What the Warren Buffett indicator tells us about market valuations today

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A slew of recent negative cues have led to the view that the Indian stock market, which has been shrugging off these concerns, needs to see a meaningful correction and remains an expensive bet compared to peers.

But what does the market capitalization-to-gross domestic product (GDP) ratio, also known as the Buffett indicator because of stock market guru Warren Buffett’s penchant for this yardstick, has to say about valuations?

Consider Chart 1. India’s market cap-to-GDP ratio is trading above its long-term moving average, but despite the sharp rally in recent years, it is still lower than the peak seen during the bull run of calendar year 2007, according to brokerage firm Motilal Oswal Institutional Research. In fiscal year 2018 (FY18), India’s market cap-to-GDP ratio is estimated to be at 90%.

While that level may be lower than the peak and suggest some juice is still left in the rally, note that 2008 was the year of the crisis and the market meltdown. What’s more the indicator needs to be taken with a pinch of salt, since the method for computing GDP has changed in India since FY12. If the GDP was underestimated before that, as is very likely the case, then the market cap-to-GDP would have been lower than shown in the chart before FY12. It is entirely possible then that market valuation is dangerously close to the earlier peaks.

In any case, given India’s large informal sector, the correlation between the stock market and the economy is weak and critics of market cap-to-GDP ratio say that this valuation parameter would work better for developed economies than developing ones.

That view is no comfort. After the sharp surge in American equities last year, the market cap-to-GDP ratio for the US is estimated to have hit an all-time high of 153% in calendar year 2017. As Chart 2 shows, that is well above the level reached before the great financial crisis of 2008. As for the world market cap-to-GDP ratio, it is estimated at 102% for 2017 and is only a hair’s breadth lower than its highest level seen in 2007, just before the global financial crisis.

How is the Indian equity market valued on the more conventional parameter of forward price-to-earnings (P-E) multiple? On a one-year forward P-E basis, the premium valuation the Indian market enjoys over its peers has started to fall. But while the premium is now lower than last year’s peak, the Indian stock market is still pricey, indicating that a further decline could be on the cards (see Chart 3).

To conclude, the signs and portents suggest that caution should be the watchword for investors and the ongoing local and global woes make a forceful case for a worldwide correction in stock prices

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