Modern financial markets are triggering cognitive dissonance among investors. On the one hand, we’re seeing historical highs among stock indices. On the other hand, there are obvious signs of macroeconomic fatigue.
As I detailed recently, looking at the valuation of inflation (through the prism of the Big Mac Index), the real U.S. economy, measured in physical base goods, has actually been in a hidden recession for the last 20 years. The stock market, however, has managed to more than double over this time.
This systemic disconnect between Wall Street and Main Street generates some frightening statistical anomalies. In a previous article, I also analyzed the Buffett Indicator in detail, which reached an incredible 228%. According to classic theory, an indicator of 100% or higher points to overvaluation. That means a figure of 228% should signal of one of the most massive bubbles in history.
Looking at these numbers, an army of analysts predicts an unavoidable catastrophe every day. But what if we’re attempting to measure the modern digital economy by an old industrial yardstick? What if this is not a bubble but a fundamental, tectonic shift in the very nature of the structure of the economy?
The Illusion of a Bubble: Detachment of Capitalization From GDP
To understand why the Buffett Indicator broke, we need to remember the base math of investing. The stock market — capitalization — is not a derivative from gross domestic product (GDP) or aggregate revenue. The stock market always primarily values future earnings.
In the industrial era of the 20th century, the share of corporate profit in the general volume of the economy was a relatively stable constant. If GDP grew, corporations sold more goods, their revenue grew, and profit increased proportionally. This is precisely why the Buffett Indicator worked — GDP was a reliable mirror for the valuation of future profits.
But in the last two decades, this relationship has fallen apart. If we look at the price-to-earnings (P/E) multiple for the S&P 500 Index ($SPX), we see that the market is certainly not cheap, but it is also not absolutely absurd like the dot-com peak. Investors pay an adequate premium for real, huge profits. The paradox is that P/E multiples remain in the frame of historical norms, but the relation of capitalization to GDP flew away into the stratosphere.
How is this possible? The share of profit in the structure of GDP radically grew.
Zero Marginal Costs and the Revolution of Profitability
We have transitioned from an era of physical goods into an epoch of software and digital services.
In 2000, for a company from the real sector — like the once-mighty phone manufacturer Nokia (NOK) — to increase its revenue by $1 billion, it needed to build new factories, purchase tons of raw materials, hire an army of workers, and build out complex logistics. The margin of such a business is harshly limited by the laws of physics and the cost of labor. 10% of net margin was previously considered an excellent indicator.
Today, technological giants reign supreme. Microsoft (MSFT), Alphabet (GOOGL), and AI developers don’t need to build new factories to sell a million subscriptions. Marginal costs on the creation and distribution of an additional digital copy trend toward zero. That creates companies with profitability by net profit exceeding 25%, 30%, and sometimes 40%.
The stock market fairly values this efficiency. Stock indices decoupled from macroeconomic indicators, such as the Big Mac Index or GDP, because the market ceased to be a mirror of economic turnover. It became a mirror of margin.
New Distribution of Wealth: The Lorenz Curve in Action
This growth of margin has direct macroeconomic consequences. If corporations take 30% of net profit from every dollar in the economy instead of 10%, this money has to come from somewhere.
Here, we observe a global process of the redistribution of incomes. In economic theory, there is a concept called “labor share of income.” Historically, this was stable. But over time, it has steadily lowered, yielding to the “share of capital.”
Put simply, the economy still generates goods. However, the lion’s share of the added value does not go into salaries (with which people buy base goods like Big Macs) but instead transforms into corporate profit, which then capitalizes on the stock market. The Lorenz curve, illustrating the inequality of the distribution of incomes, is becoming increasingly skewed. The rich owners of capital and assets become richer not because of the evil intent of governments, but because the very structure of the economy began disproportionally rewarding the owners of intellectual property and algorithms, depreciating physical labor.
