Jyoti Rahman and Shaheen Islam.
Published in the Star Weekend Magazine on 21 January 2010.
This piece explores the microeconomic reasons behind the share market debacle.
Amid signs of weakening through most of December, the bull run in the Dhaka stock market came to a screeching halt on the morning of Monday January 10, when the general index lost more than 9.25 per cent within an hour of the start of trading. This prompted the Securities and Exchange Commission (SEC) to suspend trading for the first time in its history. Angry investors, who had already demonstrated violently a number of times in December, clashed with the police, thereby attracting the world’s attention.
And then, on the following day, the market rebounded with the index rising by 15 per cent.
What happened? Why did it happen? What will happen next? What should (have) happen(ed)?
We don’t pretend to have anything more than a tentative answer to only some of these questions. In a nutshell, by the end of 2010, Dhaka stock exchange was very much in the bubble zone. What happened in the second week of January could have been a bursting of that bubble. A hard landing has been avoided, at least for now. Instead of trying to guess what will happen next, let’s explore how we got here, focussing particularly on the microeconomic aspects.
Asset prices are said to be in a bubble territory when they are unhinged from the economic fundamentals. A few years ago, house prices in the United States and a number of European countries reached the stratosphere, even though supply and demand could not explain the boom. A few years earlier, stock prices of technology companies in the US reached levels unsupported by economic fundamentals. Both were bubbles. In both cases, the initial rise in prices could have been explained by economic fundamentals: house prices were primed for a boom in the early part of the last decade given low interest rates, and financial innovation allowed more people to enter the market than was previously possible; the tech boom owed its origin to the realisation in the mid-1990s that the internet had tremendous potential.
Every bubble has its genesis in fundamentals. So it has been with the Bangladeshi stock market. Compared with similar economies in South and Southeast Asia, Bangladesh has been posting remarkably stable growth since the 1990s (Chart 1). Meanwhile, with the landslide victory by the Awami League in the December 2008 election, investors had reasons to be optimistic about the political climate in the country – traditionally a key risk to investment.
These fundamentals would have justified a bull market. And until the second half of 2009, that’s what we had. However, from around August 2009, the market started to get completely unhinged from the fundamentals.
From the beginning of the decade till August 2009, the direction of short-term fluctuations had been unpredictable, even though it appreciated strongly over the long run. Between August 2009 and November 2010, share prices rose every month. The price boom had lasted longer than 1996 (Chart 2). And with foreign participation in DSE being less than 2 percent, the boom has been a domestically driven one.
But how can we tell that share prices had entered the bubble territory? One way to make that call is to look at the price-earnings ratio (P/E ratio).
One of the fundamental reasons why people hold assets is because of the stream of earnings they provide. A low P/E ratio indicates that investors have not taken much risk in view of past earnings: even if the price they paid seems high, the earnings have been high enough to justify such a price. On the other hand, a high P/E ratio indicates that investors are overtly optimistic about the future earnings of such shares, and are therefore willing to pay a higher price.
Chart 3 compares the mean P/E ratios for selected sectors after August 2009 with their long-run (December 2005 – August 2009) values. With the exception of the banking sector, every industry has seen sharp rises in their P/E ratios. What fundamental changes in the economy could justify the rise in P/E ratios in so many sectors to such extent?
Interestingly, the industries with the smallest numbers of publicly-traded companies have tended to post the largest increases in P/E ratios. This suggests that the increases in sectoral P/E ratios may have been driven by a handful of well-performing shares. Did the future profitability of the firms concerned increase that dramatically that quickly? Or did these prices rise on the back of word-of-mouth among myopic investors?
Let’s think through the myopic investor idea with some examples.
Suppose one had invested 100 taka in DSE in January 2002. Five years later, it would have been worth 240 taka solely through capital gains (that is, without accounting for dividends and brokerage fees) – an annual rate of return of 19.2 percent, significantly higher than what most deposit schemes pay. On the other hand, the value of the investment over the course of 2002-03 was much more unpredictable. Initially it rose, and then it fell such that the 100 TK had barely appreciated if one were to liquidate in March 2003.
After the bubble burst. Photo: zahedul i khan
The point we want to drive home is simple: up until August 2009, the stock market was a tricky place for investors looking for short-term gains, but a beneficial place for investors willing/able to invest over longer time periods.
What happened after August 2009? An unprecedented good run in which the index appreciated every month until November 2010, with the largest percentage increases in late 2009 and early 2010. An investment of 100 taka would have only increased in value in this period, and not decrease once (until the very end).
Suddenly, the stock exchange became a good place for short-term gains. This in turn attracted more short-term funds, and the volume of trade on the Dhaka bourse increased as a result. In the meantime, the number of retail investors who typically invest in a small number of shares went from less than 500,000 in 2006 to almost 3.5 million today. In just the first 10 days of February 2010, nearly 125,000 such trading accounts were opened.
Most of these retail investors have very little, if any, experience of a bear market, let alone a crash like the 1996. Indeed, the younger investors who reacted violently on 10 January would have been in their teens during the last bubble. Moreover, unlike institutional investors, anecdotal evidence suggests that the individual investors rely less on analysis of the fundamentals and trade more on personal advice from brokers or fellow investors. One can easily imagine how a small number of such investors buying a particular share could lead to other investors jumping on the bandwagon and bidding the price of that share through the roof.
Incidentally, one industry where the P/E ratio has fallen relative to the long run is bank. It’s possible that this shows the preponderance of large institutional investors in this sector. Such investors are likely to rely more on fundamental analysis than short-run herd behaviour, and are likely to enjoy superior information regarding the banking sector and its business models.
Investors usually buy/sell shares by putting down only a fraction of the money needed for investment, with the rest being borrowed from brokers or merchant banks. The maximum that can be borrowed is a percentage of how much they put down. This percentage (also called margin loans) is usually determined by the SEC.
In February 2010, with the bubble in full swing, the SEC ruled that the maximum that can be lent was 150 percent of the investor’s down payment. Thus, if we wanted to buy a stock worth100 taka, we would only have to put down 40 taka of our own money and could borrow the other 60 taka (150 percent of 40 equaling 60). Such loans could not be given against stocks with P/E ratio of 50 or more. This made short-term investing much easier and much more prone to moral hazard problems, as more than half the investment could be made with borrowed money.
By July it had become much clearer that the market was over-valued. The SEC tried to push on the brakes, but not hard enough. It deemed that the margin loans could be a maximum of 100 percent of the down payment. Even then, a short-term investor would be using only half their own money for investment. Their “skin in the game” had increased, but was it enough?
As it happens, apparently the SEC did not think so. Within four months, it squeezed the margin limit further to 50 percent of the down payment, provoking angry reactions from retail investors late last year. Within three weeks thereafter, it had loosened the requirement back to 100 percent, and 5 days after that, back to 150 percent in the face of investor ire and a market-wide liquidity crunch, as institutional investors such as banks withdrew money from the stock market.
Even then, evidence suggests that most brokerage houses and merchant banks were not lending up to the maximum margin, suggesting that at that point a minimum margin requirement would have been more apt.
The SEC’s actions thus seemed largely reactive to market developments, rather than anticipatory or even contemporaneous.
The SEC was not, however, acting in a vacuum. The macroeconomic context of the boom has been one of easy money. And the political economy of the boom has been framed by the fact that the party presiding over the last crash is in office now.
How did these macro and political economic factors fuel the bubble? And what should happen now? –These are the questions that have remained to be explored.