We've Never Seen This Stock Market Signal Since the Great Depression

[00:00:00] Speaker 1: 1965, 2000, and 2007. Each of these years marked a historic moment when the stock market had grown so large that it was worth more than the entire U.S. economy itself. And today, we're even higher than all of them. In fact, the U.S. stock market is now worth roughly twice the size of the entire American economy, a level that has almost never been seen before. The only other time this indicator reached a comparable extreme was in 1929, just before the Great Depression. Now, this metric is known as the Buffett Indicator, one of Warren Buffett's favorite ways to measure how expensive the stock market has become. And when we overlay it with the stock market, it's easy to see why investors pay so much attention to it. Every time valuations reached extreme levels relative to the economy, a major reset eventually followed. In 1929, that peak was followed by an 80% collapse. In the late 1960s, it was followed by a decade of stagnation as valuations slowly repriced lower. And in 2000, the dot-com bubble burst and wiped out trillions in market value, which makes today extremely unusual. We've been sitting at these extreme levels for more than five years now. Yet, instead of correcting, the market has continued climbing higher and higher. And while that may look like resilience, it could also mean that if sentiment eventually shifts, stocks may have much further to fall than most investors currently realize. Now, to be fair, the stock market didn't reach these extreme valuations randomly. There is a much deeper force that's been driving stocks higher. And it can be found in this chart right here. It shows corporate profits in the United States. And almost immediately, we can see why the stock market has been able to sustain such high valuations for so long. Because corporate profits have exploded higher alongside it. Over the past 15 years alone, corporate profits have more than tripled. One of the strongest and most sustained expansions we've ever seen. And the relationship becomes even clearer when we also compare those profits to the size of the GDP. Over the past 17 years, corporate profits have surged from representing roughly 5% of GDP to more than 13% today. And it helps explain why stock valuations have remained elevated for so long. The argument is simple. If corporations are capturing a larger share of the economy, then perhaps they deserve to be worth a larger share of the economy as well. In other words, if profits continue growing faster than GDP, higher valuations may be justified. But there is a reasonable argument that we are reaching an extreme when it comes to these profit levels. Warren Buffett once famously stated, in my opinion, "You have to be wildly optimistic to believe that corporate profits as a percentage of GDP can, for any sustained period, hold much above 6%." Yet today, that figure sits at more than double the level Buffett was referring to. And that's led many analysts to argue that we are no longer looking at a valuation bubble, but potentially an earnings bubble. The concern is that profit margins may eventually revert toward more normal levels just as they have throughout history. And if that happens, the consequences for stock prices could be significant. Now, it's important to understand why corporate profits should theoretically stay capped as a percentage of GDP. The reason is fairly simple. Every dollar that shows up as corporate profit ultimately has to come from somewhere else within the economy. And one of the biggest places it comes from is labor. Watch what happens when we overlay corporate profits with the share of the economy going to employee wages. The relationship is almost a mirror image. Over the past 15 years, as corporate profits surged to record highs, the share of income going to workers steadily declined. And in theory, that should create a natural limit. See, workers aren't just employees. They're also consumers. If a smaller share of the economy is going to wages, households should eventually have less money to spend. And since consumer spending drives the economy, weaker spending should eventually translate into weaker corporate revenues and lower profits. Another reason is competition. Historically, when companies earn unusually high profits, competitors rush in to capture a piece of the opportunity. Over time, that competition tends to push profit margins back toward more normal levels. So between slower wage growth and rising competition, corporate profits should have faced significant pressure years ago. Yet that's not what happened. Which suggests something else has been supporting demand. Something powerful enough to offset both pressures. And understanding that force may be the key to understanding whether today's market can continue climbing from here. This chart shows the US federal budget deficit. Or simply the gap between how much the government spends and how much it collects in taxes. When the government spends more than it collects in taxes, it runs a deficit. And this line moves higher. Now, when we compare deficits to corporate profits, the relationship becomes remarkably clear. As deficits have expanded over the past 15 years, corporate profits have expanded right alongside them. At first glance, that sounds completely backward. After all, deficits are usually portrayed as a negative, something that weakens government finances and creates debt. But from the perspective of the private sector, deficits work very differently. Because every dollar the government spends ultimately becomes income for someone else. Infrastructure projects create revenue for contractors. Subsidies support businesses. Social programs support household spending. And all of that money eventually flows through the economy. Which means larger deficits often create stronger demand. And stronger demand often translates into higher corporate revenues and higher corporate profits. Viewed through this lens, the surge in corporate profits over the past decade starts to make a lot more sense. As wage growth slowed and consumers struggled to drive demand on their own, government spending increasingly filled the gap. So the Buffett indicator isn't extreme because the market has gone irrational. It's extreme because deficits have been artificially holding corporate profits above their natural limit. And that can only continue for as long as the government can keep borrowing and maintain these deficits. Now, at first glance, that seems like the most likely outcome. After all, institutions like the Congressional Budget Office still project that US budget deficits will continue rising over the next decade. But the short-term picture may be more complicated. And the relationship reveals an important trade-off. While deficits can support economic growth and corporate profits, they also create another problem: inflation. The more money that flows into the economy, the greater the risk that demand begins outpacing supply. And when that happens, prices start to rise. We saw exactly that dynamic leading up to the 2008 financial crisis and again after the pandemic. That's why periods of rising inflation are often followed by efforts to rein in spending and slow the growth of deficits. And when deficit growth slows, corporate profits often come under pressure as well, triggering a valuation reset. In both cases, the stock market eventually fell more than 30%. Today, inflation has started moving higher again, climbing back above 4%. If inflation remains elevated for an extended period, it becomes increasingly difficult for policymakers to continue expanding deficits at the same pace as before. In other words, the very force that may have helped sustain record corporate profits over the past 15 years could be approaching its limits. And if deficit growth eventually slows, the support it has provided to corporate earnings may begin fading as well. However, if inflation begins cooling again, perhaps because geopolitical tensions ease, then policymakers may have much more room to continue running large deficits. Corporate profits could remain elevated for much longer than many investors expect, and the foundation supporting the market would remain intact. At Capital.com, we'll keep tracking corporate profits, the federal deficit, and the macro forces shaping markets in 2026. Hit like and subscribe to stay tuned. Thanks for watching.