Why the KSE100 Index Will Still Double From Here Within a Few Years

 

The KSE100 index has been on a tear over the past two years. We’re actually nearing the two-year anniversary of the beginning of this face-ripping rally. Since the beginning of this rally, the KSE100 has tripled in value and anecdotally, I sense the average citizen is far more confident investing in stocks now than before.

This is counterintuitive because when Pakistani stocks were trading at far cheaper values, people were more hesitant to invest. But now that stocks are trading at better valuations, they feel more comfortable investing although future returns are surely going to be lower than they were a year or two back.

This phenomenon highlights a key element of retail investor behaviour in Pakistan: they conduct backward-looking assessments. When deciding what to invest in or when, they look at the (recent) past returns and expect those returns to continue. This is, of course, a highly flawed view since future returns are a function of the current price. If recent past returns have been high, then future returns will likely be lower due to a reversion to the mean of returns.

Back in the fall of 2023, I was sitting in one of my course lectures where the instructor was bemoaning the then-recent upsurge in the Pakistani stock market. The index had returned 60% within three months at the time and the instructor was accusing the rally of being engineered, superficial and purely speculative. He was essentially asserting that a few big players in the market had it cornered as the market is illiquid, and that the rally would die out.

Note, this instructor runs quite a successful firm in the financial sector so these comments from him were quite surprising. Perhaps, he felt sorrow at the fact that he (or his firm) had missed out on some stellar returns, I thought. Sitting there, I defended the rally and argued that it would continue. He brushed it off. Sitting here more than a year and a half later, I am arguing that the rally will continue, and the index will still double within a few years.

Firstly, the index is still trading at a forward PE of 6 which is a far cry from the 10Y (and long-term) average of 8. PE ratio is a fraction of price relative to earnings. It reveals how much the market is willing to pay for 1 unit of earnings. For instance, if the PE ratio is 6 it means that the market is willing to pay Rs 6 for each rupee in earnings.

Consequently, if earnings remain the same, reversion to mean alone should take the index up another 30%. Plus, it’s unlikely that earnings are to remain the same as interest rates are falling and growth is picking up. Thus, with earnings expected to revise upwards, that will unlock a further increase in value. Note, if earnings go up, the PE ratio falls as earnings are in the denominator of the fraction being discussed.

Naturally, I am against using PE ratio as a proxy for valuation since PE ratio is (theoretically) a function of risk and growth rate. Hence, a lower PE ratio simply reflects lower growth rate and/or higher risk as discussed in a previous blog. Nonetheless, it is incredibly useful when conducting historical valuation analysis and judging market trends/cycles.

Based upon this, it can be concluded that there is still a lot of juice left in the rally. I have confidence in this belief because in each market cycle, the PE ratio went north of 12. So, if we assume (again and unrealistically) that earnings remain the same, the willingness of the market to pay more for earnings as confidence returns should lead the index to double within some time.

You might be wondering, why would market participants pay so much more for the same amount of earnings? Anecdotally, I can decipher that towards the end of each market cycle, there is always the hope that Pakistan’s economy has fundamentally changed leading to a new era of high economic growth – the kind that India has experienced and led its market to trade at a PE ratio of 24 or more. But usually, that’s a fad as the high economic growth sustained at the end of a market cycle is engineered through unsustainable policies such as depleting foreign reserves to keep the PKR overvalued (which fuels growth temporarily).

Anyhow, there are other metrics which reveal that a lot more is left in this rally. As discussed in a previous blog, the Pakistani stock market’s dollar market cap usually breaks its previous high in each market cycle. In the last market cycle, the previous high was set at $96 billion in 2017, and the current market cap sits at about $50 billion. As a result, it supports the view that the market (in dollar terms) should still rally and double from here on.

Then, there’s the fact that the Pakistani stock market’s market cap as a % of GDP sits at 12% whereas it has historically sat at 17% of the GDP. And again, at the peak of the market cycle, the market cap as a % of GDP has sat north of 25%. This is another metric which strengthens the view that the market will double from here on.

The key question is how long will it take? I cannot decisively answer that here as it largely depends on how swiftly growth picks up and how quickly interest rates fall (so more money flows away from fixed income and into assets like stocks). However, based upon the length of the previous market cycles, it shouldn’t be longer than five years.

Despite the view I am advancing in this blog, I would argue that stocks might not be the optimal asset for investment in the next few years. That, I feel, would be real estate simply because of how undervalued it remains, and the lower risk associated with it. Plus, there is the fact that the real estate market (in Pakistan and across the world) seems to lag the stock market by a couple of years. If stocks are to double over the next few years, then so will the real estate market. But more on that later.