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
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
Dividend Discount Model values an asset by
accumulating all the future returns in today's prices. More formally,
P D1 / E1
____ = __________
k __ g
Current Price of the Index
Expected Rate of Return
Expected Growth of Dividends
Dividend Payout Ratio
Price Earnings Multiplier
This can be restated as
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
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 -
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
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".