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After the first week of September ended with two consecutive days of losses for major stock market indices in the United States, fears of a deeper correction are mounting among investors.
Seemingly defying all that was going on in the United States, the stock market had previously rounded off a great summer with its best August in decades. The tech-heavy NASDAQ Composite Index even reached a new all-time high on September 2, closing above 12,000 points for the first time, up more than 75 percent from its low point in March. And while the months-long rally was greeted with celebrations by some people, others were eyeing it with suspicion, worried about what looks like a growing disconnect between the stock market and reality.
All three major indices in the U.S. are currently up at least 50 percent from their late March lows, despite the fact that the U.S. is officially in a recession and the world economy is facing its biggest contraction since World War II this year. “The gap between markets and economic data has never been larger,” Matt King, global head of credit strategy at Citigroup wrote in a research note in April and several analysts have chimed in since, calling the recent rally a huge disconnect from reality. So is the stock market really overheated or are investors simply looking beyond present conditions, anticipating a strong recovery for 2021?
One way of looking at stock valuations is the market value of all publicly traded companies as a percentage of GDP, which Warren Buffett described as “the best single measure of where valuations stand at any given moment” in a Fortune interview in 2001. “Two years ago the ratio rose to an unprecedented level,” Buffett said shortly after the tech bubble had burst. “That should have been a very strong warning signal.”
As the following chart shows, the ratio of market capitalizations (as measured here by the very broad Wilshire 5000 index) to GDP is even higher now than it was shortly before the dot-com bubble burst. Using quarterly average closes of the Wilshire 5000 Total Market Index and dividing it by quarterly GDP figures shows that the ratio is unprecedentedly high at the moment, which, following Buffett’s rationale, could be seen as an ominous sign of things to come.
This chart shows the Wilshire 5000 to nominal GDP ratio as a measure of stock market valuations over time.
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