Stock Market Priced Higher than the GDP

The American stock market is currently priced higher than the American GDP. This is not good, and this is why:

GDP is an estimate of the turnover of the entire economy of a country. Turnover is not profit. It is merely the movement of money.

A company doing all right, but not fantastic, manages to produce a profit of 10% on its turnover. This means that a person buying such a company for an amount equal to its turnover will have to wait 10 years to get his money back. If the company goes broke before 10 years have gone by, money is lost. If it goes broke after 10 years, money is made.

If the stock market represented the entire economy, and the companies in it were reasonable profitable, we would be looking at a 10 year horizon on our investments. However, the stock market is not the economy. GDP includes privately owned companies, private individuals and the government. None of this is represented by the stock market. The stock market is less than half the economy.

That leaves us with a horizon of at least 20 years before profits cover our upfront costs, provided the stock market contains reasonably healthy companies. But here again we have a problem. As many as 40% of the companies are currently running at a loss. This loss has to be made up in profits of the remaining 60%. This in turn pushes out the time horizon. We need at least 40 years before the stock market returns a profit equal to our upfront cost in buying into it.

Short term, no-one cares about this. All that matters is that someone in the future is willing to buy the stock market at an even higher price. However, this does not work in the long term. We all need to consume, and that consumption can only come from profitable entities. Unless we have sufficient savings to cover our 40 year time horizon, we have to take our consumption from somewhere else or sell our part of the stock market.

Most of us cannot wait 40 years before we start consuming our savings. Pension funds typically start paying us by the time we are 70. Any payment made into a pension fund after we reach 30 is therefore unable to cover the upfront cost with profits. Many companies go bankrupt in the space of 40 years. Their loss must be covered by the surviving companies. It is not at all certain that money put into a pension fund will ever recover its purchasing power.

All of this adds up to a picture in which we can say with near certainty that money invested in the stock market today will not be recovered. While it is possible, and even likely, that stocks continue up in nominal terms. The purchasing power will not increase. There is simply not enough profitable production in the stock market to cover the costs.

Purchasing power is sustained through production. Owning companies that barely make a profit is not a sound strategy for maintaining purchasing power over time.

If a 10 year time horizon can be considered reasonable, then the current stock market is as much as four times more expensive than it should be. A 75% drop will be required in order to bring its price back to a more sustainable level.

Wall Street

By Vlad Lazarenko - Own work, CC BY-SA 3.0, Link