Leaving behind the fundamentals of Macro-Economics, the Indian equity market is touching unseen heights even when the nation's GDP shrank by 7.9% (as per world bank national accounts data) in the financial year 2021 recording its worst-ever performance in the last seven decades. At the end of FY 2021, the market capital of listed companies of India stood at INR 226.5 Trillion which is double of last March. These two figures have resulted in the nation recording its highest Market Capital to GDP Ratio of 104% since December 2007.
The current high Market Capitalization to GDP ratio has raised concerns. Market cap to GDP ratio is a tool used by many investors to estimate and understand the possible direction of the markets. At the zenith of markets in the year 2008, this ratio went up to almost 103 percent for India, and 150% for global markets, being the highest in December 2007. The market experts advise that whenever the ratio (Warren Buffet Indicator) crosses the one there are reasons to be cautious. The Indian markets eventually crashed post 2008 peak and the ratio dropped to almost 55 percent in the FY09.
"...the Indian equity market is touching unseen heights even when the nation's GDP shrank by 7.9% (as per world bank national accounts data) in the financial year 2021 recording its worst-ever performance in the last seven decades."
Know more about Warren Buffet Indicator -
Equating the current listed market capitalization and GDP, it can be deduced that the markets are overheated and expensive at the moment. Before moving forward and analyzing the current scenario, let's understand the Warren Buffet Indicator and learn what it is telling about the Indian Market. Warren Buffet Indicator is probably the best single measure to know where valuations stand at any given moment. It is a model of the total value of all publicly traded stocks in a market divided by that economy's GDP. The ratio above 100 % indicates the market is overvalued and below indicates the market is undervalued (market crash). As of the current Indian market, the ratio stands at 103.56% which is significantly overvalued.
It is one of the finest indicators in the developed country where economic stability can be controlled on par with the national development. When it comes to India this ratio cannot be the only indicator of stock market analysis because of its convergent and divergent economic situations.
"...one needs to understand the concept of ‘Flow' and ‘Stock'. Flows are amounts that are traded per unit. In a financial year, several assets of different values are acquired which is a flow. But the value of an asset that has been bought is a stock. By this definition, we can conclude that Market Capitalization is a Stock and GDP is a flow."
How can value of Market Capitalization be greater than GDP?
Having said that, till now we have understood that the Market Capitalization of common stocks is greater than the GDP of the nation. But, how is it possible? For this one needs to understand the concept of ‘Flow' and ‘Stock'. Flows are amounts that are traded per unit. In a financial year, several assets of different values are acquired which is a flow. But the value of an asset that has been bought is a stock. By this definition, we can conclude that Market Capitalization is a Stock and GDP is a flow. The market cap does not designate the amount bought in the current year, it represents the current value (stock)of certificates accumulated over the years since the company was formed. Investors bought these in the past when they were originally issued. Over time they accrued dividends and experienced price increases. So the value today (a stock) is the result of investments (flows) over years.
Why Market Capitalization of listed companies is compared with GDP?
The answer is straightforward – to assess the health of the stock market. The amount acquired in the stock market of a tiny country like Sri Lanka would be much smaller than the big countries such as China or the USA. In order to scale the stock market, we need something. It can be anything – population size, demography size of the country, etc. In the case of the Warren Buffet Indicator, it's the GDP of the nation. Thus, what people often do is express the size of the market as a percentage of GDP. The countries with relatively larger markets tend to have a better functioning stock market and more liquid stocks.
Returning to the current situation – as mentioned above, the GDP has shrunk but the market Capitalization is booming resulting in widening gap and rising ratio. The Indian Market Capitalization to GDP Ratio has shot up over 100 once again. The market scenario has become a reason of concern for investors. As the indicator states, the markets are over-valued. Why this ratio has become such a huge concern for investors. To comprehend it, we need to turn the pages of history.
The chart depicts the 10-year GDP of India. India experienced a continuous growth and positive GDP rate till 2020 (global pandemic to be blamed). The nation witnessed GDP of USD 1823.05 Billion in year 2011 which further increased to USD 1827.64 Billion in 2012, USD 1856.72 Billion in 2013, USD 2039.13 Billion in 2014, USD 2103.59 Billion in 2015, USD 2294.8 Billion in 2016, USD 2652.75 Billion in 2017, USD 2713.17 Billion in 2018, USD 2868.95 Billion in 2019. In the beginning of 2020, the nation started struggling with coronavirus resulting in nationwide lockdown from March 2020 onwards. Due to limited economic activities, the country recorded negative growth of worth USD 2622.98 Billion in 2020.
The GDP of India was worth USD 2622.98 billion dollars in 2020 after encountering a negative growth rate of 7.3%. In light of pandemic, the economists projected a contraction of 8% for India. The nation performed marginally better than the projected adversity. Prior to COVID pandemic, India recorded GDP growth rate of 4%. In year 2018, the nation recorded highest GDP worth USD 2868.93 billion.
The first quarter report of FY 2021 has arrived where the nation's GDP expanded 1.6%. The COVID situation is improving with the increase in number of successful vaccinations. In consideration of current circumstances the analysts forecast that Asia's 3rd largest economy is expected to grow at world's fastest rate.
