The Stock Market capitalisation/GDP ratio has been quoted to be the “single best measure of where valuations stand at any given moment” by Warren Buffet in a December 2011 article for Fortune magazine.
Gross Domestic Product is defined as the value of all goods and services produced in a country and is used to measure a nation’s economy, while market capitalization is the total value of a company’s outstanding shares calculated as outstanding shares multiplied by price per share. Market capitalization is essentially a reflection of what the investors want to pay, thus having a large perception value.
The stock market capitalization to GDP ratio is used to determine whether an overall market is undervalued or overvalued. The ratio can be applied to both specific individual markets as well as the global market to understand possible directions of the markets.
It basically tells us what percentage of GDP is represented by stock market value.
As a thumb rule for investors, the notion is that when the stock moves above 100% of the market GDP, stocks are said to be expensive and overvalued and when it is near 50%, stocks are assumed to be cheap and undervalued.
The ratio has been successful in the past in predicting peaks in the market correctly and signalling the same but many economists believe that comparing market cap to a domestic value such as GDP may be fallible for certain markets like the United States which have significant portion of their earnings outside of their country. Also with so many significant changes in the nations worldwide like Brexit i.e. Britain’s exit from the European Union(EU), Donald Trump’s surprise win in USA, demonetisation and GST (Goods and Service Tax) in India, relying on any one indicator to deploy or employ money is unsuitable. There are a broad range of indicators such as Price-to-Earnings, Price-to-Book Value to assist Market Cap-to-GDP ratio in achieving the optimal asset allocation.
One fine example depicting market cap to GDP ratio’s predictive value is given by the fall of the US market after the dotcom bubble burst when the ratio showed a sign of overvalued market at 153% in the 2000s according to the World Bank.
Having said that, India’s current market cap to GDP ratio (as on March 20 2017) stands at 77% (according to moneycontrol.com) which indicates that there is still scope for the economy to rise and grow.
NIFTY on 20 March, 2017 was 9126.85 and today as on, 13 July, 2017 closed at 9891.70, an approximate increase of 8.08%. Thus we can expect the current Mcap to GDP ratio to be approximately higher by that percentage since 20 March, 2017.
As the Indian economy, being an emerging market is still growing compared to other developed economies which are in stagnant or low growth phase, any small increase in the Market cap-to-GDP ratio is not alarming but should be treated as a caution amongst investors. Indian economy is at a pivotal time of formalisation of the economy where informal business dealings and sectors will evolve to metamorphose into an organised form providing an impetus to growth of the organised economy. Investors should understand that the listed companies on the stock exchange form a part of this formal segment of the economy. Formalisation of economy is being achieved by major reforms by the government that include demonetisation and implementation of the destination-based tax, GST.
Due to the volatility and uncertainty of the current India economy, the investors must focus on Marketcap to forward GDP, rather than current GDP. Prediction of Indian economy’s GDP being less than 7 percent as an aftermath effect of demonetisation was proved wrong in the October-December quarter. It was during this period when the Central Statistics Organisation CSO) announced that India was growing at a healthy GDP rate of 7% and further pegged its advance GDP growth estimate for 2017 at 7.1 percent.
As published by Live Mint E-paper on April 06,2017: Motilal Oswal Securities Ltd. made estimates for the Market capitalisation to GDP ratio for 2017 to be 80%. This measure is above the long-term average of 78% calculated from Financial Years 2006 to 2016. The Motilal Oswal report also claimed India’s share in the world market cap to be 0.2% greater than its own long term average of 2.4%. India also beat the world’s increase in market capitalisation by 17%.
Click here to read the full report