Warren Buffett thumb rule suggests that the Sensex is not going bonkers

Warren Buffett, the world’s most famous investor, once said that the ratio of a country’s total market valuation to its GDP is a very good indicator of whether the market is undervalued or overvalued. In particular, he said if the stock market’s valuation is above 100 percent of GDP, one should be wary.

Given the Bombay Stock Exchange’s dizzying rise (it closed above 25,000 on Friday, 6 June), it is time to ask: has the Indian market reached the point where one needs to be cautious?

The Buffett rule-of-thumb says no. The markets still have some way to go.

The stock markets are currently valued at just under Rs 89.8 lakh crore - or around $1.5 trillion - says The Times of India. As opposed to that, the 2013-14 GDP has come in Rs 104.72 lakh crore ($1.77 trillion). At its current level, the market is at 84-85 percent of GDP. This leaves it scope to gain at least another 17-18 percent before it equals the GDP.

But even this is a conservative estimate. The markets discount the future, and if we assume even 5.5 percent real GDP growth and 5.5 percent inflation, the GDP will rise to Rs 116.23 lakh crore in 2014-15. This means the current market cap is only 77 percent of the current’s year’s likely GDP. The market has a lot of leeway to grow this year - maybe even by another 30 percent.

From current levels, this means the Sensex can rise anywhere to 30,000-32,000 over the next one year if we go by the Buffett rule.

India’s market-cap to GDP ratio, in fact, ought to be higher than 1:1 for the simple reason that we are a growth economy and not a developed country. The US currently has a market-cap-to-GDP ratio of 115 percent, which means the stock market is 15 percent higher than the country’s GDP.

High market cap-to-GDP ratios are usually indicators of impending stock market crashes.

Robert Lenzner, writing in Forbes.com , notes that the ratio reached 183 percent of GDP at the peak of the dotcom bubble, and the market duly crashed. “In 2007, just as the housing credit bubble was bursting, the ratio was 135%… the GDP. These are all times when the stock market looks overvalued.”

The trillion-dollar question: is the US market, now quoting at 115 percent of GDP, overvalued and set for a fall?

Probably not. With the US economy recovering, which is why the US Fed is steadily reducing its bond-buying plans, this 115 percent ratio may not be an excessive overvaluation.

In April, Warren Buffett himself claimed in a CNBC interview that American valuations were not “too frothy”, but Doug Short, an economy and market watcher, gives a counter-point to Buffett’s optimism. He wrote: “Both the Buffett Index and the Wilshire 5000 variant suggest that today’s market is indeed at lofty valuations, now above the housing-bubble peak in 2007. In fact, the more timely of the two (Wilshire/GDP) has risen for eight consecutive quarters and is now approaching two standard deviations above its mean – a level exceeded for six quarters during the dot.com bubble.”

Predicting the US market is dicey, but as far as India is concerned, a stock market valuation of 84-85 percent of GDP, which is now set to emerge from stagflation and policy paralysis, appears very reasonable.

This is not to say markets have nowhere to go but up. Markets typically rise, then correct, and then rise again in a bull phase all the while watching real economy developments. If we have seen the Sensex rise quickly from 18,000-20,000 a few months ago to 25,000-plus today, the index could also correct to 20,000-21,000 levels after the July budget if it fails to impress. If the budget is reasonably good, the index will against start reviving from October, after a breather.

The medium-term outlook (the next one to two years), based on the Buffett thumb-rule of 100 percent of GDP, is thus cheery.