It looks like a bubble. It feels like a bubble. But is it really a bubble?


Dec 20 - 26, 2004




















Never afraid to state the obvious, we will now present an argument that the KSE 100 is significantly overvalued to put it politely. We regret that in the process, we may have to resort to some algebra. It is elementary, but if you cannot abide equations then read only this before you go.

The stock market has risen too high without good reason. It will fall. The rich are used to these musical-chairs of fortunes won and lost. But for the first time since 1947, this collapse will directly affect the lives of ordinary middle classes. In other cultures and societies, the stock markets have played a big part in the efficient re-allocation of wealth. Thus far, it has always been from the poor to the rich.

At current levels of KSE-100, our guess would be that the players in the market are mostly hedged. If you think that hedge is something that grows round a lawn, then this is good time to exit the market. That's it. You can go. Or if you want to stay, you are most welcome.

To begin with, we assume that the stock market is fairly valued. We apply the classical Dividend Discount Model-DDM to examine exactly what assumptions about the future are being priced in by the market. If the market is fairly priced then all the expectations must be reasonable. We will show that some of these assumptions are irrational.

Dividend Discount Model values an asset by accumulating all the future returns in today's prices. More formally,

  P         D1 / E1
____ = __________
E1           k __ g


P =

Current Price of the Index

E1 =

Expected Earnings

D1 =

Expected Dividend

k =

Expected Rate of Return

g =

Expected Growth of Dividends

D1/E1 =

Dividend Payout Ratio

P/E1 =

Price Earnings Multiplier



This can be restated as

              D1 / E1
k___g =   _______
                 P1 / E1

And that's about all the algebra required here. So we have three elements to work with:

1. Dividend Payout Ratio
2. Price Earnings Multiplier
3. Spread between the required return (k) and expected dividend growth (g).

Figure 1 shows the evolution of Dividend Payout Ratio. It is currently below the historic average and more likely to increase, thus increasing the left hand side of the equation (k - g).

Figure 2 shows the evolution of P/E Ratio. It is currently at historic average and more likely to fall, again increasing the left hand side of the equation (k - g).

The probability of k-g falling is relatively low. But since our argument is not based on this, we will accept that the current state will persist. It will neither increase which would support our case, nor fall.

So what's with (k - g)? Figure 3 should interest you. It plots the KSE 100 index versus (k - g). It seems to have a lot to say about where the market is headed. As (k-g) falls, market rises. (Don't forget k-g is shown in inverted scale). Over the past 4 years, their relationship has been almost perfectly negative.

Figure 4 brings this out more clearly. It also shows the approximate changes you could expect. For example, if (k-g) moves from current 4.4% to 5.0% the market will come down to around 4500 level.

So anyone who feels that the index is going to 6000 also expects the spread between the required return (k) and expected dividend growth (g) to fall by 1% to around 3.5%.

We are willing to accept that the index may move to 6000 or even higher, we cannot see how (k-g) will fall.

The required return (k) is a function of:

1. Risk Free Interest Rate (3 month T-Bill)
2. Inflation Expectation
3. Risk Premium

Which of these three is likely to fall in the near future? Quite the reverse: Interest rates are rising; inflation is creeping up and will become more acute as the consequences of credit boom take hold. We don't see the

Risk Premiums to fall in the near future. The k in (k-g) is going up.

The expected dividend growth (g) is function of growth in corporate profits. At the index levels, they are likely to average the overall economy.

Over the last 40 years, Pakistan's economy has averaged real growth of just under 5%. Estimates for 2004 are already indicating a slight slow down. Figure 5.

The g in (k-g) is going nowhere.

Join the dots: if it is going anywhere at all, (k-g) is going up. And it is only a matter of time before the market follows its lead. Especially as Figure 6 shows the leverage story is close to its end. The surfing enthusiasts will see a pattern in this chart that will be sobering.

It is our view that this speculative feast was hosted by the banks by creating a credit boom. They will be the ultimate and sole beneficiaries of this.

In the words of Dr Frasier Crane, "the smart money has already left the building".