Is a Crash Just Around the Corner?

Mon, 13 Jun Pre-Open

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Did you know that the world's most famous investor, Warren Buffett, has a good way to tell if the stock market is expensive? Yes, even we were a bit surprised when we heard him say it. But it perfect sense. Buffett favours the market cap to GDP ratio. He considers it to be the single biggest measure for long-term valuations of stocks.

Ever since he made this declaration, the ratio has been known as the 'Buffett indicator'. It is calculated by dividing the market capitalisation of a country's stock market with the GDP of its economy. What does this indicator say about the Indian markets? Well, as per an article in the Economic Times, there is a huge mismatch between India's GDP and stock market valuations.

Currently, India's market cap to GDP stands at about 83%. This is higher than the long-term average of 76%. But this is not the real concern. The ratio has been this high for about two years now. It is no coincidence that the new method of calculating India's GDP also came out two years ago.

The new method has been criticised by several economists who say that the numbers overstate India's GDP growth. If this is indeed the case, then India's market cap to GDP ratio could be artificially inflated. If the old method of calculating the GDP were still being used, the ratio would be a mind-boggling 143% right now!

It's pertinent to remember that just before the dot com crash in 2000, the market cap to GDP of the US markets was 153%. Also, the Sensex P/E ratio is close to 20. Does this mean that we are close to a major crash? It is certainly possible in our view. The markets are no doubt very frothy right now and any adverse global event could cause a sharp outflow of foreign funds.

But does this mean that you should sell all your stocks now and stay out of the market? Absolutely not! We at Equitymaster believe that there is a strong possibility of the Sensex scaling 40,000 in the coming 3 years. We have sound logic of a revival in earnings growth backing up this claim.

In case there were to be a crash, we would be the first ones to tell you to buy fundamentally strong businesses. And if you do so, we have no doubt that you will make very good profits over the next few years.

For information on how to pick stocks that have the potential to deliver big returns, download our special report now!

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