How liquidity and rising wealth explain today’s high valuations in the stock market
Introduction
Many market commentators warn that stock valuations are dangerously
high, pointing to elevated price-to-earnings (P/E) ratios and market
cap-to-GDP levels as evidence of a bubble. These warnings often rely on
outdated benchmarks. What was considered expensive fifty years ago isn’t
necessarily expensive today.
Two structural forces have redefined what counts as “normal”
valuations. Today’s levels are not irrational but the natural outcome of
two powerful trends:
- The persistent expansion of global liquidity.
- Raising capital stock per person has pushed down the natural rate of interest.
Together, these forces have changed the equilibrium level of
valuations. A Price-to-Earnings ratio of 20 was considered expensive 50
years ago, but now it can be a good value.
Liquidity growth doesn’t just provide more money to invest; it
fundamentally alters risk perception, reduces systemic risk fears, and
creates a “risk-on” environment in which investors are willing to pay
more for future earnings.
Furthermore, a nearly continuously growing stock of capital per
person has reduced discount rates, which further encourages higher
valuation multiples.
Misconceptions About Liquidity and Valuations
Many analysts argue that liquidity is “neutral” for valuations. Their reasoning typically takes two forms:
– Liquidity simply inflates earnings. When liquidity
increases, prices, sales, and company earnings grow accordingly. Based
on this reasoning, valuation metrics like the P/E ratio should remain
unchanged because higher stock prices only indicate higher earnings.
Therefore, liquidity would affect the “E” in the P/E ratio, but not the
“P.”
– Stock market capitalization-to-GDP ratios can’t increase because liquidity inflates GDP.
Critics also point to market capitalization versus GDP, arguing that
liquidity affects both equally. If GDP is higher due to inflation caused
by abundant liquidity, they contend that the market cap-to-GDP ratio
should stay stable since both the numerator (market cap) and the
denominator are influenced by liquidity.
While intuitive, these arguments miss a crucial point: liquidity not only fuels nominal growth but also changes how risk is priced. It drives a repricing of assets, lifting valuations independently of GDP or earnings growth.
Liquidity as a Valuation Multiplier for the stock market.
Liquidity is more than a measure of money in the system. It is a
structural driver of asset pricing. When the growth of global money
supply outpaces real GDP, surplus capital competes for a limited pool of
assets. This competition raises prices and pushes valuation metrics
higher.
The chart below shows the year-on-year percentage change of the
S&P 500 compared to global M2 (money supply) over the past 10 years.
We see that although the S&P 500’s annual performance might be
above or below M2’s yearly growth, they tend to move in lockstep. The
S&P 500 lags 6-12 months behind M2 growth, with a correlation
ranging between 0.35 and 0.4. The most recent reading suggests that the
stock market is neither too overextended nor too depressed.

How does this astounding correlation between liquidity and stock market performance come about?
The key mechanism behind liquidity’s effect on valuations is its ability to alter risk perception.
Abundant liquidity acts as a cushion against systemic risk. Crashes
and severe bear markets often emerge from liquidity traps or credit
shortages, where even solvent entities cannot secure funding. These
crises create downward spirals, forcing investors to demand steep risk
premiums. In contrast, liquidity-rich environments do the opposite:
- They reduce systemic risk fears. Investors recognize that abundant
liquidity minimizes the likelihood of financial meltdowns, thereby
lowering the perceived risk of holding equities and other risk assets.
- They compress volatility expectations. High liquidity levels reduce
the probability of market dislocations. Lower expected volatility drives
higher valuations because investors are willing to pay more for future
cash flows when risks feel manageable.
- They improve market functioning. Deep liquidity allows distressed
assets to be absorbed quickly, reducing contagion risk. This stability
encourages long-term investors to remain fully invested, adding further
upward pressure on prices.
- They encourage a search for yield. With abundant liquidity and low
interest rates, investors shift from cash or bonds into equities,
boosting demand and driving multiples higher.
This is why liquidity expansions have an asymmetric effect: they push valuations higher much faster than they push GDP or earnings.
They change investor psychology and pricing models, making equities and
other risk assets appear safer relative to their historical risk
profile.
The chart below plots M2 (x-axis top) vs. the PER (y-axis). We
observe that M2 tends to grow exponentially as every doubling of M2
occurs in less time. The linear regression shows that the higher M2, the
higher the PER.

Illustration 2: Correlation M2 and the S&P500 performance.
And what happens to the stock market when liquidity increases so much that its annual growth rate exceeds that of the real GDP?
When the U.S. M2 annual growth exceeds annual real GDP growth,
equities deliver much stronger returns. When GDP growth outpaces M2
growth, the stock S&P500 stagnates or declines. This shows that liquidity
does not merely raise nominal stock market earnings or GDP; it reshapes
the market’s willingness to pay for those earnings.
Jim Paulsen’s research captures this dynamic as he shows in this chart:

