KSE100: The Market Cycle and the Macros

The Pakistani stock market is known to follow a well-established market cycle trend. It booms for a few years and then retreats or stagnates for a few more. Rinse and repeat ad infinitum. As covered in a previous blog, macroeconomic fundamentals are the key trigger for this behaviour; some of which include oil prices and the PKR/USD rate, or rather the stability of the rate. 

Over the long run, the stock market should appreciate to provide a positive real return in dollar terms (theoretically, at least). The graph below plots out the KSE100’s dollar market cap over time along with the 5-year moving average. Since the 5-year moving average is a backward-looking lag variable, it tends to be sticky and trails the market cap. 

Based on the graph, one can quickly notice two periods of 1997-2002 and 2009-2012 where the 5-year moving average faced a slump. Shortly after, the dollar market cap of the KSE100 index picks up. Note, the 5-year moving average lags the improvement in market cap by roughly a year. 

Now from 2018-2023, the 5-year moving average faced a similar slump. But note, 2023 saw the KSE100 appreciate 24% in dollar terms. Hence, the five-year moving average is likely to pick up from next year. 

Once the five-year moving average picks up, it remains on the uptrend for about six to seven years. Once again, the lagged nature of the variable means it lags the start and end of the rise of the KSE100 dollar market cap by a year. What does this mean? The market is looking very tasty for the next three to four years both in PKR and USD terms.

Interestingly, in each uptrend cycle, the previous dollar market cap high is broken. With the current market capitalization of KSE100 standing at $34 bn, breaking 2017's high of $91 bn would imply a 167% return (in $ terms). Note, the all-time high KSE100 dollar market cap is actually $99 bn.

However, this might be improbable given the steepness and depth of the preceding market decline since 2018 as well as the massive overvaluation of the rupee in 2017. Nonetheless, the stock market should yield solid returns over the next few years.

Moving on, the graph above uses a metric known as the 'Buffett Indicator'. Named after Warren Buffett who used to tout its efficacy, the metric utilizes the fact that the stock market must reflect changes (growth) in the GDP, thus the indicator must be constant over time. 

Based on this, the KSE100's Market Cap as a % of GDP has been far below its long-run average over the past few years once again highlighting the cheapness of the market at present terms. Once the market enters the boom phase of the cycle, the Buffett Indicator tends to remain above the average for roughly four years. 

The two graphs above display the relationship between the KSE100 index and brent crude price as well as the PKR/USD parity. 

With the PKR/USD parity, we observe that when the rupee is stable, the KSE100 tends to perform well. This can be rationalized by the fact that when the Pakistani rupee is stable, investors are confident that the value of their investment will be sheltered. This is of great importance to foreign investors which is why foreign portfolio investment rises during periods of PKR stability. But local investors also shift their capital to rupee-denominated assets like Pakistani stocks during such periods as dollar-denominated assets become less attractive in rupee terms.

At the same time, it is seen that the KSE100 tends to fully reflect and adjust for PKR depreciation. In fact, the graph shows that KSE100 far outperforms holding the USD. Since the inception of the KSE100 index, the index has provided a cumulative return of 2666% versus the dollar’s cumulative return of 813%. 

As for oil prices, the KSE100 index tends to perform well when brent crude prices are falling or stable. The 2010s were notable as brent crude prices crashed but the KSE100 index soared with that result. The transmission channel here is that lower brent crude prices improves Pakistan’s current account which lowers pressure on its foreign reserves, thus helping the country avoid (or at least delay) a balance of payment crisis. This in turn relieves speculative pressure on the PKR/USD rate. 

However, KSE100 can perform well even in the face of rising brent crude prices as the 2000s showed. However, the prolonged period of rising crude oil prices eventually did push Pakistan into a balance of payment crisis in 2008-09. So, in general, falling brent crude prices are favourable. 

However, oil price changes are a major contributor to price level changes so over the long run, the KSE100 index tends to show a positive relationship with brent crude prices. This is because the index will and does adjust to reflect price level changes over the long run. 

What does all this mean? The Pakistani stock market is a great buy at the moment despite the spectacular rise it saw last year. The uptrend phase of the market cycle has just begun, and Pakistan’s macros look good. The key question would be: when should one exit? The good news is you probably have a few years to contemplate that question. 

Allocating across Asset Classes: Gold, USD or Stocks?

Over the past few years, a large segment of the Pakistani population has espoused the belief that the dollar is the best asset class in Pakistan. Traditional economic theory would differ from this belief as prices and exchange rates have a one-to-one relationship in the long run, thus holding the vehicle currency (dollar) over the long run provides no real return. But let’s take a deep dive into how gold, USD and stocks perform over time.

Firstly, Pakistani fixed income investments are being omitted from the analysis as they’ve barely provided a positive real return over the long run; inflation has averaged around 7.9% over the long run while interest rates have averaged around 8%. Moreover, real estate has been excluded due to lack of aggregative data on property prices. Zameen.com does have a property price index but it is limited in its time frame as well as geographical aggregation.

Historically, gold has been expounded as an inflation-neutralizing asset class. However, that statement applies when the comparison is made for developed nations. In Pakistan, it is generally an inflation-beating asset class. This is a result of gold being a dollar-denominated asset so not only does its return reflect depreciation/devaluation of PKR but also increase in the price of gold over time. The twofold source of return provides a nice cushion for a gold investor.

As for cross-comparison of asset classes versus inflation, it is observed that the USD has not beaten inflation over a long-time frame. Meanwhile, both the KSE100 index and gold have significantly outpaced inflation. Till the end of 2023, gold edged out the KSE100 index but the trajectory of both stocks and gold in Pakistan is fascinating, to say the least.

Interestingly, there have been time periods where the KSE100 index has outperformed gold but also a huge stretch of time where it has lagged behind gold. Much of this is down to the market cycles observed in stocks and real estate in Pakistan.

Based on these observations, an astute investor would not allocate any of their capital towards the USD as gold is a much better inflation hedge which already incorporates the return from holding the USD. But to take it one step further, allocation between gold and stocks should be tinkered with from time to time.

When the market cycle enters the growth phase, one should shift their allocation towards stocks as stocks tend to outperform gold during this phase. Meanwhile, when the market cycle returns to the stagnation phase, one must lean more towards gold in their allocation.

It is important to note that correlation between gold prices and the KSE100 is 0.68 suggesting a moderate positive relationship. Thus, reflecting the fact that both asset classes adjust to nominal inflation effectively over the long run.

My personal gripe with real estate in Pakistan is the lack of liquidity and the large amount of investment required to invest in real estate – which leads to overallocation of capital to real estate. Nonetheless, selective pockets of real estate in the major cities of Pakistan have been excellent investment opportunities. If one possesses information not available to the public, plenty of money can be made in real estate. But that means high barriers to entry so not something a regular investor can count on. Thus, the emphasis on gold and stocks remains.

Regardless of the viability of real estate as an asset class, this much is clear: holding the USD makes for a very poor investment. One should stick to a mix of gold and stocks. Gold can be a great inflation/depreciation hedge, while stocks can act as a good source of steady income (dividends) and inflation hedge over the long run.