U.S. equity markets, particularly the C Fund, continued to push higher last week as we go deeper into the new year. Here is the one-year performance of the various TSP funds:
This recent period has also seen a new valuation record, which has given some investors a moment of pause. The ratio of total U.S. stock market capitalization to U.S. GDP has now surpassed the height of the Dotcom Bubble of 2000, at over 150%:
The stock market capitalization is the value of all shares of all stock, basically the cost it would take to buy every company in the C Fund and S Fund. And for clarity, the GDP and the market capitalization components are shown separately on the chart below. The ratio comes from dividing the blue stock market capitalization figure by the green GDP figure:
Besides high equity valuations (such as the price-to-earnings ratio), many investors assume that the primary cause of this record high market-cap-to-GDP ratio is due to increased sales from U.S. companies to foreign markets.
Large companies are global these days, so their share prices may not have much correlation with the country they happen to be headquartered in.
However, during the past two decades, foreign revenue as a percentage of total revenue by the companies in the S&P 500 (which makes up about 80% of total U.S. equity market capitalization) has not changed much, and is even down a bit vs a decade ago.
The latest figures for 2019 are not available yet, but the trend over the past decade is quite stable:
Instead, the stock market capitalization as a percentage of GDP has mostly been driven by two main variables: higher equity valuations, and corporate tax cuts.
The higher equity valuations are clear, and tend to occur during strong points in the business cycle. The change in corporate tax rates has been less noticeable to many people, but has made a huge difference.
On the chart below, the blue line is the amount of annual corporate taxes that the government receives divided by the total amount of U.S. corporate profits. In other words, it’s a good proxy for the federal corporate tax rate in practice. The red line represents the absolute amount of corporate taxes collected by the government each year:
Effective federal corporate tax rates used to be 30-40% or more back in the 1950’s and 1960’s. They decreased to 20-25% in the 1980’s and 1990’s, and to 15-20% during the 2000’s.
The Tax Cuts and Jobs Act of 2017 further cut corporate tax rates starting in 2018, and now corporations are effectively paying below 10% of their operating income in taxes.
In addition, the absolute amount of corporate tax rates has come down. The current amount paid, roughly $160 billion, is in line with the 2002 and 2009 recessionary periods, even though corporate earnings, GDP, and inflation have all increased since those times, and the economy is not currently in a recession. It’s half of what it was a year ago, which was over $320 billion.
This is why some valuation metrics that take into account after-tax earnings (like the price-to-earnings ratio) are showing moderately high valuations, while other valuation metrics that do not take into account the tax changes (like market-capitalization-to-GDP, or price-to-sales, or price-to-EBITDA) are showing all-time record high valuation levels, even above what they were in the year 2000.