. If government interest rates, now at a level of about 6%, were to fall to 3%, that factor alone would come close to doubling the value of common stocks. Incidentally, if you think interest rates are going to do that--or fall to the 1% that Japan has experienced--you should head for where you can really make a bundle: bond options.

(2) Corporate profitability in relation to GDP must rise. You know, someone once told me that New York has more lawyers than people. I think that's the same fellow who thinks profits will become larger than GDP. When you begin to expect the growth of a component factor to forever outpace that of the aggregate, you get into certain mathematical problems. In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well. In addition, there's a public-policy point: If corporate investors, in aggregate, are going to eat an ever-growing portion of the American economic pie, some other group will have to settle for a smaller portion. That would justifiably raise political problems--and in my view a major re slicing of the pie just isn't going to happen.

He goes on to say also that besides these two factors, a stock should also appreciate at the rate of GDP. So between these two articles, we can get a good understanding of the factors Warren Buffett looks at when valuing the general market.

1) The relationship between current yields on government bonds and yields on common stocks. If the spread on these is large, you could expect to have long run performance gains from their convergence.
2) The future direction of interest rates
3) GDP growth
4) After-tax corporate profits as % GDP

And as for where we stand today:
1)
30 year bond yield- 4.69%
S&P500 earnings yield- 5%

2) Current yield is at 4.69%. Where we are going? (more below)
3) We appear heading for a period of either slower growth or recession at the moment.
4) After tax corporate profits are currently at 8.3%, which is the upper extreme of the historical range.

So using the Buffett approach, it is hard to make a case for large gains in the stock market. The yield difference between stocks and bonds is very minimal. If you assume interest rates remain constant, then you will need either GDP to grow or for corporate profits to take a larger portion of GDP, something which is Buffett discusses as very unlikely above. If we're optimistic and use the 5% GDP nominal growth over the next 10 years, then that appears to be what we can expect to earn. Unless, the future direction of interest rates goes down. Predicting future interest rates seems much more difficult, and Buffett does not give any insight into this. I'll have to look more into this.

Finally, below is an up to date stock market capitalization as % of GDP chart from Fairfax's 2007 Annual Shareholder's Meeting.