13Apr2010: Warren Buffett calls this ratio as ‘probably the best single measure of where valuations stand at any given moment'. His disregard for macroeconomics is legendary. But even he is willing to relax his otherwise strict stance on the subject just for this one ratio. It is the ratio of a country's stockmarkets' total market capitalisation to its economic size or GDP. Call it the ‘market cap to GDP ratio'.
Over the years, this ratio has done a very good job of determining long-term returns that an investor can expect from the stock markets. As the chart below suggests, for India, the average market cap to GDP number over the past 2 decades has been 52%. Indian markets were trading near this ratio in March 2009 (when this rally started). And as we stand currently, the markets are back at almost their 2008 peak!
As per Buffett, a 70-80% range on this ratio indicates that markets are somewhere between moderate valuation and fair valuation. If the ratio exceeds 115% (we are almost there!), the markets are in the overvalued zone where odds of investing are not in the favor of investor.
http://www.equitymaster.com/images/2009/042109-Market-cap-to-GNP-ratio-equitymaster.gif
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