Buffett Indicator for Stock Market Valuations


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Buffett Indicator for Stock Market Valuations

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Market Capital to GDP Ratio is used to determine whether the overall stock market is overvalued or undervalued or in simple words, Is it a right time to buy stocks or one has to wait.

Most of the investors use indicators like RSI or CCI as a major indicator to find if any particular stock is overbought or oversold. If it is overbought, it's time to sell the stock, and on the other side, if the market is oversold, then one can make a buy position.

Although you can also use RSI for S&P BSE SENSEX or NIFTY50, Market Capital to GDP Ratio talks about the valuation market digesting major macroeconomic data.

Warren Buffett indicator or Market Capital to GDP Ratio compares the combined market capitalization of all listed stocks to the country's total output of all goods and services.

For the Indian Stock Market, If the value exceeds 75 (Which is the historical average of last two-three decades) levels, then it indicates that the market is overvalued while a number 75 indicates that the market undervalued.

If the Buffett Indicator is very high, it means that the sectors are not producing enough profits to be worth their valuations, and therefore, a downward price correction is inevitable. In valuation terms, Price/Sales and EV/Sales, i.e. (Enterprise Value/Sales) ratios, are used as a measure of valuation.

The lowest level in the last two decades was roughly 42% in FY04 and hit the peak value of 149% in December 2007 during the 2003-08 bull run.

During the COVID-19 pandemic, the stock market crashed, and Market capitalization to GDP ratio dropped below 50 levels, which showed the deep undervaluation in the broader market. As the market rebounded, it went back to 68 levels in the month of June 2020. So, the relation can easily be identified.

The two peaks when the Market Cap / GDP ratio crossed the 100% mark represent the two massive peaks of 1999 and 2007. In 1999, the global market crashed when the technology boom came to an end, and the 2007 crash began after the sub-prime crisis broke out, which eventually led to the bankruptcy of Lehman Brothers and brought the entire financial markets to the brink.

In 2017, the markets once neared the 100 marks and the only two occasions when the Market Cap / GDP ratio crossed 100 resulted in huge wealth destruction. That is something the world markets need to be cautious about.

Limitations:

Have you ever thought why the historical average for the US is 100 and India has 75?

That's because the Indian market only captures the value of all the listed companies/stocks in the country, but the Gross Domestic Product is the value of all products and services that include all unlisted private companies, small rural and urban businesses, MSMEs, proprietorship firms, partnerships firms, All government companies, Numerous government departments, etc. So to some extent, the numerator and the denominator are not entirely comparable.

We need to be a little more careful of the absolute numbers in an economy like India, which is still making the big shift towards a more organized mode. Higher Market Cap / GDP may not be a real worry for India!

One more aspect can be added. The market cap / GDP moving higher can also be attributed to the sharp rise in funds collected by IPOs. During fiscal 2017-18 the IPO markets have collected $12.5 billion, and that has added to the market cap without really disturbing the GDP. So, the ratio surged.

Market Cap to GDP ratio is a veritable method of gauging whether the stock markets are overpriced or not. However, Warren Buffett believes that Market Cap to GDP Ratio is one of the best measures of where valuations of the market stand at any given moment.

The best part of the stock market is whether the overall market is bullish or bearish, there will be stocks/sectors/companies which are always having either a bull or a bear phase of its own for some reason.

It's just about how much you are aware of it.

If you wish to add something, don't forget to mail me.

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Akshay Seth
Research Analyst (SEBI Regd.)
Linkedin | akshay.equity@gmail.com

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