The market capitalization to gross domestic product (GDP) ratio of a country can be interpreted as an indicator of how frothy markets have become. The accompanying chart shows this ratio for Bombay Stock Exchange (BSE) stocks over the past 12 years. Market capitalization at the end of March every year has been taken and computed as a percentage of nominal GDP at market prices. Notice the sharp rise in market capitalization from 2005 to 2008. Also, while the ratio dropped sharply in March 2009 because of the global crisis, it was still well above the level for March 2005. During the tech bust in 2001-02, the ratio had fallen to much lower levels.
Now consider the current market cap to GDP ratio. If we compare the market cap of BSE stocks on 20 November with the nominal GDP at market prices for 2008-09, we get 109%. The objection to that would be that it would be wrong to compare the current market cap with last fiscal year’s GDP. We need to compare it with the GDP for 2009-10. The Prime Minister’s economic advisory council has given an estimate for GDP growth for this fiscal last year and they had said that GDP at market and current prices for the current year will be at Rs58.3 trillion. At current market cap, that gives a market cap to GDP ratio of 99%. Notice that the only year in which that ratio was higher was 2007-08. But if the ratio is already as high as it was during the final year of the last boom, that doesn’t look too good for returns from the stock markets in future. It is yet another indication that market valuations have become very stretched.
Graphics: Yogesh Kumar / Mint
Incidentally, Barry Ritholz of the Big Picture blog has drawn attention to the fact that the market cap to GDP ratio of the New York Stock Exchange together with Nasdaq has crossed 100%. This had happened twice before: during the dotcom boom and during the housing bubble. What it indicates is that the US market is back to bubble territory.
It’s true that the very lax liquidity conditions could propel the market cap to GDP ratios to new heights. But as Citigroup Inc. ex-CEO Chuck Prince learnt to his cost, you cannot bank on a bubble.
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