This is our first blog here, with hopefully many more to come. By way of brief introduction, my partner and I have a combined experience of 25 years in Pakistan’s capital markets, on the buy-side, sell-side and private equity. We are value investors at heart, and firmly believe that value investing tenets can be applied successfully within the Pakistani context. TrueNorth.asia would be where we share our ruminations on Pakistan’s economy and the stock market.
In this particular blog, we want to provide a “big picture” analysis of Pakistan’s equity market. That seems particularly relevant given that the current bear market low was reached last week. We analyze Pakistan’s bull and bear markets through the framework defined by the famed Howard Marks of Oaktree Capital (both his books “The Most Important Thing” and “Mastering the Market Cycle” along with his memos on the website of Oaktree Capital are highly recommended reading).
Marks defines three stages of bull and bear markets. Let’s see these in the Pakistani context.
Bull market optimism…remember that?
Three years ago, sentiment in Pakistan’s equity market was markedly different from today; greed, optimism and credulity reigned supreme. By June 2016 (when MSCI first announced that Pakistan would be upgraded to Emerging from Frontier), the bull market (which began in January 2009) had entered its third and final stage, “when everyone is sure everything will get better forever” (for definitions of cycle stages, please study the table below). Most investors were too sanguine to be skeptical; although a healthy dose of skepticism was the need of the day. Markets were pricing-in that trees really do grow to skies!
The three stages of Pakistan’s bull cycle (2009 to 2017)
Underlying the sentiment at the time were a couple of deeply flawed assumptions.
1.) The currency could indefinitely be kept stable due to adroit financial management (although the real effective exchange rate highlighted a 25% over-valuation), and interest rates would remain well below historical averages.
2.) The Pakistani consumption story was for real, and recent double-digit demand growth (in cement, steel, autos, oil products) could be extrapolated into the future. As a result, cyclical sectors such as cement, steel, and autos were egregiously over-valued, trading between 2-5 times of replacement cost, and yet a broad swathe of professional and amateur investors were sanguine on their prospects.
By early 2017, tangible triggers for a bull market collapse had surfaced. Pakistan’s current account imbalance started to deteriorate rapidly from November 2016, and a balance of payments/ currency crisis was imminent. Yet the stock market zoomed up from 42,000 to 52,000 in the next six months, as most investors stayed in denial.
Unfortunately, then as now, most investors did not bother confusing themselves with the facts! Here are some of the relevant ones that should have been considered at the time.
1.) Aggregate demand of the economy during the 3 year period from FY15-18 was 137% of income (GNP). Yes the times felt good, but what about sustainability?
2.) At the household level, the consumption boom was primarily fueled by property wealth effects. Low interest rates also reduced the opportunity cost of consumption; the private saving rate fell from 16.0% of GNP in FY15 to 11.6% by FY18. Marginal propensity to consume was 107% in this period, and with a 25% over-valuation in the exchange rate, the bulk of the consumption pressure fell on imports, ranging from oil products, construction material, food items, consumer durables, to vacations.
3.) At a macro level, Pakistan’s export engine was being run into the ground; exports to GDP fell from a long-term average of 11.0% to 7.0% by FY17. Policy-makers were least bothered about what Pakistan could sell to the rest of the world to fund the elevated import demand.
4.) The ensuing trade gap was bridged by an unprecedented increase in the external debt (which rose from US$65bn in June 2014 to US$95bn by June 2018).
Sentiment nose-diving whilst economic realities are improving
Built on flawed foundations, the previous boom collapsed under its own weight, and when the tide went out, optimism started being swept away from the markets. Bullish sentiment was tempered reluctantly at first, but has now moved full circle from unquestioning euphoria to full-blown depression.
Three Stages of Pakistan’s Bear Cycle (2017-2019)
The limits to negativity
The crescendo of criticism being heaped on current economic policy-makers is mind-boggling from a rational perspective, but ultimately should have been expected from a psychological point of view. The tendency to shoot the messenger is not a new one. With no quick fixes of the inherited economic mess, current policy-makers must bear the brunt of the disgruntled sentiment. The recent sharp decline in sentiment and increasing derision towards the current government’s economic policies is indicative that we are in the third stage of a bear market, where “everyone is convinced things can only get worse.”
Below are some examples of the excessive pessimism currently built into stock prices.
1.) Signs of an aggregate demand slow-down from various industries are bringing on a sense of despair, whereas earlier, most agreed that demand compression was required to rein in the current account deficits. Therefore, even improving trade and current account deficits are not being viewed in a positive light.
2.) Whilst the IMF program is about to be finalized, many of those we speak with have started questioning whether the market will even rally on an IMF program anymore. In the second stage of the bear market, investors were largely of the belief that an IMF program would lead to a significant rally.
3.) Inflation, which had remained well under control given the massive currency devaluation, saw a reading of 9.4% in April 2019, leading to significant pessimism. Ignored in the noise was that a large part of this CPI reading was one-off; the 12 month moving average for CPI is still 6.4%. Furthermore, the last time such a massive currency devaluation (FY09) had happened, inflation averaged 21%.
4.) Downbeat IMF forecasts of 2.7% GDP growth have been believed without debate and have created an overall sense of despondency. Has anyone bothered analyzing the IMF’s track record in their Pakistan economic projections?
5.) The equity market has come down in the last few weeks to its recent lows, yet very few buyers have come forth; even value buyers active over the last two years seem exhausted.
1.) Trade deficit and the current account, the most visible symptoms of the economic malaise which led the market into a tailspin in 2017 have shown considerable improvement over the last few months. Imports are down 18% in the last three months, and the overall trade deficit is down 28%.
2.) Although the headline export number is flattish, textile export volumes are up by 13%.The volume growth has been off-set by price decline in USD terms. Basically, foreign buyers are not letting local companies keep all the windfall gains from devaluation, hence the price has declined in USD.
3.) Foreign exchange reserves have increased by US$2bn in the last six months, after plummeting by US$10bn in the two years preceding that.
Yet the investing herd is giving up and capitulating. The important point is that the hopelessness in the face of improving ground realities is a good sign; an indication that the bear market which began in 2017 has entered its third and final stage. Those who were believers when the unsustainable boom was playing out are skeptical today when a structural and intended economic slowdown is restoring macro balance.
This is a time to be skeptical of the pessimism of the investing herd. Such pervasive pessimism is typical of market bottoms, leading us to believe that the bear market in Pakistani equities is on its last legs, and a bull market will commence sooner rather than later. The bad news has already been baked into the stock prices, the positives are not. Those invested appropriately are well-positioned to capitalize on a once in a decade investment opportunity.
Sir John Templeton’s description of a bull market resonates today;
“Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.”
Till next time,
Farrukh Karim Khan, CFA
Umer Habib
True North is your orienting point - your fixed point in a spinning world - that helps you stay on track as a leader. It is derived from your most deeply held beliefs, values, and the principles you lead by. It is your internal compass, unique to you, representing who you are at your deepest level. The key to finding fulfillment in life is to Discover Your True North.
*This is not research material and there is no investment recommendation in this blog. These are our personal views.
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