What is Market Cap to GDP Ratio (Buffett Indicator) | Latest India Number?

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Is the Indian stock market closer to the bottom of current correction phase? After the steepest correction of almost 30% (YTD), India's Market Cap to GDP ratio is at its lowest since FY2010, leading to unprecedented collapse in market valuations.

India’s Market Cap to GDP Ratio at its Lowest Since FY2010

Introduction

Is the Indian stock market closer to the bottom of current correction phase? After the steepest correction of almost 30% (YTD), India’s Market Cap to GDP ratio is at its lowest since FY2010, leading to unprecedented collapse in market valuations in bear markets.

Market Cap to GDP Ratio, also popularly known as the Buffett Indicator is used to assess the valuations of the stock markets of a country. Let us discuss what does this valuation metric tell, how to interpret the ratio, what are the limitations of The Buffett Indicator in the Context of Indian Market Valuation etc.

Detailed Stock Analysis by Invest Yadnya
Detailed Stock Analysis by Invest Yadnya

Market Cap to GDP Ratio | The Buffett Indicator

Market Cap to GDP Ratio | The Buffett Indicator
Market Cap to GDP Ratio | The Buffett Indicator

Meaning

  • Buffett Indicator is a valuation metric which is used for assessing whether the country’s stock market is overvalued or undervalued, compared to its historical average.
  • The ratio has become known as the Buffett Indicator in recent years, after the investor Warren Buffett popularized its use. Warren Buffett believes that Market Cap to GDP Ratio is one of the best measure of where valuations of the market stand at any given moment.
  • As per Buffett’s comment, the ratio is a simple way of looking at the value of all the listed stocks on an aggregate level, and comparing that value to the country’s total output (which is its gross domestic product).  

Formula

  • Market Cap to GDP Ratio = (Value of All Listed Stocks in a country / GDP of the country) * 100
  • Thus, It is a measure of the total value of all publicly traded stock in a country, divided by the country’s Gross Domestic Product (GDP).

Interpretation

  • If the Ratio is :
    1. 50% to 75%, the market is said to be modestly undervalued
    2. 75% to 90%, the market may be fair valued
    3. 90% to 115%, the market is said to be modestly overvalued
  • In short, if the Buffett Indicator is too high, it means that the companies are not producing enough to be worth their valuations on the stock market. Therefore a downward price correction is inevitable.
  • The Buffett indicator is like a Price-to-Sales ratio for the entire country.  It relates very closely to a price-to-sales ratio, which is a very high-level form of valuation.
  • In valuation, the Price/Sales or EV/Sales ie.(Enterprise Value/Sales) metric is used as a measure of valuation.
  • A Price/Sales ratio of greater than 1.0x (or 100%) is generally considered a sign of being overvalued. On the other hand, companies trading below 0.5x (or 50%) are considered to be undervalued.
  • In order to properly assess a company’s valuation, other factors have to be taken into consideration, such as margins, growth etc.
  • This is consistent with the interpretation of the Buffett Indicator, which makes sense, since it’s essentially the same ratio, for an entire country instead of for just one company.

India’s Market Cap to GDP Ratio

  • From the below chart we can clearly see that, the Buffett Indicator of India has rarely exceeded 100%. This is because unlike developed economies like US, India’s economy is dominated by the unorganised sector, which is unlisted.
  • However, the Buffett Indicator is helpful in Indian context too. Whenever it has moved too far from the long-term averages, it has signalled a likely correction in over-optimism or over-cautiousness among market participants.
India’s Market Cap to GDP Ratio – Year-on-Year Trend
India's Market Cap to GDP Ratio at its Lowest Since FY2010
India’s Market Cap to GDP Ratio at its Lowest Since FY2010
  • The ratio is a backward-looking indicator comprising historical data. The historical average of India’s Market Cap to GDP ratio over the last 20 years period is around 75. Thus, we can say that current stock market outlook (where the ratio is 56) is moving closer to its bottom.
  • Thus the Buffett indicator gives investors an early warning before bottoming of the markets.
India’s Market Cap to GDP Ratio – Month-on-Month Trend

How the markets valuation changed month-on-month for FY2019-20? Below chart shows the monthly movement of India’s Market Cap to GDP Ratio.

India’s Market Cap to GDP Ratio Monthly Trend FY2019-20
India’s Market Cap to GDP Ratio Monthly Trend FY2019-20
  • The historical average of India’s Market Cap to GDP ratio is around 70. Corporate Tax Rate Cuts (20th Sept-19) was a great boosting measure given by the Government to Indian Corporates to build business confidence and Removal of Surcharge on FPIs, Foreign Investors were quite positive about
  • FPI investments were started reviving after corporate tax rate cut announcements on 20th Sept from earlier 30% to 22%. A positive sentiment has been built in the market due to expected increase in profitability of Indian corporates. Also, Roll-back of Super-Rich tax to revive economic growth and Government’s PSU Divestment drive, FPIs have been buying in Indian equity segment.
  • As a result, there was a consistent rise in the India’s Market Cap to GDP ratio from 69 in September 2019 up to 80 in January 2020 (As shown in the above chart).
  • However, after the Coronavirus outbreak in China, Italy, South Korea, United States, the overall sentiments of Foreign Investors got affected adversely due a number of uncertainties across global economic outlook. Heavy sell-off by FIIs in Indian Equity market was seen since last few weeks (February-20 & March-20).
  • In current Equity market outlook as on March 18, 2020, India’s Market Cap to GDP ratio corrected sharply at around 56. It is mainly due to the recent corrections in the stock market amidst Coronavirus outbreak and its impact on economic outlook, both domestic as well as global.
  • As investors watch for the stock market to hit bottom, the Buffett indicator shows there’s a long way left for stocks to fall.

Limitations of The Buffett Indicator

  • The market only encompasses the value of all the listed companies in the country. But the GDP is the value of all incomes which includes unlisted private companies, small businesses, MSMEs, proprietorship, partnerships, government companies, government departments etc. To that extent the numerator and the denominator are not entirely comparable.
  • The ratio is impacted by :
    1. Trends in Initial Public Offerings (IPOs) and
    2. Percentage of companies that are publicly traded (compared to those that are private).  All else being equal, if there was a large increase in the percentage of companies that are public vs private the Buffett Indicator would go up, even though nothing has changed from a valuation perspective.
  • The applicability of the buffett indicator is higher when the market cap reflects a much larger share of economic activity in the country. That is why the ratio is widely used in the advanced/developed countries like the US, UK, Singapore, Germany, Sweden where more of business comes under the formal sector.

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