Still, it is probably the best single measure of where valuations stand at any given moment." So said Warren Buffett in December of 2001, in reference to the market capitalization to gross national product ratio (he used GNP in 2001 and GDP, or gross domestic product, while giving a talk earlier in 1999).
Buffett used the ratio in 1999 to illustrate that stock market returns were far higher than the rate of growth of the economy over a 17-year period and that stock valuations looked expensive. Sometime later, the Dot Com boom went bust and the rest, as they say, is history.
Since then, punditry of all kind has jumped on to the bandwagon and this ratio has become one of the most used and abused in the financial markets.
These days it is almost heresy to argue against what Buffett has said. However, the ways in which the market cap-GDP ratio is used these days is not right. Buffett himself has not given an unconditional support to this ratio. In the same article, in Fortune, he says, “The ratio has certain limitations in telling you what you need to know."
When we use the market-cap-GDP ratio to do cross-country comparisons, we come to strange conclusions. Let us look at an example. Say, the US GDP is approximately $17 trillion and the market cap is $22 trillion.
The ratio of the two works out to 1.29. At the other end, let us look at Saudi Arabia. Here the GDP is about $745 billion and the market cap is only $483 billion. So, the market cap-GDP ratio would be 0.64. Does this mean that Saudi Arabian stocks are undervalued and American stocks are overvalued? (We are not considering oil prices here.)
What if I told you that the estimated market value of Saudi Aramco, the national oil company which is not listed, was estimated at $7 trillion by The Financial Times?
If this company were to be listed on the Saudi Arabian stock exchange, the market cap-GDP ratio of the country would immediately jump to more than 10.
In cases of communist countries such as Cuba, there may not be any market cap as there are no listed companies, while obviously there is GDP.
Hence, conclusion No.1: Cross-country comparisons do not always make sense. The ratio would get skewed because each country would have a different proportion of listed versus unlisted enterprises.
Let us do a thought experiment. Assume that all the states in the US are independent countries. Would it make sense to compare the market cap-GDP ratio of California (which has high-tech industries, entertainment, tourism, and more) to that of Nebraska (agriculture) or Texas (mainly oil and agriculture)?
In the same way, it does not make sense to compare Russia or Australia with India on this parameter.
Conclusion No.2: The composition of each economy differs. Some economies are material-led and have sectors such as mining and oil and gas. Some have manufacturing companies while others are services-led. In such cases, too, cross-country comparisons do not work.
Comparison across time
So what about comparing an economy over a certain period? Surely monitoring the market cap-GDP ratio of the Indian market over the years would indicate some trends on valuation? Maybe not. For one, the proportion of listed businesses versus the unlisted ones keeps changing over time. For example, we did not have companies like Tata Consultancy Services Ltd, Coal India Ltd and DLF Ltd listed on Indian stock exchanges in 2003. These businesses existed for many years before getting listed. But the fact is that even just these few companies may account for as much as 8% of India’s stock market’s market cap today.
And we still do not have entities such as Indian Railways, Life Insurance Corp. of India, Bharat Sanchar Nigam Ltd and Air India Ltd listed on the exchanges. If these organizations were to get listed, say, over the next decade, comparing the market cap-GDP ratio for Indian markets over a period of time would again not make sense.
This means that using comparing this ratio for the same economy over time is also fraught with risks. So, take the pontifications of gurus on this ratio with a pinch of salt.
Market cap-GDP ratio versus interest rates
Investors are looking at opportunity cost all the time. Some may patiently wait, keeping their money in a bank account till the right opportunity arrives. Ultimately the money has to be put to work and returns that one gets depend on the investing environment.
One of the important factors governing the investing environment is the prevailing level of interest rates on risk-free government bonds. Buffett refers to this in his 1999 and 2001 articles. The market-cap-GDP ratio was low at the time when government bond yields had gone up to 15% per annum. Conversely, when interest rates are down and are expected to stay low, the ratio increases.
This brings us to another conclusion, that the ratio also has to be seen in the context of the prevailing interest rates and the opportunity cost of capital.
The ratio is not something that can be used to pass judgement on where a market is in terms of valuations and whether it is attractive or not. Many people use the ratio to call market tops or to give buy advice. It is incorrect to do so.
Rajeev Thakkar is chief investment officer and director, PPFAS Asset Management Pvt. Ltd.