“The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment.” — Warren Buffett, 2001
Saudi Arabia’s stock market capitalization jumped from about 100% of GDP to an astonishing 300% on 11 December 2019. Had the stock prices of the country’s listed companies tripled overnight? Not at all. The only noteworthy activity on the Saudi stock exchange was the listing of the shares of a company that had just completed a successful initial public offering (IPO) a few days earlier.
That company was Saudi Aramco. Its valuation, $1.7 trillion. Or about twice Saudi Arabia’s GDP of roughly $900 billion
What Is the Market Cap-to-GDP Ratio?
Simply put, the so-called Buffett Indicator measures the total value of all publicly traded stocks in a market divided by that economy’s GDP. Valuation 101 teaches that a stock’s price is the present value of all its future earnings and cash flows. Thus, a country’s stock market capitalization is the aggregate of the present value of all the combined future earnings of all its listed stocks.
GDP, meanwhile, is the monetary value of all final goods and services produced in a country in a given period of time, usually a year. So hypothetically, if every economic activity in the country were corporatized, GDP would basically reflect the aggregate annual turnover of all the companies.
Given these definitions, there are some differences between what the numerator and the denominator are measuring. While GDP is constrained by a time metric — one year — market capitalization is effectively looking to infinity. Further, while market capitalization is influenced by earnings, GDP corresponds to the annual turnover of the companies. GDP is a flow variable, market capitalization a stock variable.
So if GDP is concerned with the top line over a definite time period and stock markets with the bottom line over an infinite period, why compare the two?
To answer that, we need to understand how GDP is measured. There are two approaches: by expenditure and by income. Both end up at the same terminus: the monetary value of all final goods and services produced.
The expenditure approach measures the money spent on goods and services, while the income approach measures the income earned from the production of goods and services. The premise of the latter approach is that in the production process, the total value of a good or service is fully attributable to the factors of its production — land, labor, capital, and entrepreneurship. Land earns rent, labor earns wages, and capital and entrepreneurship earn interest and profits. The measure of the aggregate rent, wages, and profits is GDP. Stock market capitalization largely depends on only one of these components: profits.
Factor Returns Are Cyclical.
The factors of production are in constant competition to increase their rewards and their share of the overall pie. The returns for each factor depend on the prevailing socio-economic conditions, and this share keeps changing as the background conditions evolve.
If the return for a particular factor increases over time, more of it is supplied compared to its demand. This lowers the return that the factor earns and thus its share of GDP. This demand–supply dynamic leads cycles. Periods of above average profits as a share of GDP tend to be followed by periods of below average profits.
The Buffett Indicator Helps Us Think beyond the Cycle.
When corporate profits are elevated, the price-to-earnings (P/E) ratio may look reasonable, as high share prices are divided by high profits. But the stock market cap-to-GDP ratio will flash a warning signal. If the share of profits reverts back to its cyclically adjusted average, stock markets will look overvalued.
The opposite applies in periods of low corporate profitability, and especially during severe economic downturns. In these times, earnings may be so depressed that stock markets look overvalued based on P/E ratios even amid low market cap-to-GDP ratios. As profits reclaim their share of GDP and stock prices rise in tandem, the Buffett Indicator would seem, once again, to be a better performance indicator.
But Does Market Cap-to-GDP Work as a Rule of Thumb?
“The stock market capitalization-to-GDP ratio is a ratio used to determine whether an overall market is undervalued or overvalued compared to a historical average. If the valuation ratio falls between 50% and 75%, the market can be said to be modestly undervalued. Also, the market may be fair valued if the ratio falls between 75% and 90%, and modestly overvalued if it falls within the range of 90 and 115%.” — Will Kenton, Investopedia
So is the Buffett Indicator relevant only to the US stock market or to the stock markets of other nations as well? Several considerations come to mind.
1. Comparisons across Time Periods
For comparisons over different time frames to have merit, the share of profits of listed companies should be broadly consistent with the profits of unlisted companies. This does not mean no new IPOs. After all, creative destruction ensures new firms and sectors disrupt the old. If amid this process, the proportion of aggregate profits flowing through stock markets is broadly constant, the ratio is useful.
