Stock Market Today

It depends on how much faster the stock market is growing. The growth rates of the economy are a historic metric, measuring the growth of the economy over the past periods. The increase in stock prices, on the other hand, are a reflection of the investor’s expectation about future growth of the corporate earnings. As a result, the two growth rates may be different: in an extreme case you may have negative growth rates in the economy, reflecting the past period’s recession, but positive growth rates in the stock market, reflecting the investors’ optimims about a quick recovery and positive future growth of the economy.

The metric most often used by analysts is the Price Earnings Ratio (P/E Ratio), which measures the market price of per share divided by the total earnings per share. It measures how much investors are willing to pay for the future earnings of the company, reflecting the growth prospects of the company perceived in the market. On average, the P/E Ratio of US stocks is about 15. If the market goes above that average it can be assumed that the investors are optimistic about the future growth prospects of corporate earnings and the economy in general. Only if the PE ratio reflects an unrealistic growth of the economy (P/E ratio of above 25), it is likely that a stock market bubble is building up.

Of course, there are other indicators of possible bubbles. And comparing the growth rates is clearly one possible indicator. For example, China’s economy is growing at an annual pace of 8%. However, the stock market in Shanghai is up 90% year to date, with a P/E ratio of 75. This looks very much like a bubble to me.

It is however, possible in some extreme cases that the stock market is in fact bigger than the economy. Such a case is Hong Kong whhere the market capitalization of the companies listed on the Hong Kong Stock Exchange is 640% of the GDP. This is related to the particular structure of the Hong Kong economy.