A popular metric, recently front-paged by a business paper, is to compare GDP to market capitalisation of listed stock to determine the level of under- or over-valuation of stock prices. It is sheer nonsense

After weeks of dilly-dallying around 18,000, the Sensex has broken out on a massive upswing, and is now within kissing distance of the 2008 high. And, as happens, experts have begun to dig out more and more metrics to determine whether the market is overvalued or not.

The idea is to push the belief that ‘there is still plenty of upside potential to this market’. One of the metrics — which a business daily front-paged prominently a few days ago — is market-cap to GDP. The article suggested that there is still some steam left in this rally, because the current market cap to GDP ratio, standing at 104%, is well short of its all-time high of 160% in January 2008. The article quoted some market experts who point out that the market valuation of domestic companies has lagged the pace of economic growth, which offers scope for further appreciation.

What this essentially assumes is that one, GDP and stock prices are closely correlated and two, a ratio of GDP to market-cap of the last peak is a high watermark that mysteriously reveals to us how high this bull market can go: the new peak is not conquered if the previous ratio is not breached. Nothing can be more naive and wrong. Stocks do rise because of economic growth (as reflected in expanding GDP) but the correlation between GDP growth and stock prices is not strong. Let’s put some facts on the table before we get to the explanations and conclusions.

Consider for instance, the period between 1994 and 2003 when the economy grew every single year, clocking average GDP growth of 6.8% a year. What did the Sensex do during this period? Shocking, but during this very period, the Sensex was down a massive 39%! So the idea that you should hold on to your stocks, or buy some more since India’s GDP growth is going to be strong, is bunkum.

There are similar instances from other economies too. Asian economies like South Korea, Taiwan and Japan enjoyed some periods of scorching economic growth in the latter half of the 20th century. Surely, their stock markets were on fire too, as expert views would suggest. Not quite.

Taiwan clocked a GDP growth of over 5% between 1990 and 2008. How did its stock market fare during this period? It fell almost 50% from its level of 12,000 on January 1990. Taiwan’s economic growth story is one of great success but its stock market performance is one of the worst in the developing world. It pays to look at facts before peddling an opinion.

We have described in simple quantitative terms that stock prices are delinked from macro growth figures. What about the connection between the qualitative aspect of the economy and stock prices? For instance, every bullish presentation
about India starts with generic notions like India is an English-speaking democracy with a rule of law and long tradition of business and trade. Does it matter? Taiwan earned the sobriquet of ‘Taiwan Miracle’, which refers to its spectacular economic growth that transformed it from being a war-ravaged poverty-stricken nation after World War II to a modern prosperous nation. In the first phase, it started land reforms that benefited agriculture. In the second stage, it developed massive labour-intensive, export-driven industry which led to massive trade surpluses and huge foreign exchange reserves. Socially, Taiwan has had a stable and harmonious society, universal and continuously upgraded system of compulsory education, a frugal and hard-working population that led to a savings rate of 40% in the first two decades and the right developmental strategies at the right time. But all this could not prevent 15 years of stagnancy in the country’s benchmark stock index.

Why go back to the 1990s? Right now, look at China’s economy and the fate of Chinese stocks. The latter would seem to suggest that China is in a deep recession; not an economy that is recording double-digit growth.

The market-cap to GDP metric is irrelevant because it fails to take into account the contribution of unlisted entities, government, agriculture and unorganised sectors which contribute in a big way to the country’s GDP growth. In essence, the movement of stock prices may not be entirely reflective of the country’s growth and vice-versa. Also, the economy may owe its growth in part to such segments which cannot translate into higher valuations for listed companies.

Market valuation moves on three engines of earnings: growth, market psychology and liquidity (in turn determined by interest rates). If market valuation was about GDP growth, US markets would have been half the current value.

If corporate earnings are expected to be on the higher side, stock price valuations are bound to go up. This concept also disproves the notion that GDP growth drives market valuations. Sometimes, earnings growth may not reflect in the overall economic growth of the country. Other times, despite a fall in the earnings growth, the economy may report better GDP numbers.