This article was written on Tuesday, November 9, 2010 at 11:57pm as a facebook note. Within a month of this writeup the stock market started coming own and in the next 3 years came down by around 60%. The piece is still a personal favorite of mine because I was able to make a very big call using the simplest of logic.
Background to the issue at stake
Starting from mid 2009, the Bangladesh Stock Market has experienced a prolonged bull run. The market returns has been among the world’s highest over the period. Even in 2010, only Sri Lanka (+110%) and Mongolia, has probably beaten our market where prices grew roughly by about 90%. Now while this sounds great, people often forget the risks of investment in such times of “irrational exuberance”.
Coming back to the point. I have thought for a while that the market will undergo a correction. However, for better or for worse the market stuck to its upward trajectory. But I believe that this has made the situation even riskier. Lets first look at what made the market go up in the first place.
What caused the market to act this way?
The first half of 2009 was a bad time for the capital market. Firstly, investor confidence in the economy was low after the 2 year stint of the caretaker government. But most importantly, the world was experiencing the phenomenon called the “global financial crisis”. Even though Bangladesh is relatively less correlated with the global economy, most economists were projecting a bleak macro outlook. Consequently, stock prices suffered.
From mid 2009 the situation started improving thanks to heavy investment in the capital market by state-owned banks and financial institutions. This brought back the confidence in the capital market and since the stocks were at extremely cheap prices (I remember AB Bank trading at a trailing P/E of around 6) all stocks looked like a bargain. After that we saw positive surprises in our GDP growth rate (5.7% growth achieved despite global slowdown) and corporate earnings. But the biggest reason that led to the current state of the capital market was what we call “excess liquidity”. To explain that let me use bullet points.
1. Because of power and infrastructure shortages most entrepreneurs could not invest in the real sector (meaning industries).
2. Bangladesh was having current account surpluses (thanks to huge remittance flows). So more money was coming in than going out.
3. Interest rates went down. So, it was not a good idea to get around 8.5% interest per year (before tax) when inflation was around 5-7%.
So suddenly, people had a lot of idle money which they were unable to invest anywhere. Anywhere except the stock market that is. Thus the joyride of equities (stocks) began and that situation is still continuing. Because of this excess flow of funds by both general investors as well as institutions (Banks, NBFI’s and Insurance companies), multiple attempts by the regulator failed to cool down the market. I can’t blame anyone because no alternative investments were available. Plus, when you can earn 30% return in 7 days why would someone invest elsewhere?
Why do I think that a reversal is imminent?
The simplest of reason is that nothing goes up forever. But since I am supposed to be an analyst in profession I need to do my job.
1. Market P/E (trailing) is around 30 at the moment. This is probably amongst the highest in the world right now. High P/E’s can only be justified when you expect superior earnings growth. But that is not the case here. The best companies in BD over the last 10 years have experienced earnings growth of about 20%. For 20% earnings growth on average, the market P/E should be around 20 and not 30 (which it is at the moment).
2. The P/E is calculated using the earnings reported by the companies. However, not all of these earnings figures are recurring earnings. Specially for banks and nbfi’s a large percentage of income is coming from one-off equity gains that might not be repeated in the future years.
3. Investor confidence is coming back in the real sector as seen by the indicators like loan disbursement, opening of LC’s for capital machinery etc. If this trend continues then at least some money would come out of the capital market to the real economy and in the process share prices would fall.
4. Interest rates are going up. Just a few days ago 1 year fixed deposit rates were about 8.5%. Now it ranges from 10%-10.5%. Since inflation is going up, we can be quite sure of further increases in interest rates. When that happens some funds will move from the capital market to the banking sector and other fixed income investments.
I can probably list other reasons as well but since these are the major ones, we can ignore the less important ones.
But I thought the macroeconomic outlook was improving?
Let me be VERY VERY clear on one issue. There is a big “top down” (or in other words growth) story in Bangladesh. It is a small country with a large young population. By all probabilities (Inshallah) the economy will continue doing well and if there are advances made to solve the power and infrastructural bottlenecks then we are definitely going to grow at a higher trajectory (7-8%).I believe myself to be among the most optimistic people about the long-term prospects of the country.
Now from common logic
Strong Macroeconomy=Good corporate earnings=Higher share prices.
While this is true there is always a price for everything. Compared to a Dhaka College shirt I am surely going to pay more for a designer shirt made in Italy but if the price tag is unreasonable then it is not justified. We do not have to look very far. Even in Vietnam (a frontier market very similar to Bangladesh) a few years ago the stock market had tremendous performance. The whole idea was economic growth. But the market fell because the prices being paid for growth were not justified by fundamentals. Please go to the link below and choose the 5Y graph to see the Vietnam market performance.
When will the crash occur?
It is almost impossible to predict a crash. The higher stock prices go up, the more confident investors become and the more risk they take. Right now we are at the peak of investor confidence due to which regulators cannot do anything to the market. So, the crash can happen in the next 1-2 month or it might even take 1-1.5 years. But we probably need a catalyst to dampen the investor confidence. Such possible catalysts could be
1. Big investors and big institutions like banks and NBFI’s getting out of the overvalued market.
2. Any natural disaster (Happened in Pakistan recently. The flood there had a major impact on the share market. Pakistan market P/E is about 7 right now where Bangladesh is about 30).
3. Any sort of political unrest
4. Lower than expected earning figures.
Can we expect a slow correction instead of a crash?
While it is possible, I would assign a very low probability to a slow correction. Why? Because, if that was the case then investors would have started to move out of the market. Everybody understands that the market is overheated. However, everyone also thinks that they can earn another 15-20% and have the perfect exit. Unfortunately perfect exits are quite impossible. So, once a big downward movement starts everyone will just jump on the bandwagon.
Our present situation has surprising similarities to the housing bubble that happened in the west. When housing prices skyrocketed (beyond logical limits) Wall Street knew very well that houses are overvalued. However, because everybody assumed that house prices would just continue going up they should not lose out on the marginal profit. Now here we are doing the same thing. Almost all investors will tell you that stock prices are too high (compared to earnings off course) but only a handful are acting on the conclusion that they are making themselves due to “expectations” of greater returns.
What should my strategy be?
1. Risk averse investors can sell all their shares and wait for the market to come down.
2. Those with more appetite for risk can partially offload their shares and keep the rest of the money in defensive shares with solid fundamentals. Staying away from any company whose earnings depend on the capital market would be strongly advisable.
If you liked this writeup don’t miss a few other predictions of mine around that time that also came true.