Suppose you read the following statement:
In 2006 the measured economic output of the entire world was around $47 trillion. The total market capitalization of the world's stock markets was $51 trillion, 10 percent larger.... Planet Finance is beginning to dwarf Planet Earth.
Are you impressed? You shouldn't be.
A year's output is the value of goods and services produced over that year, while equity values reflect the (discounted) value of all future streams of profits. If you are comparing the two, you must at least have a sense of what a decent benchmark for comparison would be.
So if, say, half of GDP originates in the corporate sector and profits are one-third of value added, the present value of profits discounted at a continuous rate of 8% amounts to 208% of GDP (=0.5x0.33/0.08). This suggest that the value of stock markets should be more than double that of annual output, not the mere 10 percent extra that the above numbers suggest. Planet Finance is not all that huge after all--at least given the numbers we are presented.
What is somewhat disconcerting is that the above statement comes from Niall Ferguson's new book, The Ascent of Money. Ferguson knows no doubt the difference between flows and stocks, or income and wealth. But the way he sets this up is misleading nonetheless.