For a while the Indian economy has been the fastest growing large economy in the world and is likely to remain so for the foreseeable future. However, if you as an investor thought that was a free pass for markets to continue to grow in excess of the growth in economy, then the Economic Survey has few words of caution for you.

On page 65, while highlighting the remarkable surge in market capitalisation of the Indian stock market over the years, the survey also has this to say ‘the market capitalization (Mcap) to GDP ratio is not necessarily a sign of economic advancement or sophistication. Financial assets are claims on real goods and services. If the equity market claims on the real economy are excessively high, it is a harbinger of market instability rather than market resilience.’

The Mcap/ GDP ratio is globally popular as the Buffett Indicator, termed so as it is one of the favourite metrics of Warren Buffett. He once noted that this metric was the single best measure of where valuations stand at any moment. In fact, bl.portfolio in an edition dated July 14, had published an article ‘The Buffett Indicator and why you must view long term Sensex targets with caution’, bringing investors’ attention to the fact that it was at its highest levels ever and indicated that markets were over-heated.

The above data from the Economic Survey gives a perspective on how Mcap/GDP ratio has moved over the years for major economies. Since December 2023, the ratio has further increased for India and had crossed 150 per cent in the second week of July. It now trades well above the 142 per cent that Indian markets had touched in December 2007, just before the deep correction that followed. In the US, the ratio today is hovering around 200 per cent, around the levels where it was before the dotcom crash.

The ratio is typically high, when fundamentals and sentiment are on a high. It’s the sentiment that pushes the ratio to extreme levels and that is what the Economic Survey wants investors to take note of. Euphoric sentiment overvaluing assets linked to the real economy can result in disappointing returns or even sudden crashes when sentiment is impacted sometime in the future, whatever the cause may be. This does not just affect the investors but can also have collateral damage on the economy. For example the bursting of the dotcom bubble caused the recession in the US in 2002.    

There always is a tendency to dismiss the Buffett Indicator when it reaches a high, with convoluted justifications as to why ‘this time its different’ or the ‘Buffett Indicator’ does not apply to India. Further Market Gurus and analysts might give five-year Sensex and Nifty targets that imply the past rate of growth in equities can continue. But there is good chance you would be better of heeding the cautionary tone from the Economic Survey. Growth in value of financial assets cannot forever outpace growth in the real economy. There will be phases in future when Mcap/GDP ratio will also decline from current high levels, implying growth in value of stocks turning out to be lower than growth in economy or nominal GDP.

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