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Are markets overvalued? Ask the Buffett Indicator!

Are markets overvalued? Ask the Buffett Indicator!
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GDP or Gross Domestic Product is something that has been discussed by almost everybody over the past week – even those who have been otherwise oblivious to most concepts of macroeconomics. I kid you not, there is a legit Facebook event for which thousands have signed up to stand at their balconies, bang thalis and shout “Grow GDP, Grow!”. While this might be a little dramatic, India’s GDP growth has reached precarious levels in the 1st quarter of FY 2020-21 after the Ministry of Statistics and Program Implementation released quarterly GDP data last week. As many of you might already know, GDP contracted by a whopping 23.92% in the April – June quarter of FY 2021 – that’s the highest contraction ever in India’s recorded history. And of course, among other things, the credit goes to the coronavirus induced lockdown that bought all forms of businesses and livelihood to a standstill.

Quarterly GDP growth – India

While this quarter might have witnessed the largest contraction in GDP ever, India’s GDP has been slowing for a while now. As you can see in the chart above, GDP growth has been on a downward trajectory, especially starting from the 4th quarter of 2018. And it’s stock market, on the other hand, has been testing new highs ever so often. Doesn’t make sense right? How can the stock markets rise when the economy isn’t doing well? What’s behind this disconnect that has occurred between the economy and stock market?

Let’s first look at what we are talking about, before dissecting what the reasons for the same might be.

The divergence between the stock market and the economy

The blue straight line signifies the linear growth of the Nifty 500 index (which is a broad proxy for the entire stock market). As we can see, the stock markets have seen phenomenal growth since FY 2013. However, GDP’s linear growth line (in red), has been on a downward trend during the same period. This peculiar kind of relationship between 2 variables, which were thought to go hand-in-hand, has led to a lot of debate in the finance world.

Then comes the Buffett Indicator…

Among other contributions that Warren Buffett has made to the world of finance, one intriguing concept was the Stock Market Capitalization (SMC) to GDP ratio. It was also called the ‘Buffett Indicator’ since he popularised its use. Buffett’s wealth can be attributed to his investment style – he is a value investor. His philosophy advocates investing in companies that are priced below what they are actually worth. He advocates the use of this indicator to judge the valuation of an economy’s stock market. This indicator, to a large extent, helps determine whether the overall stock market is undervalued, overvalued or fairly valued compared to its historical average.

Why does it matter right now?

The stock market capitalization to GDP ratio in India has soared to about 98%, the highest after 2007 – the year that preceded the Global Financial Crisis. That’s a worrying sign… or some think it might not be. Before getting to the formula’s efficacy, let’s look at what it’s all about.

The ratio goes something like this…

Buffett Indicator = (Stock Market capitalization of all listed companies combined / GDP) * 100

The market capitalization of a company is the price per share multiplied by the total number of shares of that company. If we sum up the market cap of all the listed companies in the country, we will arrive at the total stock market capitalization of the country – the numerator of the formula.

As for the denominator, it is the GDP of an economy in any given financial year. Based on historical data, there seems to be a consensus on the range of values that help judge whether the stock market is over/under/fairly valued.

The average historical ratio has hovered around 75% for India. A figure above that is said to signify that markets are overvalued while any figure below that would mean that the stock markets are undervalued.

As must be clear by looking at the formula, this ratio tends to go up when the market cap of companies goes up, or when GDP contracts. Ergo, the recent rally in the markets, coupled with the fact that GDP was on a freefall has left this ratio unusually high! Some economists are of the opinion that such a high market cap to GDP ratio might be a sure sign that a market crash is inevitable in the foreseeable future. Others, however, dismiss that thought. Economists that think that this signals an upcoming crash say so because stock prices have become more expensive relative to the country’s GDP – which means that markets are overvalued. However, the other side’s advocacy might not be so obvious. So let’s dig into that.

Across the globe, the Buffett Indicator has seen an upward trend in recent years. This has led to a debate where different sides argue about the viability of the indicator as a measure of stock market valuation. The sect of economists that think that this the Buffett Indicator is losing its ability to judge stock market valuations, say so because of the nature of the modern monetary policy. Modern monetary policy advocates the use of policy tools that involve increasing the money supply in the economy to revive an economy from financial turmoil – basically governments pump in money into the system in the hopes that spending and investment will rise and the economic growth will get back on track. I mean it’s obviously not so simple, but that’s the idea of modern monetary policy. For example, countries have pumped in trillions of dollars into the economy since the coronavirus related lockdown halted all business activity and the economy plunged into recession. Until the 20th century, such aggressive use of monetary policy was not advocated – simply because it created a debt burden on economies that future generations would have to pay, coupled with a potential rise in inflation – one that is above optimal levels. However, what’s changed now, is the interest rate environment. Global interest rates are at an all-time low. That means the cost of borrowing money is at an all-time low.

While an upward trend in the Buffett Indicator might indeed not be as worrisome as some people think, the reason for its uptick is this – As governments print money to pull the economy from a recession, such money gets inevitably directed into the stock market. That pushes stock prices (market capitalization) upwards. GDP remaining constant (or on a downward trend due to occurrences such as Covid-19), the Buffett Indicator, thus tends to be higher. Hence, it can well be concluded that modern monetary policy, in a way, renders the Buffett Indicator less useful. Moreover, the indicator has certain limitations due to which this indicator is better suited for the developed world rather than for a developing country like ours.

Let’s look at some of the limitations of the Buffett Indicator –

  • A large portion of India’s economy is informal. Therefore, the success of the Buffett Indicator as a metric requires the stock market to reflect a large portion of the economic activity – which might not be true in India’s case considering the magnitude of our informal sector.
  • The stock market capitalization subsumes only those companies that are publicly traded, whereas GDP encompasses private companies, MSMEs, government companies, etc. along with public firms. So it’s not really an apples-to-apples comparison.
  • The ratio also gets skewed by the number of IPOs in a particular time period. If in any given year, there is an unusually high number of IPOs, the SMC will be higher due to which the Buffett Indicator will also be high.

To conclude, I’d like to say this – economists use assumptions and models to understand the world around us. This formula is an example of that (and yes, Buffett could well qualify as an economist – a very competent one!) However, no economic theory is always entirely true – there exists an anomaly for even the simplest of economic theories. However, it does a good job of approximating the world around us. It gives us a rough idea about how the world works. The SMC to GDP ratio might not be very useful for developing economies with a large informal sector like ours, but in the developed world, where stock markets form a large portion of the entire economy, the Buffett Indicator still renders itself as a useful metric.

Happy Investing!

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Are markets overvalued? Ask the Buffett Indicator!
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