Monday, February 16, 2009

Financial Intelligence - Part XX

Golden Dreams, Ironic Reality

Just like Pyrite, commonly referred to as ‘Fool’s Gold’, the allure of investing in the stock market is just as irresistible. After all, wasn’t the fortune of one of the richest man in the world today built solely on investing in the stock market? Unfortunately, just as the road to hell is paved with good intentions, the stock market is also littered with many who have lost their fortune by gambling in it. Let us set aside the golden dreams we have of striking the lotto in the stock market and look at the cold ironic reality of investing in the stock market.

[Click on the chart to enlarge it]

Long term Capital Appreciation
The market capitalization of our listed companies in Bursa Malaysia was approximately RM132 billion as at end of 1990. As at end of 2008, this amount has risen to RM664 billion as at end of 2008. Over a period of 18 years, the compounded annual growth rate (CAGR) is a mere paltry 9.39%. Assuming the average interest rate of fixed deposit during this period was 4%, the stock market yielded only an additional return of approximately 5% for the risk taken.

Gross Domestic Product (GDP) Growth vis-à-vis Capital Appreciation
Briefly, GDP can be considered to be the market value of all the output produced in a nation in one year. Let us consider the nominal GDP growth in Malaysia from 1990 to 2007 (i.e. inclusive of the effects of inflation). Nominal GDP in 2007 was RM641 billion as compared to RM119 billion in 1990. The CAGR over a period of 17 years is 10.41%. There appears to be a strong correlation between the long term growth rates of our GDP versus the capital appreciation of the market capitalization of Bursa Malaysia as a whole. Both have grown approximately 10% per annum over almost a period of two decades. Comparing these two indicators may give us a indication whether the stock market has bottomed out.

Market Capitalization as a % of GDP
A review of this ratio indicates that this ratio has been hovering between 1.0x to 3.6x from 1990 to 2008. The ratio was at its’ peak at during the Bull Run in 1996 just prior to the Asian Economic crisis. This may be a good indication that valuations of the stocks listed on the then KLSE were excessive. As indicated in the chart above, at Point A, market capitalization in the then KLSE exceeded nominal GDP by RM553 billion. In fact the value of the entire stock market was three times more than the GDP. Clearly this was unsustainable and more than RM431 billion was wiped out in the stock market crash in 1997.

At the end of 2007 as indicated at Point B, the market capitalization in Bursa Malaysia again exceeded our GDP by RM465 billion. The market capitalization as a % of GDP ratio of 1.73x indicates that stocks were possibly overvalued, although on less excessive scale as compared to 1996.

Where are we now?
Market capitalization as at end of 2008 was approximately RM664 billion. Assuming Malaysia’s nominal GDP grows at a conservative 3% from 2007, 2008 GDP would be approximately RM661 billion. Based on the overall trend, one could say that the Malaysian stock market may have reached attractive levels at the ratio is now at a historical low of approximately 1.0x. However, this may not necessarily be the case. The growth in our stock market from 1986 to 2008 was largely fueled by the transformation from an agrarian industry into a manufacturing industry catering largely to exports to US. With the current US economic recession and the emergence of competing countries including China, Vietnam, Cambodia etc, the Malaysian economy is at crossroads. Our economy may recover, or it may not. So, it would be foolish to extrapolate past trends into the future. Having said that, valuations of stocks on the Bursa Malaysia appears to be reasonably priced at this time and one should consider cautiously entering into the market in 2009.


Damien Tan

I'm no stock market expert but yeah, I can see how market caps rise and fall with GDP. What I wonder is, how accurate are the GDP forecasts given by the central banks and do they tally with actual market cap movements.

GDP tells us how fast we're going. A more fundamental question is why we're going as fast (or slow) as we are and whether the underlying reasons are as forecastable as we think, given the constantly changing psychology of supply and consumption.

IMHO, at the core of forecasting failures is the inability to rationalize human decisions responsible for market confidence that drive GDP. There's been many theories, including herding and the so-called wisdom of crowds that still failed to predict the rise and crash of markets.

I keep in mind that all it takes to take markets down is the unforcastable act of some crazed guy hitting a button and launching a big bomb somewhere, metaphorically speaking. It can be someone who stumbles on a game-changing technology, some guy like Madoff or a terrorist who launches an actual big bomb. The effect on markets are the same - they destroy old forecasting theories and build new ones.


Dear Damien,

Although forecasting theories are prone to errors, there is a tendency for history to repeat itself. The best we can do is to to learn from these events and apply this to investing in the stock market.

There are always risks to every venture, including the risk of doing nothing with one's wealth (such as inflation).


Eddie Law

Hope to see you there. Pls RSVP asap because not many seats left now.


long since i came reading..hehe..

am not an expert but i do invest in stocks..

GDP while may influence stock market, it is more likely the market can sniff a nation's economy.. It often bottom up earlier than growth in GDP and by the time the
"herd" came in, it is already ready for another bear..

where to see a bottom? many data n statistic then came. unemployment, global economic health, etc these are all related to GDP but the real gem is when to sniff out GDP before it reveal itself..

no fast n hard rule so people look at historical long a bear run, how long a bull run, movement of graph, etc..

where we stand? somewhere near but not yet there..there is still room for fall but at a lower any way, look at DJ as a guide n then we may know if US economy recovering, and it directly affect the whole world, malaysia not excluded..then it is the time to see if bursa bottoming up...

currently looking at bursa breaking 800 and perhaps 750..the market will bottom up faster than GDP though...


Dear Amethyst213,

GDP is just a general guide to the growth in the economy. You are right about market tending to 'sniff out' or anticipate the GDP of an economy and price the stock market accordingly.

It's real use to help us get 'real', i.e. to see when the stock market is overheating and the bull run cannot sustain itself. You can see that prior to each major crash, market cap exceeded GDP by a huge amount. As to the bottoming, things are not so clear as of yet. But if market cap drops to about 70% of GDP, I'm definitely going in.

Overall, while the GDP vs. Market Cap is close to 1.00, it appears that stock valuations for most blue chips are still high. This is either due to the large no. of privatization that has taken place including Maxis and/or bottoming out of 'second tier' Main Board companies. So, stocks are still not cheap yet.

Looking at the US DJIA, I'd say you are right about Bursa KLCI touching base at 750++. When that will happen, is another question altogether.



Like Winston Churchill said, there are lies and statistics. Yes, the GDP/MC ratios look enticing, and seem the lowest for the time line shown. Still what is to say that it may not go another 50% down.

Like Citibank now, even Temasek thought otherwise a year ago.

Sigh....decisions, decisions,


Dear MoreIncome,

You're right. We don't! That's part of life isn't it :)

The ratio is merely a macro indicator that it's time to monitor the market for possible bargains. We still need to look at each individual companies to see whether they are worthwhile investing.

BTW - Thanks for dropping and commenting :)

forex guides

HI.. Good informative post..

forex guides


Waiting for your next post.


Dear Forex Guides & Rahsia,

Thanks for the kind comments. I'm a bit tied up at the moment, so posts are few and far in between.

Still, a lot of interesting things are happening in the moment and I'll be sure to blog about it when I'm more free.


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