Stock market capitalization is the sum of the market capitalization of all stocks trading on an exchange. Market capitalization of each stock is the product of its market price and the number of shares outstanding. Gross domestic product is the sum of consumer spending, private sector investment, government spending and the difference between exports and imports. The ratio of market capitalization to GDP, usually expressed as a percentage, changes with stock prices and the quarterly estimates of the GDP.
Facts
The ratio of the total market capitalization of the New York Stock Exchange and NASDAQ to the U.S. GDP was 119 percent in June 2011, according to a July 2011 blog post by market observer and financial columnist Barry L. Ritholtz. The long-term average for this ratio is 63 percent. The ratio increases if the market capitalization of the reference stock exchange rises, the GDP falls or a combination. The ratio falls during market downturns or if the markets fail to keep pace with GDP growth.
Function
The ratio of stock market capitalization to GDP shows the relative valuation of different stock exchanges to the GDP. The combined NYSE and NASDAQ market capitalization first hit 100 percent of GDP in October 1996, according to Ritholtz. Perhaps not coincidentally, in December 1996, former U.S. Federal Reserve Chairman Alan Greenspan made his "irrational exuberance" comment on stock market valuations. The ratio had stayed within a 20 to 60 percent range until about the early 1990s, when it started to trend higher. Part of that is due to the addition of NASDAQ to the calculations, but the overall trend line since the early 1990s is still up.
Influences
Ritholtz points out that the two biggest changes since 1996 are been globalization and low interest rates. Globalization means more revenues for U.S. corporations from overseas operations and more foreign companies listing on U.S. stock markets. The proliferation of mutual funds and increasing number of initial public offerings, especially during the technology revolution of the 1990s and the early 2000s, has contributed to a higher stock market capitalization. This has led to a higher ratio because GDP growth has not kept pace with market capitalization growth. Low interest rates may lead to higher GDP as consumer spending and business activity increase. However, stock markets also tend to rise during periods of low interest rates, as they did through the 1990s and beyond.
Stock Market Bubbles
Very high stock market capitalization-to-GDP ratios often precede sharp market drops. For example, the ratio of the NYSE stock market capitalization to GDP was almost 90 percent before the 1929 stock market crash. The ratio was about 180 percent before the 2000 dot-com crash. It was more than 140 percent in mid-2007 before the real estate markets started to weaken, which eventually led to the 2008 financial crisis.
