I receive a lot of questions about market capitalization, or “market cap” and how it applies to various asset classes such as stocks, gold, or bitcoin.
In particular, transfers between asset classes seem to be a somewhat unintuitive concept, and thus worthy of review and examples.
The key reason to understand market capitalization dynamics is because they affect how market bubbles play out, and we’ve been in a period of rolling market bubbles, with certain sectors or asset classes getting temporarily out-of-hand before correcting. In addition, there’s a particularly strong virtuous/vicious cycle for US asset valuations, offset by trade imbalances, that we need to monitor.
So, this article breaks the concept of market capitalization down and shows some of the unintuitive nuances for how it works.
Stock Market Capitalization Definition
The market capitalization of a company represents the total price of the whole company. It is calculated as the number of shares in existence multiplied by the price of the shares.
For example, if a company consists of 500 million shares, and each share is currently worth $50, then the company has a $25 billion market capitalization.
In reality, if a larger company were to try to buy out the full company, they would have to pay a premium for the company to ensure that the board of directors and the majority of shareholders of that company agree with the acquisition. For example, they might have to pay $30 billion in order to buy a $25 billion market cap company, so that the board of directors agrees to it and signs off on all of the shares being transferred (even those shares of individual investors that might not have wanted to sell, since the legal entity itself gets absorbed into the buyer).
But aside from acquisitions, the market capitalization of an asset is the number of pieces that it exists as, multiplied by the price of those pieces.
Other Asset Market Capitalizations
We can also apply the concept of market capitalization to non-equity assets, and to entire sectors.
Gold Market Capitalization
The World Gold Council estimates that 201,000 tonnes of gold have been mined in human history, with most of it in the past century. This is equivalent to a cube of less than 25 meters on each side.
Since one of the properties of gold is that it is infinitely reusable and nearly chemically indestructible, and since it is expensive enough that only small bits of it ever get thrown out, the majority of mined gold still exists.
And then specifically, 44,000 of the 201,000 tonnes are estimated to exist as private investment, (i.e. coins and bars held for private entities including individuals).
At $1,700 per ounce, the estimated gold market capitalization would be about $12 trillion, of which somewhere around $2.6 trillion would be held specifically as private investment. If we include national investment in gold reserves, and the subset of gold jewelry that is used specifically for investment (such as 24k gold jewelry in India, bought for the purpose of storing wealth), then the amount that is held as private and public investment is well over $5 trillion, and probably closer to $7-8 trillion.
Bitcoin Market Capitalization
Similarly, we can calculate the market capitalization of bitcoin. It’s the number of coins in existence multiplied by the price per coin. YCharts has it here:
Unlike gold, we can audit the entire supply of Bitcoin and know the exact figure rather than estimate it.
However, there is a broad range of estimates that generally point to somewhere around 20% of those coins being “lost”. Many of these lost coins were mined when bitcoin didn’t have a market price or had a very low price, and computers were thrown out and destroyed with the private keys on them, which makes them forever inaccessible.
So, the effective market capitalization may be more like 80% of the total. More on this later in the article.
US Equity Market Capitalization
On the global stage, all country stock markets combined are worth in the ballpark of $100 trillion. As of this writing, the US stock market capitalization alone is worth over $40 trillion.
US Real Estate Market Capitalization
Zillow estimates that the US residential real estate market capitalization (the total value of all residential homes in the country) is around $36 trillion.
On the global stage, all residential real estate combined is worth close to $200 trillion.
Credit Suisse, in their annual global wealth reports, estimates that there is over $400 trillion in wealth in the world, including equities, real estate, cash, bonds, and alternatives. This includes assets minus liabilities, so the total value of the asset side is well north of $500 trillion.
The Marginal Buyer Sets the Price
Perhaps the most unintuitive fact about market capitalization, and the main reason I wrote this article, is that large changes in market capitalization can be done with much smaller amounts of money.
In other words, if a stock goes from a $500 million to a $600 million market capitalization, many people assume that means that $100 million flowed into that stock. However, that’s not how it works. The marginal trade sets the whole price.
This is why bubbles can exist, and can be so destructive. Wealth can simply be created when real innovation happens, and can be destroyed if an asset class deflates in value. Wealth doesn’t necessarily need to “go” anywhere.