The idea that, at some point in the future, AI and robots will automate processes and take work away from people is hopelessly outdated. This process has already been happening. And its main manifestation is not a crowd of unemployed workers on the street, but record indicators of profitability and a growing share of profit in GDP.
Companies learned to earn more, utilizing less expensive human labor on a unit of revenue. This is precisely why the stock market — the concentrate of profit — is peaking at the same time that the ordinary economy — the concentrate of salaries and consumption — stagnates.
Why Big Tech Spending Holds the Economy From a Crash
This brings up a logical question: If super-profits concentrate at the very top, and the share of labor (salaries) in the national income falls, why has the U.S. economy not collapsed into a depression from a shortage of consumer demand? If people become poorer in terms of Big Macs, who pays for this holiday on the stock market?
The answer hides in how exactly modern corporations dispose of their unprecedented margins.
Imagine a catastrophic scenario for a moment. What would it be like if the first hundred companies of the S&P 500, earning trillions of dollars of net profit, simply folded the money into their bank accounts and formed gigantic war chests? They would physically extract liquidity from macroeconomic turnover. This would lead to a harsh deficit of money on the lower level, a collapse of demand, and a depression.
Surprisingly, though, the U.S. economy continues to grow — and the secret of this growth hides in the current investment phase. Tech giants earn colossal money, but they also spend it. They return this capital back into the economy in the form of gigantic capital expenditures.
If we look at reports from the U.S. Bureau of Economic Analysis (BEA), we can see an amazing picture: one of the main locomotives of real economic growth is not consumer demand on goods, but the capital investments of businesses.
Data Centers Are the Railroads of the 21st Century
Today, we find ourselves at the epicenter of the AI boom. Computing capacities of unimaginable scale demand for the provisioning of the work of AI algorithms. The construction of gigantic data centers today appears to be a macroeconomic analog of the laying of railroads in the 19th century.
When tech giants decide to spend billions of dollars on new data centers, this money does not just evaporate. It pours into the real sector of the economy.
Thousands of tons of concrete and steel are purchased. Multi-billion-dollar contracts with energy companies are signed. Manufacturers receive record orders for cooling systems, cables, and complex industrial equipment, while high-paying jobs are created for builders, mounters, and engineers.
This exact cycle saves the system. As the profit generated by high-margin digital business gets reinvested into heavy, physical infrastructure, the balance of incomes and expenses is preserved. Tech giants act like huge distributional pumps, returning the money they extract back into the hands of workers and traditional industries.
Many financial analysts today criticize tech giants for spending too much on AI without seeing an immediate payoff. But from a macroeconomic point of view, the fact that they spend so much is a colossal boon for the U.S. economy. In fact, if tech giants were to stop spending so much, it could be catastrophic.
Conclusion
Let’s return to our Buffett Indicator of 228%. Does this number mean we find ourselves in the scariest bubble in history?
No. We simply find ourselves in an economy with absolutely new physics.
This is not a bubble of empty promises, like the one that created the dot-com crash in 2000, when companies without revenue cost billions. The current valuation of the market is based on absolutely real, record profitability. We have survived a structural shift; automation, software and now AI have allowed companies to forever change the structure of costs. Profit began to occupy a larger share in GDP than 20, 30, 40 years ago, and the curve of income distribution transformed.
The stock market — capitalization — is tied to this very profit. Therefore, its decoupling from nominal GDP is a mathematical inevitability of this new era.
We live in a paradoxical world. In terms of base needs and the Big Mac Index, an ordinary consumer feels stagnation as the share of his or her labor in the economy falls. But the stock market is beating records because the share of capital and margins of businesses are growing like never before.
This system will not collapse under its own weight, so long as the beneficiaries of this new economy continue to return trillions back into the real sector through the construction of data centers, power stations and infrastructure. Investors shouldn’t panic because the Buffett Indicator has exceeded 200%, or because of the huge expenditures of Big Tech. The real cause for panic will be the day that corporations cease to spend their phenomenal profits in the real sector.
On the date of publication, Mikhail Fedorov did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
