Two weeks ago in Ahead of the Curve, I wrote about Warren Buffett’s favorite tool for measuring the overall valuation of the market: the ratio of total market cap to GDP.

Today, we’re going to dig a little deeper into that analysis… and compare the U.S. market to some of its peers overseas.

First, there is no “correct” ratio of market cap to GDP, or any formula that suggests what ratio is optimal. This is very much a relative value analysis in which we can compare a given market to its peers, and to its own history.

So without more ado, let’s jump into the data. The chart below, courtesy of GuruFocus, shows the current market-cap-to-GDP ratio (in blue) within the context of its historical range (blue and green combined).

150505 AOTC chart

As you can see from the chart, the U.S. ratio is just a hair’s breadth below the all-time highs set during the 1990s tech bubble. Meanwhile, Chinese stocks look like an outright steal.

Be careful how you interpret this data, however. China’s historical range includes bubble valuations from a decade ago that we cannot expect to be repeated. And China may also be facing a destabilizing hard landing after three decades of monstrous growth.

Japanese stocks also look cheap at first based on their historic range, but their history, like China’s, is also not likely to be repeated. Plus, Japanese stocks are even slightly more expensive than American stocks as a percentage of GDP… and this despite all of the macro challenges Japan faces.

So, anyone who tells you Japanese stocks are cheap has a very poor understanding of Japan.

Some countries will naturally have a much higher ratio than others. Switzerland is a tiny country with several massive global banks and multinational companies. With that in mind, a ratio that would seem absurd in the U.S., UK or France would be perfectly reasonable in Switzerland. So, don’t be distracted by the seemingly high valuations in countries like Switzerland and Belgium. But here’s the big picture: As I’ve tried to ram home for the past several weeks, American stocks — the stocks I expect you to most likely hold in your portfolio — are very expensive today, both in absolute terms and relative to their peers overseas.

And again, it doesn’t mean a crash will happen tomorrow. But it does mean investors should practice a little more caution than usual.

Take a play out of Warren Buffett’s handbook and keep a little cash on hand. That way, when we eventually do see bargain pricing, you’ll be able to jump on it.

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Charles

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Charles Sizemore
Charles Sizemore is the editor of Peak Income, a monthly newsletter focusing on income and retirement strategies.