Example 1) Small Stock
Suppose someone named Mary founds and runs a company, and after a long time, she decides to sell it to the public with a direct listing. For simplicity of example, she breaks it into 10 million shares, and is able to sell them for $50 each.
Day 1
As the day of the public listing ends, Mary walks away with $500 million in cash. The company now is publicly-traded and has $500 million in market capitalization.
The cost basis of the new investors in this overly-simple example is also $500 million, since all the shares started trading at the same price.
Day 2
Suppose the next day, a big investor named Maximillian hears about it and decides to buy a million shares. None of the existing investors want to sell for $50/share, or $51/share, or $52… so eventually he offers as as high as $60, which is the lowest offer that any of them will accept. Some of the investors finally agree to that price, so 1 million shares trade hands for $60 each.
The market capitalization is based on the most recent price, so at $60/share multiplied by 10 million shares in existence, that’s now $600 million.
In other words, the marginal buyer set the effective new price for the company, even though only 10% of shares were traded. Maximillian and those investors he bought the shares from traded $60 million in value, and it boosted the market capitalization of the company by $100 million.
The weighted-average cost basis of the investors in the company is $510 million. This is because 9 million of the shares were last purchased at $50 each (totaling $450 million), and 1 million of the shares were last purchased at $60 (totaling $60 million), which together adds up to $510 million.
The remaining original investors therefore have $90 million in unrealized profits.
Day 3
A big momentum investor named Beatrix saw the company go public, and then go up 20% in price the next day. She wants in on the action!
She offers $60/share to buy in, but nobody else wants to sell at that price. So, she ups her offer to $61, then $62, then $63, and eventually finds buyers (from among the originals who bought in at $50) willing to sell for $70/share. She buys a million shares.
The market capitalization is now $700 million.
The cost basis among current investors consists of 8 million shares at $50 totaling $400 million, plus 1 million shares for Maximillian at $60 million, plus 1 million shares for Beatrix at $70 million, which adds up to $530 million.
The remaining original investors have $160 million in unrealized gains, and Maximillian has $10 million in unrealized gains.
Day 4
All of the investors are excited now, since most of them have big unrealized profits.
A bunch of them think that they actually wouldn’t mind exiting here at $70/share either, now that they think about it. They can lock in some profits and diversify! However, when some of them put their shares up for sale, they don’t find any more buyers at that price. So, they start lowering the price to $69, then $68… and then a few of them get nervous.
Eventually, they find a buyer named Hector at $65/share. He buys 1 million shares from the original investors at that price, and he feels like he got a great deal because he bought the dip.
The market capitalization is now $650 million.
The cost basis consists of 7 million shares at $50 totaling $350 million, plus 1 million shares for Maximillian at $60 million, plus 1 million shares for Beatrix at $70 million, plus 1 million shares for Hector at $65 million, totaling $545 million.
The remaining original investors have $105 million in unrealized gains. Maximillian has $5 million in unrealized gains. Beatrix has $5 million in unrealized losses. The net result is $105 million in unrealized gains.
Day 5
A bunch of investors are concerned that the price is going down, so they sell their shares. There aren’t currently buyers interested at $65/share, so the price starts ticking down and down and down until it reaches $55/share and a new investor Gretchen steps in to buy 1 million shares at that level.
The market capitalization is now $550 million.
The cost basis consists of 6 million shares at $50 totaling $300 million, plus 1 million shares for Maximillian at $60 million, plus 1 million shares for Beatrix at $70 million, plus 1 million shares for Hector at $65 million, plus 1 million shares for Gretchen at $55 million, totaling $550 million.
On average, there are no unrealized gains or losses anymore. The remaining original investors still have small unrealized gains, but Maximillian, Beatrix, and Hector all have unrealized losses.
Note that only $55 million traded hands on this day, but the market capitalization declined by $100 million.
Day 6
Maximillian decides he wants out! He puts all of his shares up for sale. There aren’t many interested buyers, so he has to keep lowering the price until he finds a buyer named Anabelle at $45/share. She’s happy because she’s buying below the original listing price.
Later this same day, some of the original investors freak out, because literally everybody except Anabelle has losses now. So, another 1 million of the original shares are sold, but they’re only able to find a buyer at $35. Some Nebraskan guy named Warren takes them off their hands for that price.