In spite of encountering the growth bump of the nation due to the second wave of COVID in India, the stock market of the nation is flourishing like there's no tomorrow. The given chart depicts the 16-year growth of India. India's Market Capitalization has grown at a CAGR of around 18 percent in the past two decades. India has ranked at 8th position in terms of Global Market Capital with its USD 3 trillion capitalization.
Talking about achieving a significant milestone of USD 3-Trillion Market Capital, there are some interesting figures that the market capitalization history of India holds for us. The nation took 70 years since Independence to reach the market capitalization of USD 1-Trillion in 2007. Then, it took 10 years to double the previous capitalization and touch the milestone of USD 2- Trillion in 2017. And now the country has attained its USD 3-Trillion mark in 2021.
Historical Ratio of Total Market Capital over GDP of India -
Market Capitalization to GDP Ratio which is also known as Buffett Indicator is calculated by taking the sum of listed stock market capitalization and dividing the same by Gross Domestic Product. Warren Buffett described this indicator as best measure in his December 2001 Fortune Magazine article. Market Capitalization to GDP ratio keeps a check on the valuation and sentiment of any market. Any movement above or below hundred indicates the investor whether the market is undervalued or overvalued.
Taking a peek at the history, the Buffett Indicator has rarely exceeded 100 but this is not the first time when the ratio has gone above hundred in India. The remarkable years in Indian Stock Market – 2007, 2017 and 2021, the years when the market capitalization crossed USD 1 Trillion, USD 2 Trillion and USD 3 Trillion mark, were the same years when the indicator crossed 1. It must be noticed that in past two scenarios – 2007 and 2017, markets corrected. And this can happen again as well.
The long-term average of Market Capitalization to GDP is around 0.75x whereas the current ratio is around 1.1x. Further, in the developed countries such as USA, the ratio ranges between 1.4x to 1.8x.
Global Comparison -
As of today, the total market index stands at USD 45563.4 Billion which is 206.5% of the latest reported GDP. Taking world market capitalization into consideration, the stock market recorded two peaks in Market Capital/GDP Ratio– in year 1999 and 2007. In year 1999, the boom of technology came to an end and in year 2007, the global markets suffered financial crisis caused by subprime mortgage crisis. At this point, the developing nation like India also encountered its highest Market Capitalization to GDP Ratio ever – touching the peak of 146%.
Taking into consideration the BRICS countries (Brazil, Russia, India, China and South Africa), India has recorded the highest ratio (excluding South Africa). China's current ratio stands at 81%, 52% in Russia and 73% in Brazil. India share similar per capita income with Indonesia and the ratio over there is around 47%.
Key-Points of Market Capitalization to GDP Ratio Chart -
Different opinions are prevailing in the market. Some investors believe that this is just temporary or India's step towards development. And some cautious investors are considering the past records and believe what Buffett indicator theoretically stands for. As per a report by Motilal Oswal Finance Services, there are certain key-takeaways that must not be ignored by a careful investor.
The GDP growth rate of an economy ultimately settles at less than 6% after attaining a rate of 7%-8%. India suffered multiple lockdowns due to global pandemic just like other countries. It can be concluded that the economy is at the edge of revival. Once the businesses start running at full pace, the GDP will grow at remarkable rates resulting in deflation of the mentioned ratio.
An important factor towards shooting of Market Capitalization can be IPOs. In year 2017, the markets accounted collection of USD 12.5 Trillion which is further not added in GDP. Same can be the scenario here as well. IPOs become a part of market capitalization without actually interfering with the gross domestic product of the nation.
Over the past few years, with the emergence of technology and digitization the recording and analysis of data has become feasible. Now, the companies can't hide the real figures of sales and income resulting in more transparency. With passing years, a more clearer picture of GDP can be expected.
Is it a bubble?
In stock market, a bubble is generally referred to a situation when the price of an individual stock or a financial asset or class of assets is overvalued resulting in excessive worth that its fundamental value.
India's Market Capitalization is much higher than the long-term average of 77% but still much lower than the peak of 2007 boom recorded at 149%. Another notable data figure with NSDL – FPIs (Foreign Portfolio Investors) pumped in INR 14,750 crore in Indian economy in January so far. Till now, this can be understood regarding current scenario of Indian market that the liquidity boost, foreign fund inflows and corporate earnings are pushing the market high. In consideration of these factors, the analysts have raised their suspicions over the rich valuation of the market. Experts believe that a lot of stocks are in the bubble. Also, the market will encounter correction. But there are certain points that you must not miss.
Market Capitalization changes every day but the GDP numbers are declared once in a year and that too with a lag. Year 2020 encountered negative growth and even year 2021 faced lock down. By year 2022, we can expect that the situation will improve resulting in better production, more employment opportunities and stable economy. In light of these factors we can expect a better number of GDP which would ultimately affect the ratio.
Market Cap to GDP ratio is an absolute method of assessing whether the stock markets are overpriced or not. However, we should be a little more cautious of the numbers in an developing economy like India where we still are taking steps towards more organized business and sector.