Warren Buffett indicator flashes warning sign on stock valuations, but St no worried

The rip-roaring rally on the Street has seen a sharp spike in the market cap-to-GDP ratio, an indicator of stock market valuation used by legendary investor Warren Buffett, raising concerns over valuations.

The ratio is currently hovering at 95%, a sharp jump from 80% in March 2017.

When the value of all stocks is 80% or less than the size of the economy, "buying stocks is likely to work very well for you," Buffett wrote in 2001. But when total equity value exceeds the size of the economy and it's a sign that investors are getting too greedy, he had said.

However, experts said even at 95%, the ratio does not indicate an extremely expensive Indian market. There may still be some steam left in Indian equities given that the previous peak market cap to GDP in early 2008 moved up to 130-140%, but investors would do well to be cautious as domestic equities close in on their fair value, shows a survey by DNA Money.

With the Sensex at over 33300 and Nifty at 10300 levels, valuations are not exactly cheap anymore. Markets have risen 78% in five years. Today, the market cap of all listed firms in India adds up to Rs 144.14 lakh crore, or 95% of estimated Rs 151.84 lakh crore GDP (at current prices) in fiscal 2017. A majority of the experts surveyed have asked investors to exercise some caution, though they project more upside if the sluggish GDP catches up with market capitalisation's speed.

Rusmik Oza, head-midcaps, Kotak Securities, said, "Indian markets are fairly valued on the criteria of market cap-to-GDP at nearly 1x (100%). The rise in market cap is also a function of newly listed companies that have hit the capital market for the first time. Few of the developed nations are already trading at 1.3-to-1.5 times market cap-to-GDP at present."

The current market cap-to-GDP ratio is 139.4% for the US, while the mcap for the whole world is 89.59% of the world GDP.

The link between big-picture economic indicators and specific companies and their stock prices may at times be fickle. Saravana Kumar, chief investment officer, at LIC MF, said, "GDP of a country is backward looking indicator comprising past data which is slightly dated whereas market cap is a more of a forward-looking data point. Buffett did not suggest that the ratio should be used for forecasting purposes...current level of this indicator is slightly above our comfort zone and which suggests caution while investing in equity markets."

Gautam Duggad, head of research, Motilal Oswal Institutional Equities, said this indicator is useful only at extreme points, for example in 2009 or in 2008.

"In normal times, earnings growth, fundamentals, valuations are fore more important than such broad brush measures," he said.

In 2007, India's market cap-to-GDP had reached to 151% and in the next year, in 2008, when there was global crash it came down to 54%, almost a third of the previous year.

Anita Gandhi, whole-time director, Arihant Capital Markets said considering growth outlook going forward is positive, it does not look overvalued today. "However, if growth defaults going forward, further rise from the current levels will be difficult to justify," said the veteran with over 25 years of experience.

Vikas V Gupta, CEO & chief investment strategist, Omniscience Investment Advisers, says investors must realise that the economy is still in a trough rather than its peak as compared to the 2007-08 cycle. "Further, the economic trough was lengthened because of demonetization and GST. The expectation is that the GDP should have a significant spurt in the next couple of years."

Nevertheless, with the Buffett gauge near 100%, the fear of a sharp correction looms large. Rakesh Tarway, head of research, Reliance Securities, said, "Currently market cap to GDP for India stands at little less than 100%, which is quite high as compared to average of around 70%...last time when market cap to GDP hit more than 100% in 2007-08, equity markets had a huge correction. But that is probably the only instance where we hit more than 100% market cap to GDP. Therefore, one can't say with conviction that this indicator will provide true valuation metric for Indian equity markets."