Illustration 3: Correlation between excess liquidity and the S&P500 performance.
I quote Jim Paulsen:
“[s]ince 1960, for all quarters when real excess annual
liquidity growth was positive, the forward 1-quarter average annualized
S&P 500 total return was a robust 15.97% compared to a forward
1-quarter average annualized S&P 500 loss of -6.08% for quarters
when real excess liquidity was negative. Moreover, during
quarters when excess liquidity was negative, the S&P 500 index
suffered forward 1-quarter total return losses nearly 50% of the time
compared to only 22.6% of the time when real excess liquidity was
positive.”
As an aside, as of this writing (early September 2025), Jim Paulsen’s observation is bullish for the US stock market.
Historical Perspective: Liquidity Traps and Crashes
Market history shows that major financial crises, such as the Great
Depression, the 2008 Global Financial Crisis, and the 2020 COVID-19
crash, were triggered or amplified by liquidity shortages. When
liquidity dries up, credit channels seize, systemic risk skyrockets, and
investors demand steep discounts for risk assets.
Conversely, periods of abundant liquidity not only support valuations
but also act as a stabilizing force. In the post-2008 era,
unprecedented central bank liquidity injections not only prevented
systemic collapse but also ushered in a decade-long bull market. This
underscores that liquidity doesn’t just follow market cycles; it shapes
them.
But there’s a catch. Markets can become “hooked” on easy liquidity, making them vulnerable to sharp pullbacks if it suddenly dries up. That’s why timing indicators matter: they help us ride the wave when liquidity flows freely and protect us when the tide turns.
Rising Capital per Capita and the Decline in Natural Rates
While abundant liquidity helps push higher values, another crucial factor is the growth of capital per person.
As economies become wealthier, capital becomes more plentiful,
leading to lower natural interest rates. By “natural” interest rate, I
mean the interest rate free of inflation that would typically prevail in
a given economy without central bank interference. The Austrian School
of Economics has excellent insights into the natural rate of interest.
Interest is the cost of capital. If capital is scarce, the natural
interest rate will rise. If it becomes abundant, like the price of
everything, its rate will decline. This is why wealthy countries have
lower interest rates than poorer countries. Lower interest rates result
in higher valuations for stocks (PER).
A proxy for the capital stock per capita is GDP per capita, which I will use for the rest of this article.
I created the chart below that shows the relationship between GDP per
capita and PER. I used the ETF representing each country as a proxy for
its stock market. The x-axis displays GDP per capita, and the y-axis
displays PER. The linear regression line clearly indicates that the
higher the country’s GDP per capita, the higher the PER.
The correlation between a country’s wealth and its PER is noteworthy:

Illustration 4: Correlation Between Wealth per Capita in several countries and Valuation Multiples
The chart above has a Pearson correlation coefficient of 0.64, which
is high, implying that a 2x richer country tends to have a 1.4 P/E points higher valuation (based on the fitted slope).
But things get even more interesting when we focus on the USA. The
USA has continually grown richer in inflation-adjusted terms, which
means a higher real GDP per capita.

Illustration 5: Correlation Between US inflation-adjusted GDP per Capita and Valuation Multiples
Higher capital, measured by GDP per capita, also contributes to
higher valuations in the USA. GDP inflation-adjusted has risen from the
1960s to today, as has the PER.
A lower natural interest rate resulting from increasing GDP directly
boosts valuation multiples: when future earnings are discounted at a
lower rate, their present value rises. Comparing current valuation levels to those of the 1970s or 1980s ignores this structural change. In a world with abundant capital, it is rational—not speculative—for investors to pay higher prices for each unit of earnings.
How much of the PER expansion is due to liquidity and how much to growing GDP per capita?
So far, we have examined how both liquidity and rising GDP per capita
influence stock market valuations. An attentive reader might wonder
whether we are conflating these two variables, as both affect the
price-to-earnings (P/E) ratio. It is essential to separate and isolate
the impact of each factor on P/E expansion.
Using AI, I conducted an in-depth analysis to separate the effects of
liquidity growth from those of increasing GDP per capita. How much has
each factor contributed to expanding PERs?
Since 1960, there has been a rise in the trailing P/E of about +12.7 points in total.
- Of that, roughly +4.1 points came from GDP per capita growth.
- Roughly +8.6 points came from more liquidity (real M2).
Therefore, for Trailing P/E, liquidity accounts for about twice as much of the increase as GDP does, but both are important.
Roughly, an increase of +1% in GDP per capita results in an increase of about +0.032 PER points.
And an increase of +1% in real M2 brings about a rise of +0.046 PER points.
Conclusion: Implications for Investors.
For investors, this analysis changes how valuations should be read.
High P/E ratios or market cap to GDP levels are not automatic warning
signs. They reflect powerful forces: abundant liquidity, low natural
interest rates, reduced systemic risk, and a growing capital base.
Valuations must be measured against these realities rather than clinging
to outdated rules that label a P/E of 10 as cheap and 22 as expensive.
In this vein, just as a P/E ratio of 22 is often seen as expensive,
many investors claim that another indicator points to extreme
overvaluation: the Buffett Indicator, which compares the total stock
market value to the country’s GDP. At first glance, its current reading
(red line in the chart) appears extreme and seems to confirm that a
crash is inevitable. That conclusion is wrong. Adjusting the Buffett
Indicator for M2 gives a very different picture. The blue line at the
bottom of the chart shows the ratio has hardly moved, from 0.13 in 1978
to 0.14 today.
During the dotcom bubble, the liquidity-adjusted indicator reached
0.296 in March 2000, more than twice today’s level. Seen through the
lens of liquidity, current valuations are elevated but nowhere near the
excesses of that era.

In today’s global economy—wealthier, more liquid, and
better-capitalized than at any time in history—high valuations are not
signs of irrational exuberance but reflections of structural forces that
have permanently shifted the baseline for pricing risk.
However, should liquidity suddenly contract and/or GDP per capita shrink (due to misguided economic policies, war, etc.), then we should brace ourselves for a market crash,
which is precisely what happened in the 1930s depression: Shrinking
liquidity and real GDP. Market timing will be the lifeboat in such a
case.
Sincerely,
Manuel Blay
Editor of thedowtheory.com