Market-cap to GDP: Another nonsensical ratio
Moneylife Digital Team 23 September 2010

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.

1 decade ago
I fully agree with the view, which should be obvious to any serious observer of the markets and the seasoned traders/ investors that the market valuation is driven by perceptions of earnings and of growth as also by market psychology based on the principle of trend studies besides availability of liquidity which is a factor of interest rates. There can not be any arguments about the fact that were the market valuation about GDP growth, US markets would have been half the current value. History should give sufficient examles of earnings growth not reflecting (rather the opposite) the overall economic growth; there are instances when there was a fall in the earnings growth, while the economy reported decent GDP numbers. What does this study serve- rather whom ?
1 decade ago
The market rise has got nothing do with the growth/GDP.
It is the money( hot or cold) chasing the returns, drives the markets up/dn.
Basically, it is the index game going on now. Not many stocks are participating in the so called "bull run".
Prakash Mehta
1 decade ago
Market Cap /gdp ratio represents status of Market Valuation at one particular point of time and I dont know why history of GDP growth is given.MCap /GDP ratio never says that whether GDP will grow or if GDP will grow market will grow. In Fact Mcap/GDP ratio gives warning signal that even if GDP will grow , market return will not be in proportion. For Example in Jan 2008 when MCAP/GDP ratio was 1.6+ it was clearly saying that market has discounted good GDP growth and market is expensive and similarly in March 2009 when same ratio was at 0.7 Market was clearly saying that this is time to buy even is we have neagative gdp growth in near future. Generally reasonable mCAP/GDP ratio can be said around 1.25 and when it crosses 1.5 it comes in expansive zone and all bubbles in world crossed at 1.5 ratio. I think Author need to study more as s/he is writing in moneylife and not moneycontrol.
Replied to Prakash Mehta comment 1 decade ago
Hello, fully endorse moneylife's article.This ratio does not look at govt. spends, this aside this country has such a big unorganised and unlisted space...this ratio is for superficial consumers of business newspapers
Replied to Prakash Mehta comment 1 decade ago
how profound!
another round of opinion without any statistics to back up - exactly what the mint article had done and exactly what the moneylife piece is warning against.
i think mr mehta should be writing this rubbish in mint site, not in moneylife. moneycontrol is of course a better choice for such sweeping nonsense
Prakash Mehta
Replied to rakesh comment 1 decade ago
Dear rakesh,

What statistics back up you required. Author diverting all matter to GDP growth and Market Growth whereas Mcap/GDP ratio is a simple ratio at one particular point of time and it has nothing to do with GDP growth and it infact proved to be a usefool tool to measure that whether broad market at that particular point of time is expansive or not.
Replied to Prakash Mehta comment 1 decade ago
Prakash is right. i dont know which article this Moneylife author is trying to blast.. but the author of this story is writing with a flawed vision. Market cap/GDP is not nonsense. But if you are reading its implications upside down then its wrong like saying with high Mkt Cap/GDP wil mean GDP growing faster.. high ratio simply means mkt itself is highly valued and its wise to pull out or atleast not invest fresh..
1 decade ago
What we talk in the name of STOCK INVESTMENT has nothing to do with the actual game. So also the ratio of
Marketcap to GDP. Aim is to increase
trading volume and survive .
1 decade ago
GDP growth to stock prices relation is a BAKWAS-this relation can be only true if companies start paying all profits as dividends to share holders-but that never happens and accounts of all cos are mostly manipulated-profit making cos show LOSSES and LOSS making co shows PROFIT-this is particularaly within india where BRASTACHAR is MOOLMANTRA-so co relating GDP with stock prices is misleading BAKWAS
p v maiya
1 decade ago
A ratio could be worked out between any two figures, with or without any meaningful relation.Instead of GDP:stock market index,it is more meaningful to compare stock market index to heart attacks or diabetesor insolvency in broker community. Why not?
kanu doshi
1 decade ago
This was really useful & illuminating.
The team works hard to educate its readers. Pl keep up the excellent work.
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