The market closes for the day, and the market capitalization is a weak $350 million.
The cost basis is a bit messy to calculate now. There are still 5 million shares held by original investors at $50, totaling $250 million. Beatrix is still holding at $70 million, and none too happy about that! Hector is stuck at $65 million. Gretchen is at $55 million. Annabelle is at $45 million. Warren is at $35 million. The total cost basis adds up to $520 million. Investors have $170 million in unrealized losses.
Note that only $70 million traded hands on this day, but the market capitalization declined by a massive $200 million.
Day 7
A bunch of value investors run some numbers, believe the company is now undervalued, and so they come in and start making offers. Another million of the original shares agree to get out of this mess, at $40/share.
The market capitalization is up to $400 million.
The cost basis consists of 4 million original shares at $50, adding up to $200 million. Beatrix is at $70 million, Hector is at $65 million. Gretchen is at $55 million. Annabelle is at $45 million. Warren is at $35 million. And this pool of new value investors is at $40 million. The total cost basis is $510 million.
Warren has an unrealized gain of $5 million, the latest value investors are even, and everyone else is still at an unrealized loss.
And from there, the price starts making its way back up over the next week, as value investors and momentum investors keep jumping on board.
As demonstrated through this set of hypothetical days, we see that wealth can go up and down, without the full portion of that wealth “going” anywhere. It can simply be created or destroyed, since the latest buyer effectively sets the effective price for all shares of the company.
Example 2) Houses on a Street
Similarly, let’s say that twenty nearly-identical houses are built on a brand new street, and twenty different families come in and buy them each for $300,000. The market capitalization of that street is now $6 million, after this $6 million of “IPO” capital flowed into the street. For the next few years, the houses remain held by the original buyers.
Then, during a particularly active year, three of the owners separately sell their homes for an average price of $400,000 each. Appraisals will then probably revalue the rest of the houses on the street up to a similar amount as well, since we now have a better indication of current market price for nearly identical homes. The effective market capitalization of that street is now $8 million. It’s 20 homes multiplied by $400,000.
Did $2 million new dollars flow into that street? No. Buyers came in with $1.2 million in fresh capital, and sellers left with $1.2 million in existing capital. So, $1.2 million traded hands, and 15% of houses traded hands. And yet the value of the street went up by $2 million. The marginal buyer sets the price.
Of course, the reverse would happen if those three homes were only able to be sold for $250,000 on average, after a long time of being listed and various price cuts to attract buyers. The whole street would lose estimated value, even though only 15% of the homes changed hands. The rest is unrealized gain or loss.
At any given time, the majority of the wealth around the world in stocks and real estate and most other assets consists of unrealized gains.
Example 3) Total US Assets
The stock market, real estate market, and bond/cash markets make up the bulk of where wealth is stored. These are cashflow-producing assets, although the advent of zero-and-negative-yielding bonds in some places has somewhat challenged that basic notion.
Besides that, there are alternatives such as gold, fine art, collectibles, and so forth that usually do not generate cash flow, but are expected by the buyer to retain their value via their finite supply, desirability, and long-term price appreciation.
During the 2007-2009 period, approximately $11 trillion in US household asset value simply disappeared.
Chart Source: St. Louis Fed
The wealth that was lost didn’t “go” anywhere. It didn’t flow out of the country to somewhere else, for example. It just vanished, because asset prices went down. House prices went down. Stock prices went down. Bonds, cash, and gold did well, but not enough to compensate for stocks and real estate.
The relative asset exposures, however, did shift around quite a bit, mainly from changes in price. For example, if you started with 50% in stocks and 50% in bonds, and didn’t buy or sell any of them, and the stock prices were cut in half while the bond prices stay the same, then suddenly you’ll have one third in stocks and two thirds in bonds.
This chart shows the percentage of US household assets that consist of equities, since the 1940s:
Chart Source: St. Louis Fed
Most of the changes in percentage on this chart come simply from changes in equity valuations, although fund flows in and out of equities also affect it to a lesser degree.
Example 4) Bitcoin
I wrote about the bitcoin market capitalization earlier, but there are other ways to calculate it.
