A Google search for “Warren Buffett’s favourite indicator” will return several million hits and you can find dozens of articles citing this indicator—market capitalisation (cap) to gross domestic product (GDP) ratio.
As the name suggests, this metric compares the total price of all publicly traded companies to gross domestic product.
It’s also thought of as a way to judge the valuations for all companies relative to the total amount of the country’s economic activity.
More importantly, according to Buffett, when the resulting figure is above 100 per cent, its proof that stocks are pricey but when the percentage falls to the 70 per cent or 80 per cent area, buying stocks is likely to work for you.
Great. But here comes the question: is the indicator useful to the average local investor? I am doubtful.
First of all, there are three problems: The first, according to this metric, Kenyan stocks are measured as grossly undervalued (no score above 50 per cent) since 1991.
That means, according to Buffett’s interpretation, stocks listed at the NSE have been undervalued 100 per cent of the time in the past 25 years.
This can’t be considering that the market has experienced boom/busts cycles in the past. Therefore, knowing the metric’s higher value (46.2 per cent, 2006) and a lower value (5.3 per cent, 1991) compared to its historic mean (25 per cent since 1991) doesn’t provide much insight as to whether you should buy or sell stocks.
Secondly, valuation relative to the GDP assumes that the Kenyan economy is the driver of capitalisation. It really isn’t.
Many studies have shown that there is little correlation between current economic activity and the stock market.
Take for instance, despite a 5.7 per cent in GDP growth in 2015, markets still tumbled some 20 per cent. Likewise, despite a 5.8 per cent GDP gain last year, shares still gave up another 20 per cent.
Such “weak” correlation is proof that markets do not give a true reflection of underlying fundamentals. Therefore, the rationale that Kenya’s economic output should somehow track the earnings of its listed companies (and therefore share value) is somewhat misleading.
The NSE is a different beast altogether, often driven by extreme mood swings (read: deviation from economic trends).
Lastly, using an assumption that the current reading of the market cap/GDP ratio (29 per cent based on estimated FY2016 GDP) is a screaming buy, there’s would still be no clear signal.
This is because as markets go, oversold/undervalued positions can stay “irrationally longer” than anticipated. As some bears will tell you, a persistently oversold stock is a sign of weakness.
The opposite is the true. In this regard, the indicator is rendered more or less useless to the average investor.
So, in all, what does market cap as a percentage of GDP tell us? The answer is: Nothing. Again, the stock market is not the same thing as the economy.
That said, salvation for the indicator may come from tweaking the indicators rules – resetting the boundaries. As some have said before: “There are no bad indicators. There are just bad interpretations of indicators.”