Warren Buffett states the ratio of market capitalization (market cap) to GDP as “probably the best single measure of where valuations stand at any given moment.” Undoubtedly, investing community uses it worldwide to judge whether the market is over/underpriced. However, I have my reasons to be wary of using this indicator. This ratio has the market cap in the numerator, a stock concept (at a particular time) and GDP in the denominator, a flow concept (over some time). Having said that, is there any inference we can draw from this indicator?

To begin with, let’s look at the graph of the world market cap to GDP. Sourced from the world bank, it spans 1976 till 2020. It indicates that the two peaks when the Market Cap / GDP ratio crossed the 100% mark represent the two massive peaks of 1999 (Dotcom bubble) and 2007(global financial crisis). In 2017 market once again touched the 100 mark but corrected quickly. However, since 2020, amidst the worldwide pandemic devastation, the markets have been above the 100 mark.

Source: World Bank data

Looking at the same numbers for India exhibits an interesting pattern. The peak was observed in 2007. Interestingly, 2020 saw India’s market cap / GDP ratio crossing the 100% mark after a gap of almost ten years amid the pandemic. Roaring stocks in the struggling economy brings to the forefront a disturbing disconnect between the stock market and real economic growth. So, if the past is any prologue and we are to learn anything from history, then this is something that the world markets need to be cautious about, but not be scared.

According to the original Buffet Indicator, the Stock Market is Significantly Overvalued. However, In India, particularly demonetisation, Goods and service tax (GST) has brought more and more Indian businesses into the mainstream, which is gradually reflected in the market cap / GDP ratio. To that extent, there may not be room to worry. We all have been living with the belief that economic growth and the stock market are correlated. A higher economic growth/ recovery is reflected in higher stock market returns. In the present situation, however, this relationship seems to be failing. So how can one make sense of the long-term relationship (or the lack of one!!) which runs counter to our received wisdom.

Examining the factors of this tremendous increase, following pointers are to be kept in mind.  The recent IPO glut (roughly A lakh crore of raised money) has added to the market cap without disturbing the GDP.

Another vital factor is that the stock market is (or at least attempts to be) forward-looking while GDP is backwards looking. It implies that the higher prices we are witnessing today anticipate higher economic growth (GDP).

Investors’ expectations that ‘the GDP is already at its bottom and what worse can happen further’ is driving these returns. On the other hand, GDP indicates what has happened in the future, more recent quarter – the economy’s actual performance. As the investor’s greed and fear emotions dominate the market- it has decoupled from the fundamentals. Stock returns somewhat move with economic growth but have a life of their own driven by greed, fear, optimism, and emotions. And because these emotions tend to fluctuate more than the economy does, so do stock returns — this is a significant reason why stocks are more volatile than economic growth.

Considering India, positioned as one of the fastest-growing economies, the investor’s community’s exuberance may not be totally unfounded. In their attempts to moderate the impact of covid 19 pandemic, liquidity being pumped into the economies globally by the to fight the recession and to moderate the economic consequences of the Covid-19 pandemic. Foreign capital is finding its way to the Indian markets, contributing to high stock index values.

Another possible factor contributing to the dismantling of the relationships in the last few years is the economic imbalances. Few companies/ sectors like Information technology and pharmaceuticals are fueling the stock market. Typically, the ones who were not much affected, or were quick to recover and adapt in these unprecedented times. For example, companies with economies of scale-like Reliance and Hindustan Unilever or an IT company like TCS or Infosys, are not overly impacted by physical supply chains. Hence, these stocks are gaining value much faster.

It is rightly said that FAANG stocks (Facebook, Apple, Alphabet, Netflix and Google) are not the economy; they represent just a fraction of the total economy. At times, the stock index could be heavily weighted towards the companies with the futures that everyone is most excited about rather than the ones whose presents have the most significant impact on the current economy. The market is not the economy. Its job is to tabulate investors’ consensus views about the future of listed companies, with no attention paid to the private businesses, MSMEs, government and other vital parts of the economy. In sum, the stock market’s buoyancy is echoing the revival in the organised sector.

On the other hand, GDP reflects the pain in the informal sector, where the recovery is painstakingly slow.  The impact of Covid 19 has been more severe on the informal sector. One can still see the flashes of the sight when thousands of migrant labourers were forced to travel on foot.  Specifically in India, though the contribution of agriculture and industries to GDP and their representation in the stock market performance is declining over the period, it is still the largest employer.

Another reason for the unexplained optimism in the market, despite the pessimistic GDP forecasts, is the strong household balance sheets, which is often a common outcome of the recessions in the past.  This is partly due to the fewer spending and borrowing opportunities, greater control on expenditure, coupled with financial stimulus/ relief packages. Suppose you leave out the most vulnerable sections. In that case, most people are still employed and earning close to their pre-recession income but spending a lot less. Increasing number of Demat accounts corroborates this fact. With low bond yields, investors are left with little room to invest in assets other than equities. This triggers the fundamental demand-supply dynamics in the stock market and pushes the stock prices higher.

A poor GDP forecast adds fuel to the equity demand. Investors expect RBI to maintain an easy monetary policy stance.  Nationwide vaccination drive, easing out of lockdown curbs, and signs of economic recovery in the future are possible reasons the market to celebrate. But this celebration is only for fundamentally strong companies.

This confounding dichotomy might not be surprising anymore if we look at the broader picture. The differential impact of lockdown on the organised and unorganised sector is the main reason for this seeming disconnect between the stock market performance and the real economy. Given this, the future will belong to resilient companies which are agile and efficient. 

I leave you all with hope. I hope that the Indian economy will return to robust growth in the near future, indicated by Moody’s sovereign rating upgrade. I hope that the policymakers will find innovative ways to address the pain points in the informal sector. I hope that a rise in stock prices would bring about a wealth effect, which increases consumption. This increased consumer spending would give a fillip to economic growth. The increased use of technology would improve the data collection and analysis, gradually reducing the underreporting of revenues to save taxes, giving a more realistic picture of the GDP. And I hope this sharp rise in market capitalisation to GDP ratio is not temporary, but a new normal for the Indian Economy!

Dr. Tarunika Jain Agarwal Ph.D.

Alpha Research