Coin Metrics, for example, has a detailed article on the “realized capitalization”, which in some ways is like an estimated cost basis for bitcoin. In a simplistic way of describing it, it records the last time that coins changed hands, and the prices they changed hands at, to determine a weighted average across the entire Bitcoin network of what coins were last bought at.
The realized capitalization is usually lower than market capitalization, except at the bottom of major bear markets after the price crashed. This is a logarithmic chart, so the gaps between the green line (market capitalization) and red line (realized capitalization) are larger than they appear:
Chart Source: Coin Metrics
In other words, just because bitcoin’s market capitalization is around $1 trillion at the moment, doesn’t mean that current investors collectively purchased $1 trillion worth of bitcoin. Many of them bought at lower prices a while ago, and then subsequent buyers at higher prices contributed to the increase in prices for all the coins.
The amount of capital invested in bitcoin, as measured by the realized capitalization, is currently around $360 billion. This is well under 0.1% of global net worth. Only 2-3% of people in the world own any bitcoin.
By extension, for bitcoin to add another trillion to its market capitalization would not require new investors to pile in with another $1 trillion in cash. It would only take a period of demand outpacing supply, driving up the prices on the margins with a few hundred billion dollars.
Bulls and bears both use this sort of information for their arguments.
The bull argument is that even a couple hundred billion dollars in new inflows globally would likely result in massive percent gains in price, and that bitcoin remains very early in its adoption curve and total addressable market. The bear argument is that if the world stops liking bitcoin for whatever reason and there become a ton more sellers than buyers on a persistent basis, it can collapse like a house of cards, as could any other non-cashflow asset.
Market Capitalization vs GDP
Aside from the CAPE ratio, the Q ratio, and all sorts of broad valuation methods, some investors like to watch market capitalization as a percentage of GDP. It gives a “sanity check” on how large the market is relative to the size of the economy.
Guru Focus, for example, has a long-term chart that shows the ratio of US stock market capitalization to US GDP in green. As of this writing, this is at a record high of over 200%. They also have a modified version that adds the Federal Reserve’s balance sheet to GDP, in blue:
Chart Source: Guru Focus
If we look at the value of all US public and private equity value on this next chart, the sum is equal to around 300% of US GDP, compared to about 200% in 2000:
Chart Source: St. Louis Fed
Some people assume that this sharp rise in market capitalization is because US companies sell an increasing amount of products to foreign markets. However, the trend has actually been the opposite for the past 10+ years. S&P 500 foreign revenue as a percentage of S&P 500 total revenue hit decade-lows over the past couple years.
Instead, aside from pure investor sentiment and euphoria, there are a few main fundamental variables that have led to these unusually high US equity valuations over time. There are certain factors that have led to higher corporate profits as as a percentage of GDP, and then certain factors that led to higher average valuations applied to those profits.
Corporate Dominance
A big variable for outsized equity performance and market capitalization over the past few decades has been the increase in corporate dominance in the US economy. And this variable has two main sub-variables: decreasing labor share and decreasing taxes.
First, capital owners have increased their leverage over laborers. After being relatively steady with a mild decline for five decades, the labor share as a percentage of GDP declined sharply and has been hanging around post-WWII lows during the past decade or two:
Chart Source: St. Louis Fed
This is partly due to technology and automation, partly from offshoring labor to emerging markets, and partly from other variables. These changes have increased capital’s hand and decreased labor’s hand at the bargaining table for a while now.
Chart Source: EPI
Secondly, the effective corporate tax rate has gone down for decades. This chart shows the percentage of corporate profits paid in taxes, with the federal share in red and the combined federal/state share in blue:
Chart Source: St. Louis Fed
As a result, after-tax annual US corporate profits used to range between 5-8% of US GDP, but over the past 15 years, it has been more like 8-11%:
Chart Source: St. Louis Fed
Pre-tax profits, on the other hand, haven’t changed as much.
So, when we look at equity market value as a multiple of total after-tax corporate profits, the valuation is only the second-highest in post-WWII history, rather than at record highs (as the market capitalization to GDP ratio would otherwise suggest), and those record highs are partially explained by low interest rates:
Chart Source: St. Louis Fed
Interest Rates and Global Investment
Besides decreasing labor share and decreasing taxes benefiting corporate net incomes, monetary and fiscal policies have resulted in higher typical valuations applied to those incomes by investors.
