Barring the last few days, Pakistan’s equity market has been on an explosive roll for the past two and a half years. The Karachi Stock Exchange’s benchmark index, the KSE-100, has recorded growth of 165pc since starting its seemingly unstoppable winning streak in January 2012 — placing it firmly among the top-performing markets in the emerging universe during this period.

Macroeconomic stability, an improvement in investor perceptions about political stability and economic prospects, better liquidity conditions, changes to Pakistan’s outlook by international credit rating agencies and in the weightage of the KSE in Frontier Market indices, have all contributed to powering the KSE-100 to historic highs.

A part of the rocketing skyward of the KSE indices has roughly coincided with the installation of the PML-N government, prompting the finance minister to declare on more than one occasion (like his predecessors) that the domestic stock markets’ performance is the manifestation of business confidence in the government’s policies and reflects a change for the positive in wider investor sentiment.

To examine this assertion, and to put the stock market performance in context, it is important to ask — and hopefully, answer — the following: what’s behind the KSE-100’s meteoric rise? Is it fundamental economic performance, or are other factors playing a dominant role? Is the recent performance sustainable? And, in economic terms, what do the gyrations of the stock market signify? For many readers not familiar with the peculiar working of our equity markets, and for those planning to take a first-time plunge, it is important to understand that the stock market’s performance is not ‘uni-directional’ nor is it ‘linear’. Put simply, the fact that the stock market has been going up and up for the past nearly three years, does not guarantee that it will continue moving in the same direction in the foreseeable future.

While the KSE’s overall performance over a five- or 10-year period does seem impressive at first sight, it masks significant variations and ‘boom-bust’ cycles within the period. Since 2008, for example, the KSE-100 has delivered an annual average nominal return of 16.5pc; however, during this period, it witnessed two years of negative return (2008 and 2009), cumulatively totalling nearly minus 53pc. On an annual basis, the KSE-100’s variation (as measured by the difference between its high and low point) amounted to an average of nearly 50pc. In some cases, this represented a drop from a ‘high’ to a ‘low’, while in many cases it simply represented a progression from a ‘low’ at the start of the period to a ‘high’ at the end.

More generally, for the decade of the 2000s, in overall terms the KSE has done phenomenally well. Many factors contributed to this stellar performance, including political and economic stability, record low interest rates and a policy of ‘easy money’ followed by the State Bank between 2002 and 2007, as well as record amounts of foreign investment. However, the KSE also witnessed two episodes of the worst market crashes in Pakistan’s history, which collectively wiped out billions of US dollars in market capitalisation from the bourses and necessitated, in one case, a massive bailout of stock market investors using public money. This history underscores the inherent higher volatility of equities as an asset class, alongside its potential for delivering above-par returns. (A lesson for investors: comparison of risk-adjusted returns for different asset classes over a longer period of time will give a clearer picture of the suitability of a particular investment with regard to an individual’s risk appetite.)

Does the equity market represent the wider economy? Prima facie, the stock market covers 32 different sectors of the economy, ranging from oil and gas to technology hardware and equipment. However, the benchmark KSE-100 index is dominated in its composition by six to seven sectors — and an even fewer number in terms of active trading. (Another peculiar feature is the prominent role of public-sector entities in the index, with the likes of OGDCL, PSO, the two gas utilities, PIA and NBP.)

In addition, the base of ‘investors’ in Pakistani stock markets is small and narrow, with around one million active participants, and overall proceedings heavily influenced and dominated by a coterie of large brokers. Even the foreign portfolio investment is thought to be concentrated in a handful of large funds (while a significant chunk is considered by insiders to belong to large Pakistani investors who are ‘round tripping’ their investments).

Finally, eroding the reliability of the stock market as a barometer of the wider economy is the fact that fewer and fewer companies are participating in active capital raising from this source, which is dwarfed by borrowing from the banking system.

However, somewhat surprisingly, in one important way the stock market does correlate loosely to underlying economic conditions — but only if viewed over a period of time. Generally, the annual return on the KSE-100 has tended to exceed underlying corporate profits by a significant margin, with the excess possibly reflecting ‘irrational’ exuberance or fear. However, the average for the period 2004-2012 indicates a closer correlation: the average return of the KSE-100 was 14.8pc compared to average annual growth in corporate profits of 12.4pc.

Looking at the evidence, it can be argued that the stock market has ‘re-rated’ to better reflect longer-term economic fundamentals. Even after its recent rise, the trailing market price-to-earnings ratio is still around nine times, which is not expensive by regional or historical standards.

However, like in the build-up to the market crashes of mid-2000s, one potential area of concern is the speed of the rise in the equity indices, and the drawing-in of ‘off-the-street’ retail investment by housewives etc. Another measure investors should keep a watch on is the equity risk premium — the excess return over government bonds equity investors demand for investing in a riskier asset class. Currently, with an earnings yield of around 11pc, the equity market is discounting the risk over a five-year government bond yielding 12.74pc. If the market rises any more, this negative gap will widen further, and is something investors should take into account with the other factors mentioned.

The writer is a former economic adviser to government, and currently heads a macroeconomic consultancy based in Islamabad.

Published in Dawn, August 8th, 2014