The mayhem that shook the financial markets all over the world in the month of March, has now seemed to have cool off, given the stellar rally witnessed by financial markets. During this period, one indicator that was doing the rounds was the Market cap to GDP ratio, popularly known as the BUFFETT INDICATOR:
Let’s understand the indicator and its implications!
The Buffett Indicator is defined as the ratio of total value of publicly listed stocks in a country divided by the country’s Gross Domestic Product (GDP). It is used to determine whether a market is overvalued or undervalued, compared to its historical average. A number between 50 to 75 per cent is considered to be undervalued, between 75 to 90 per cent is considered to be fairly valued and above 90 per cent is considered to be overvalued. This ratio was popularized by Warren Buffett around the time of dotcom bubble. For India, the average historical ratio has hovered around 75 per cent.
But, why does this ratio matter so much?
Given the stock prices reflect expected future earnings of the Company and the GDP as a whole, represents the total value of goods and services produced in a country, the indicator gives an estimate of whether the two are moving in tandem.
Although the indicator gives an idea about market overvaluation/undervaluation, it should be used keeping in mind the following things:
Firstly, in developed markets where the contribution of various sectors to the overall growth of the economy is better represented via the capital markets, the ratio could be considered a good estimate for market valuations. However, in developing countries like India, where agriculture, unorganized sectors, MSMEs play a pivotal role in the economic growth of the country, this ratio does not bode well, as the traditional sectors do not get accurate representation in the country’s capital markets. Moreover, the ratio is likely to get impacted as newer companies get listed given the developing nature of stock markets in these countries. So, in such countries, these indicators should be used in combination with other metrics to get an accurate indication of market valuation.
Secondly, using this metric for cross country comparison to make a conclusion on the valuation front is fraught with risks. This is because each country would have a different mix of listed vs unlisted companies. Also, the composition of each economy differs. Some countries might heavily rely on commodity-oriented businesses for their growth whereas others might be dependent on service sector.
Thirdly, one can say that it’s better to use this indicator to compare an economy over a certain period as this could indicate some trend on valuations. But this method also has its limitations. The proportion of listed vs unlisted companies in a country keeps on changing over time. For example, companies like TCS, Coal India, DLF weren’t listed on the Indian Stock Exchanges till 2003. However, these businesses were in existence for many years before getting listed.
Lastly, level of interest rates in the economy. One cannot compare Market Cap/GDP ratio, without adjusting the interest rate levels. At times of low interest rate, stock valuation tends to fly high and vice versa. Hence, while comparing one must also look at interest rate scenario. On the basis of Buffet indicator markets may look overvalued today. Nonetheless, interest rates are rock bottom today and the indicator does not take into account this fact.
As of 17Oct20, India’s market value to GDP ratio stood at c. 65%, and is believed to be fairly valued. If we go only by the Buffet metrics, then there doesn’t seem to be either long or short strategy at the current valuations. However, with interest rates going down and economy gradually recovering from the health crisis, we may expect some upward movement in the equity markets.
Although, BUFFETT Indicator is widely acknowledged by stock market pundit as a reliable measure to gauge stock market valuations, we think that using the metric in isolation can give a distorted picture. Rather, it should be used in conjunction with other tools to get a better sense of valuations. Moreover, using the metric in current times is not a prudent approach owing to uncertainty on future earnings of companies as well as negative GDP growth.
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