As previously shown, interest rates have a pretty strong inverse relationship to equity valuations, especially in the United States. Interest rates topped around 1980 when equity valuations bottomed, and then for four decades there has been a strong trend of declining rates and increasing equity valuations.
Here’s the S&P 500 cyclically-adjusted price/earnings ratio vs 10-year Treasury rates:
Chart Source: Shiller Data, Yale
Overall, rates play an important inverse relationship to equity valuations. We see some exceptions in particularly euphoric or depressed periods, however. Examples of these exceptions include the 1940s when both rates and valuations were low, and in the late 1990s into 2000 when both rates and especially valuations were high.
However, we don’t really see that inverse relationship between rates and equity valuations in Europe or Japan. Their rates went even lower than those in the United States over the past decade, but their equity valuations didn’t go as high. Why?
Well, because their investors also put their money into US equities rather than their domestic equities. The US had more tech/growth equities, and the US exported a ton of dollars via trade deficits to the rest of the world that needed to be reinvested somewhere. Foreigners reinvested those dollars primarily back into US equities. If you were to chart foreign real estate value vs rates you would find a good inverse correlation, but much less so with their equities.
Ever since the end of the Bretton Woods system and the start of the Petrodollar system in the 1970s, the US has had structural trade deficits. In other words, the US imports more than it exports, and so a lot of dollars flow out into the rest of the world.
It was in the mid-1990s (post-NAFTA) and early 2000s (China enters the WTO) that the US began a major program of offshoring labor to Mexico, China, and elsewhere, which kicked the trade deficits into high gear:
Chart Source: Trading Economics
Foreign markets took these dollars, and invested them in US assets. It began mainly with buying Treasuries, but then when everything kicked up a notch starting in the late 1990s, foreigners increasingly plowed their trade surplus dollars into US stocks as well. This chart shows the value of US corporate equities held by foreign investors:
Chart Source: St. Louis Fed
So, these trade deficits have been pretty bad for US workers in aggregate, but pretty great for US equity owners.
Unfortunately, people in the bottom 50% of the US income spectrum only own 0.6% of US equities, while those in the top 1% of the US income spectrum own over 53% of US equities, so this shift towards structural trade deficits and structural inflows to buy US assets with those trade dollars mostly accumulated wealth in the top half of the population.
This cycle negatively impacts the US net international investment position or “NIIP”. A country with a positive NIIP collectively owns more foreign assets than foreigners own of their assets. A country with a negative NIIP collectively owns fewer foreign assets than foreigners own of their assets.
The United States used to have a positive NIIP, but decades of trade deficits and foreigners using them to buy US assets (stocks, bonds, and real estate) have resulted in a deeply negative NIIP:
Chart Source: Ray Dalio, The Changing World Order
Major creditor nations that have run large trade surpluses over the years, like Japan, China, Switzerland, Taiwan, and Singapore, are the places that have built up huge positive NIIPs.
Summary: Watching for Turning Points
The biggest threat to US equity market capitalization at these atypically high levels would be a reversal of some or all of these trends.
If labor segments gain more leverage over capital markets, and/or if corporate tax rates start going up, and/or if interest rates go up somewhat, and/or if this feedback loop of foreigners reinvesting US trade deficits back into the US stock market reverses, then US market capitalization at this level compared to GDP would likely be hard to sustain.
And these things all tend to be intertwined. Raising tax rates on US corporations could reduce their relative attractiveness vs foreign corporations, which then also results in foreigners reinvesting fewer dollars into them. Additionally, if labor were to gain leverage over capital, that could very well go hand-in-hand with a program of re-shoring supply chains and reducing the trade deficit and US corporate profit margins getting squeezed.
However, at these levels, corporate market capitalization is not necessarily tied to economic growth. As 2020 showed, economic activity can collapse while asset prices soar, if enough money is printed to prop things up. The reverse can happen as well, with the economy doing fine while asset prices lag.
Whether this happens or not will largely depend on fiscal and monetary policy, which is why the 2020s will be a “macro heavy decade”, in the sense that policy can affect equity performance just as much as individual company performance can. In the meantime, keeping an eye on market capitalization bubbles is prudent, since it can inform what some of the long-term risks are.