2 min read.Updated: 01 Sep 2020, 07:36 AM ISTNeil Borate
The market cap-to-GDP ratio is at a decadal high which suggests overvaluation, say experts
The Buffett indicator’s current level was only beaten in FY2008, peaking out at around 146% of GDP in December 2007
A 22.6% contraction in nominal GDP for the first quarter of financial year 2020-21 has sent the market cap-to-GDP ratio spiralling up to a decadal high of 98%.
Also called the Buffett indicator for the attention paid to it by investment guru Warren Buffett, the ratio compares market capitalization of all listed stocks to the gross domestic product (GDP). It encapsulates the idea that stock market performance is ultimately tied to the country’s economic growth. The Buffett indicator’s current level was only beaten in FY2008, peaking out at around 146% of GDP in December 2007. Interestingly, the indicator was just 56% at the end of FY20 due to the covid-19 market crash in March. However, a surge in foreign institutional investment (FII) inflows following the announcement of stimulus packages by central banks around the world pushed the market back up and with it, the Buffett indicator.
A blogpost from broking house Motilal Oswal states that the world market cap-to-GDP ratio crossed 100% in 1999 and 2007 and they were both market peaks. Severe market crashes followed both peaks.
“A market cap -to-GDP ratio of 98% suggests overvaluation. Markets seem to have run a bit ahead of the fundamentals and are maybe pricing in recovery soon," said Vinit Sambre, head-equities, DSP Mutual Fund. “But especially if you consider that the ratio for the US market is 190%, the Indian ratio doesn’t look very alarming," he added.
Sambre dismissed the argument that GDP does not include earnings of listed companies outside India and hence the ratio is overstated. “The earnings of exporters like IT and pharma are counted in the GDP so I don’t think the fact that some companies derive earnings outside India will change the picture. Nor can we make a distinction between large caps and mid/small caps in terms of valuations after the big rally in the latter in the past four months," he added.
However Neelesh Surana, chief investment officer, Mirae Asset Mutual Fund urged investors to be cautious about indicators like market cap-to-GDP or Price to Earnings (PE) ratios in the current financial year.
“These indicators on a point-to-point basis will be extremely volatile and erratic during FY21. While market cap is a reflection of discounted sum of cash flows over many years, GDP during Q1 was impacted severely by the pandemic and will mean revert over the next few quarters. A valuation parameter like price to book value is more stable and relevant in the current environment," he said. To be sure, the quarterly drop in GDP growth may be reversed in the subsequent three quarters of this year driving the market cap-to-GDP ratio back down. Leading research firms such as Icra have pegged the FY2020-21 GDP drop at a more modest -9.5%.