India's Red Flags: Why the Buffett Indicator Keeps Warren Buffett at Bay ?

When it comes to investing in India, Warren Buffett has consistently stayed away, and there may be a strong reason for that – India's stock market valuation, as signaled by the Buffett Indicator, shows cautionary red flags.

Here’s a breakdown of what this indicator is, why India’s market is raising eyebrows, and why Buffett wouldn’t likely pour money into it anytime soon.

Understanding the Buffett Indicator

The Buffett Indicator, a valuation metric favored by Buffett himself, is calculated as:

(Data for m-Cap as on 13th Nov, 2024. GDP as per PIB Press Release)

This simple ratio gauges whether a market is overvalued or undervalued by comparing the total value of all publicly traded stocks in a country to the country’s GDP.

For a balanced economy, this ratio ideally sits near 100%. A reading above 100% suggests an overvalued market, while a lower reading indicates potential undervaluation.

India’s m-cap to GDP is higher than the 10-year average of 0.93. that’s a considerable deviation from the trend. In 2007, the m-Cap to GDP touched all time high of 1.464, before falling under 1 in 2008?

India’s Buffett Indicator: A Warning Sign?

As of the latest data, India's Buffett Indicator stands at around?1.33x, signalling an overvalued market. In comparison:

• U.S. Market: Sits at approximately 160%, high, but buffered by economic strength.
• China: Hovering closer to 60%, a zone of "value" investment.

This indicates that the Indian stock market has outpaced economic growth. A high Buffett Indicator may mean that stocks are overpriced compared to the GDP they rest on, potentially setting investors up for losses if the economy can't support these inflated values.

Why the High Buffett Indicator is a Problem

1. Unsustainable Growth: India’s market valuation isn’t proportionate to economic output. Unlike the U.S., which has companies with global dominance, India’s economy is still largely domestic-focused. Such high valuations may not be justifiable.
2. Risk of Correction: When the stock market’s value is this far removed from the economy, it often leads to volatility and corrections. Buffett avoids markets that are prone to sharp downturns, favoring steadier, value-driven growth.
3. Inflated Expectations in Key Sectors: Indian markets are heavy on financial and tech sectors, but their profitability and global competitiveness often don’t match U.S. counterparts. This over-reliance on speculative sectors adds fragility to the Buffett Indicator’s high reading.

How the CAPE Ratio Paints an Even Gloomier Picture

The?Cyclically Adjusted Price-to-Earnings Ratio (CAPE), also known as the Shiller P/E ratio developed by economist Robert Shiller, adjusts the P/E ratio to account for business cycles by averaging earnings over the past 10 years, adjusted for inflation. CAPE helps smooth out short-term fluctuations in earnings, offering a more balanced view of market valuation. Here’s the formula:

Components Explained:

1. Current Market Price (Index Level): This is the current value of the market index (e.g., S&P 500 for U.S. markets or Nifty 50 or Sensex for India).
2. Average Inflation-Adjusted Earnings: This is the average of the index's earnings over the past 10 years, adjusted for inflation, to smooth out cyclical variations and provide a long-term perspective.

Calculating the CAPE ratio

Calculation involves several steps. It is primarily focused on adjusting earnings for inflation and averaging them over a long period. Here’s a step-by-step explanation using a hypothetical example:

1. Gather Earnings Data: First, collect the annual earnings (net profit) data for a company or market index for at least the past ten years. For instance, let’s assume we have the following inflation-adjusted annual earnings per share (EPS) for a company over the past ten years: 5, 6, 7, 8, 9, 10, 11, 12, 13, and 14.
2. Inflation Adjustment: To adjust nominal earnings for inflation, convert the earnings from past years into present-day values using an inflation index (CPI). For example, if a company had nominal earnings (EPS) of Rs.50 in 2010 and the CPI in 2010 was 100. Also, assume that the CPI in 2024 is 120. We can adjust the 2010 earnings to 2024 by multiplying Rs.50 by the ratio of the 2024 CPI to the 2010 CPI (120/100). The result will be Rs.60. This adjusted figure reflects the EPS in terms of current purchasing power, allowing for more accurate comparisons across different years.
3. Calculate the Average Real Earnings: Add the inflation-adjusted earnings for each of the past ten years and divide by ten to find the average. Using our example, the sum of the earnings is 95 (=5+6+7+8+9+10+11+12+13+14). Dividing this by ten gives an average real earnings per share of 9.5.
4. Note the Current Share Price: Find the current share price of the company (or Index) or the current level of the market index. Suppose the current share price is 190.
5. Calculate the CAPE Ratio: Divide the current share price by the average real earnings to get the CAPE ratio. Using our example, the CAPE ratio would be 20 (=190/9.5), which equals 20.

Thus, the CAPE ratio for this hypothetical company (index) is 20. What does it mean? It indicates that investors are willing to pay 20 times the average earnings over the past decade, adjusted for inflation.

As a stock analyst, it will be interesting to see the difference in values between the P/E and CAPE ratios.

The CAPE ratio provides a more stable measure of market valuation by using a 10-year average rather than one year, offering insights into long-term trends and potential over- or undervaluation.

A high CAPE ratio can mean:

• Lower Long-Term Returns: High CAPE ratios suggest that investors are paying a premium for current earnings, leaving little room for appreciation.
• Heightened Sensitivity to Economic Shocks: Markets with high CAPE ratios often exhibit greater vulnerability during economic downturns, something Buffett consistently avoids.

India’s CAPE ratio is approximately 47.7 now, significantly above its historical average, indicating that Indian stocks are more expensive than the global norm.

While both the Buffett Indicator and CAPE Ratio offer insights, they are best used together. The Buffett Indicator offers a top-down, macroeconomic view, while CAPE delves into company earnings cycles

The Verdict: Buffett's Reluctance is Well-Founded

For a conservative, value-focused investor like Buffett, the Indian market’s inflated indicators are a turnoff. These signals don’t align with his investment philosophy, which focuses on intrinsic value and steady growth. Until these indicators point to a more balanced market, Buffett is likely to remain on the sidelines.

Final Thoughts

India has potential, but its current valuations suggest risk outweighs reward. As long as India’s market remains this far disconnected from its GDP and such over valuation on its Small & Midcap Stocks, it’s unlikely to become a favorite of risk-averse, value-driven investors like Warren Buffett.