50,000 index: A bubble in the making?

Confidence is the name of the game; and liquidity is the trigger. The momentum right now is with the bulls in PSX as even after exhibiting a dollar based return of 46 percent in 2016, there is no stopping for the index, which is flirting with the psychological barrier of 50k. Is this a creation of an asset bubble? Are the companies experiencing exceptional growth, or is the market rerating itself to come at par with regional peers? Whatever it is, those in stock brokerage business or heavily invested in the market are on red bull.

Lets attempt to dissect the real growth in the market. One of the prime factors of high index growth is that the liquidity in the market is at unprecedented levels; and the leverage too is less than what it used to be in previous bull runs. The interest rates are low and equity markets are darlings of investors in such times. The real estate market was climbing even higher than stocks a while back; but its momentum was broken by imposition of taxes and introduction of new valuation tables in FY17 budget.

Since then, there has been no stopping to the shift of money to stock market. Investors, both directly or through mutual funds, have been continuously pouring money into the PSX. Lately, it's getting hard for domestic money to parked abroad; and that makes stock market even more lucrative. Even lately, SECP has directed mutual funds to keep at least 5 percent cash to cater to sudden redemptions; but the fresh flows are coming at a rate higher than what is invested by funds to keep their liquid cash intact.

Fundamentally, PSX can largely be divided into two chunks. In capital goods sectors including auto, cement, steel, chemicals and pharmaceuticals, the growth in companies' earnings is high; and the stocks' prices performance is even better. On the flipside, the valuation in sectors like banks, fertilizers and energy are saner. However, the margins in the latter sectors are compressed, and multiples are even more suppressed.

The market is behaving strangely; in sectors where margins are on the rise, price to earnings multiples are getting higher, while it's the other way round where the margins are cyclically downward. This is an absurd trend as its undermining the growth in volumes.

For example, in autos (see graph), the EBITDA margins more than doubled in FY15; and within the sector, a lions share is that of higher margins, while the volumetric growth (a barometer for real growth) is relatively much less. Margins have skyrocketed due to sharp appreciation against Pak rupee against many currencies (overvaluation of PKR is no secret), and low input prices (steel and rubber). Thanks to low competition and protectionist policies, the benefit did not get passed to the consumers, and hence companies profitability soared.

High margins era continued in FY16 as well. Valuations of auto companies based on price to earnings or price to EBITDA multiples increased; and stock prices started moving up. Now, in FY17 with more liquidity coming in, the market is revising up price multiple ratios in the sector.

Similarly, in the cement sector, low input prices amid import protection in an export competitive industry did wonders. The industry is now going through an expansionary phase; and market valuation of the sector is based on current margins and future volumes. Lately, steel is an emerging sector where capacity expansions are hinged upon government protection, and valuations are simply insane.

This is a dangerous trend as excessive liquidity is making investors blind. What would happen when the commodity cycle reverses? What if the government stops protecting these sectors? Early warning signs of commodity prices reversal are already here. This would be inflationary; and pressure on external account can force authorities to depreciate currency eventually. All this can bring imported inflation; needless to say that interest rates would start climbing.

The point here is that the margins of the capital goods sectors are mean reverting. In years to come, the margins will normalize and what would matter more is the volumetric growth for valuation. Nonetheless, once the global cycle reverses, banking and energy stocks will become precious for the investors; this trend is already in the making.

Since these sectors are index heavy; and a few stocks have ample float to become part of MSCI emerging market index. PSX will be part of MSCI emerging market index in May this year constituting of nine scrips (see list). Eight of the nine stocks are in banking, fertilizer and energy businesses with only one cement company in it. This will open conduit for many global funds.

The price multiples at PSX are still much cheaper than many emerging market indices (see table); and this fact pumps up the bulls even more. Hence, these stocks may rally once foreign investors come in the market as commodity price reversal takes place. It implies that index may not go down once margins in capital goods reverse as the index heavy stocks start moving up. However, any rising trend in the interest rates will shrink the liquidity in the market, which could hurt upward moving index.

Till that time, the ongoing momentum can make the market valuation in capital goods sectors more insane. There are other reasons for stocks in sectors like steel, to surge; their free-float is less, and it's easy to drive the prices upwards when the liquidity is pouring in. This is particularly a dangerous sign; in the recent book building of Roshan Packages, the strike price came at Rs86.2 per share against the base price of Rs35 per share. The blind investor seeing nothing but returns in the past year, and all mutual fund selling has been the glory of 2016.

It's virtually impossible to pin point a level that depicts index correction; however, signs are there that irrational exuberance is driving the market.