But as with Saudi Aramco, if high-profit sectors or companies have been traditionally underrepresented in the economy and are subsequently listed, comparisons across time periods become meaningless. In India, for example, if the nation’s largest insurer, Life Insurance Corporation, were to go public, with an expected valuation of at least US $130 billion, India’s market cap-to-GDP ratio would rise by 5%.
2. Country-to-Country Comparisons
These are generally unhelpful. The degree to which stock markets penetrate into economic activities varies from one nation to the next. This divergence holds true regardless of whether countries are developed or developing, capitalist or (erstwhile) socialist.
German economic power is largely a function of its Mittelstand, for example. These small- and medium-sized enterprises form the backbone of German industry. But the German market cap-to-GDP ratio was only 55% at year-end 2019. In the United States, it was about 150%. Yet the DAX Index’s trailing P/E ratio was 25, about the same as the S&P 500’s.
3. Capital Market Size
If a particular capital market attracts listings from companies from around the world, its Buffett Indicator can be quite disproportionate. Hong Kong SAR, China, is one prime example: Its ratio tends to run over 1000%. Moreover as cross-border transactions and the size and number of multinational companies (MNCs) increase worldwide, the relationship between a firm and its home market GDP grows fainter. For instance, Tata Motors is listed in India, but its larger operations are through UK-headquartered Jaguar Land Rover.
4. Share of Profits as a Proportion of GDP
This varies from one economy to the next. Profits make up much of Saudi Arabia’s GDP since its economy depends on the low-cost high-profit oil industry. In 2018, Saudi Aramco led the world with $111 billion in profits, which accounted for about 12% of the country’s GDP, with the rest of the corporate sector contributing a further share. In the United States, between 2000 and the COVID-19 outbreak, the total share of corporate profits ranged between 5% and 12% of GDP. In India, the range has been between 2% and 4.5% over the same period.
Considering these factors, the rule of thumb does not seem to be universally applicable.
But What about Indian Valuations?
A first look at India’s Buffett Indicator chart suggests the market may be somewhat undervalued. Currently, the ratio is at around 70% as of 28 January 2021, or less than half of what it was in 2007. The ratio has been moving in a relatively narrow band since 2015.
But the ratio in itself does not provide a complete perspective: It needs to be viewed in the context of profits for Indian companies. And that is not a rosy picture.
Indian Corporate Profits-to-GDP Ratio
Note: Statistics are for overall corporate profits, not for listed companies specifically.
Since 2008, profits have steadily declined as a percentage of GDP. While they stabilized in 2018–2019, with the outbreak of the COVID-19 pandemic, the line has trended down again in 2019–2020 and will likely continue to in 2020–2021. Various factors have played into this deterioration, among them the huge loan loss provisions that financial institutions had to make, the high degree of corporate debt in some capital-intensive sectors, the regulatory challenges faced by certain industries — energy producers, for example — and the general decline in the economic growth rate.
Thus, those who believe India is undervalued based on the Buffett Indicator are either basing their analysis on a rule of thumb that may not apply to India or expect profits to return to the higher end of their historical range.
But is that profit scenario realistic? Even if the cycle reverses, and profits start to rise, what does a sustainable level of profits for India look like given the country’s socio-economic structure? Indeed, while Indian profits fell sharply and consistently after peaking at 4.7% of GDP in 2007–2008, the US corporate sector sustained its profits ratio save for a short-lived plunge during the global financial crisis (GFC).
So let’s say the sustainable level of profits in India turns out to be somewhere in the middle of the two extremes of 4.7% and 2%, say, 3.3%. That implies that stock markets are at 20 times P/E of long-term earnings. In that scenario, will India’s Buffett Indicator be over, under, or fairly valued?
It is a hard question to answer. Which is why more analysis is needed to determine the Buffett Indicator’s limitations and applications for valuations in India and across the world.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©Getty Images / Dimitrios Kambouris / Staff
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