After returning 55% (24% in USD terms) in 2023, the KSE100 index has flatlined in the first quarter of 2024. Some commentators have begun questioning the foundation of the magnificent rally that occurred in the second half of 2023. However, this short-term view suffers from a lack of understanding (or ignorance) of market cycles.
A very
well-acknowledged fact about the Pakistani stock market is that it is very sensitive
to the ‘macros’. Macros being certain macroeconomic variables like interest
rates, foreign reserves and the value of the PKR. This is in contrast
with stock markets elsewhere in the world.
In most other
nations, the growth rate of the economy (which determines earnings growth),
equity risk premium and dividend payout ratio matter for stock market
performance. This has its theoretical origins in the basic Gordon growth model. Thus, usually the market goes through boom-and-bust
cycles primarily based on changes in equity risk premium or growth rate of the
economy.
For these reasons, you frequently see global stock markets tanking when the economy goes into a recession or rising when speculation is rampant (equity risk premium falls) – dotcom bubble for instance. The key difference between these economies and Pakistan’s economy is structural.
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| Consumption as a % of GDP |
In most other nations, the economy is well-diversified with growth being channelled through a mix of investment, consumption (imports) and exports. On the other hand, Pakistan’s growth model is heavily import and consumption reliant. This causes Pakistan to run into persistent balance of payment crises when growth heats up.
Consequently,
there’s a counterintuitive trade-off between growth and creditworthiness (confidence) of (in)
Pakistan which doesn’t typically exist in most other countries. This friction
causes the Pakistani stock market to boom for four to five years followed by a period of
stagnation for the next four to five years.
Generally, the market
booms when the PKR is stable, interest rates are low/falling and foreign
reserves are rising/stable – invoking confidence. These conditions trigger
investors to realize the value of earnings which had been rising and accrued in
the period of stagnation.
From the trough to
the peak, the PE ratio of the market varies from 3 to 12. Despite the
persistence of these cycles, investors always get duped by pessimism during the
period of stagnation and the optimism of a ‘new future’ during the growth
phase.
This market cycle
is not only observed in the stock market but also the real estate market in
Pakistan. Real estate prices tend to double within a couple of years and then
stagnate for four to five years. The last cycle was observed in the 2016-2021 period.
From 2016 to early 2020, the real estate market stagnated and then catapulted
itself to new heights from mid-2020 to 2021. Now, it has returned to the
stagnation phase.
For the KSE100,
the market cycle is much easier to observe through data. The above graph uses a
metric called the ‘5-year annualized return’ to succinctly display when one
should enter or exit.
When the 5-year
annualized return shoots above 10% in a certain year, the market enters the
growth phase and when it plummets below 20% in a certain year, it enters the
stagnation phase. In 2024, the 5-year annualized return shot above 10%
highlighting that the market may have entered the upswing cycle.
There are
fundamental reasons to support this assertion. SBP foreign reserves have
recovered from a low of $3.1bn in early 2023 to $8bn in March 2024. Interest
rates are expected to begin their path downwards this year – possibly from
April with inflation trending down. Lastly, the PKR has been relatively stable
with expectations of sharp depreciation low. The balanced current account also
eases pressure on foreign reserves and the PKR.
There is genuine
cause to believe that the Pakistani stock market is in for a few good years.
Whether those few good years turn into a good decade or two depends on whether
structural reforms are implemented or not. But considering history, betting
your money on that would be risky.
The better gamble
would be to go long for the next 3-4 years. The rally of the second half of
2023 has shown that one cannot time the exact movements of the market but
staying committed will reap rewards.
One cannot know
when SBP will cut interest rates this year, but when it does a rush of money
will flow away from fixed income and into other assets primarily riskier assets
like stocks. This is an occasion where buy-and-hold is a solid strategy. At
least for a few years, that is.