April 14, 2021 | High Market Capitalization Bodes Poorly for Investment Returns

A December 2020 paper entitled The Big Bang:  Stock Market Capitalization in the Long Run, confirms that we have been living through a highly unusual period in financial markets.

While advanced-economy stock market capitalization to GDP ratios were pretty constant between 1870 and 1990s, they tripled in what the authors call a “big bang” in the 30 years since.   This structural break’s key driver was a policy and profit shift in favour of publicly listed larger firms along with stagnating economic growth.  No free lunch, the authors find that these trends do not bode well for future investment returns or stock market stability from here:

The existence of this profit shift is consistent with the broader trend of increasing market power of large firms at an increasingly uneven distribution of corporate earnings in the US and globally (De Loecker et al.,2020; De Loecker and Eeckhout, 2018). Because these high market values reflect a distributional shift within current income rather than a high future growth potential, they do not generally signal favourable near-term prospects for the economy.

On the contrary, we show that high levels of market capitalization are typically a sign of brewing trouble, predicting low returns, low growth, and a high probability of a stock market crash.

Danielle Park April 14th, 2021

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