A sign of irrational exuberance in the stock market is when people refuse to acknowledge a contrarian view to what they believe, attributing it to some bogus scheme of profiteering that has nothing to do with economic fundamentals. Another classic feature is to argue that our case in the region is “different” than what has happened else where in the world. They stress the need to use forward P/E ratios (annualizing first half results to come up with earnings figures for the year) instead of taking earnings of the last twelve months as a basis to assess if stocks are overvalued or not at current price levels.
Why should the laws of finance be different here than they are elsewhere? The sustainability of high P/E ratios is based on the assumption that companies will be able to replicate their first half results, without being affected by the rise in interest rates, or the reduction in leveraging for stock trading, or a possible downward correction in stock prices. This may not be the case now. Share prices cannot keep on rising, knowing quite well that they have surged on the average at the compound rate of 300 percent in the past three years.
Several listed companies have become over dependent on the stock market to sustain their profitability. Banks are reporting 50 percent to 100 percent increase in profits in one of the most competitive retail banking market of the world. Insurance companies are showing 10 percent growth in underwriting income and 200 percent increase from their investment income in stocks, while investment companies boast profits mirroring those of their respective stock markets. All these are indications that the stock markets of the region may have entered an irrational territory characterized by overleveraging and excessive valuation.
The economies of the region are exhibiting signs of overheating, both in their real and financial sectors. Real GDP growth is forecast to exceed this year 8 percent as an average for the region, on top of the double digit growth rates recorded in the past two years. Annual inflation rates in the first half of the year, measured either by the GDP deflator or the consumer price index, have also been on the rise across the region. Share prices as measured by the Shuaa Capital Arab Composite Index surged by more than 75 percent so far this year, following increases of 64 percent and 56 percent in 2004 and 2003 respectively. Real estate prices in the prime areas of the cities of the region is believed to have doubled during this period, a classic case of too much liquidity chasing limited number of shares and real assets.
Interest rates as measured by the average monthly bank deposit rates in the Gulf region, and Jordan have been on the rise reaching lately 3.5 percent — 4.0 percent. However, they are still below their corresponding level in 2000 of 6.5 percent. The real short term interest rates, i.e. after deducting inflation rate, of 2.5 percent to 3.5 percent, are either very low or zero, which is way below their normal historic averages. The protracted period of low interest rates of the past few years encouraged borrowing and helped boost domestic liquidity.
There are indications that domestic inflation rates in the various countries of the region have been on the rise recently due mainly to higher gasoline and other fuel prices in the non GCC Arab countries, the weaker US dollar and local currencies exchange rates vis-à-vis the European and Japanese currencies, higher prices of imported commodities and raw materials (aluminum, steel, copper etc.) and surging domestic real estate prices.
One should not also underestimate the impact of the “wealth effect” on domestic prices. A period of higher real asset prices (stocks and real estate) would give consumers extra purchasing power to spend and could lead to higher consumer prices down the line. Even though their income may not have been higher, the increase in their wealth, whether realized or not, would make them feel richer and therefore more willing to spend. This partly explains the unprecedented rise in imports to satisfy the surge in consumption.
All this calls for tighter monetary policy and stricter control of bank leveraging for stock purchasing and margin trading. The region’s central banks and monetary authorities have been tightening monetary policy, following the directional movements of dollar rates. The re-discount rate rose from a low of 2.50 percent in June 2004 to 4.75 percent recently. This helped bring higher domestic interest rate structure. However, the excess liquidity conditions in the market place kept the downward pressure on lending rates and encouraged excessive borrowing.
Because most of the Arab currencies are pegged to the dollar, the region’s central banks are compelled to follow the lead of the federal reserve of the US when setting their monetary policy. However, when interest rates in the US are on an upcycle, as it is the case now, and economic conditions in the region require tighter monetary policy, then the central backs of the region should be able to allow domestic interest rates to rise at a higher pace than those on the dollar, restoring real interest rates to more normal levels. This will change the risk/return profile of investors, encouraging higher savings and less speculation in the stock market.
If domestic interest rates rise faster than the majority expects, it will discourage margin borrowing to buy shares, thus deflation the bubble in the stock market without necessarily bursting it. The higher interest rates policy could also be complemented by raising the required reserve ratio, issuing more CDs and treasury bills, as well as, lowering loan to deposit ratio. The Central Bank of Kuwait lead the way in this respect, which we believe had contributed to relatively lower levels of speculations in the Kuwaiti stock market.
If this policy is implemented across the region, then the interest sensitive shares (banks, real estate companies, investment companies and insurance companies) will be affected more than shares of companies in the industrial, tourism, telecom and other services sectors. Given P/E ratios based on last twelve months earnings of 25 to 35 and the expected up trend in domestic inflation and interest rates, it makes sense to rebalance one’s portfolio towards companies who are less dependent on the stock market to sustain profitability. Bubbles come to an end when the majority in the market place stop believing that share prices will keep on rising and capital gains are a sure thing. Apparently the jury is still out.
(Henry T. Azzam is founder & CEO of Amwal Invest.)