THE stock market is a gauge of expected earnings of the companies listed on the exchange. If earnings are expected to do well in the future, the shares of those companies will also perform well.

Listed companies’ earnings growth is linked to the growth of the economy that increases demand for their products and increases revenue and profitability.

The recent visit of the finance minister to the Pakistan Stock Exchange (PSX) was a welcome development as it indicated the the government’s interest in providing confidence to investors.

The finance minister said during his PSX visit that, while he understands the traders’ concerns, he is “more worried about the interests of the 210m Pakistanis”. This is an important and valid point. The well-being of the many is more important than the well-being of the few.

The stock market’s health (which is another way of sayings its valuation and trading activity), is driven by several factors. Empirical research shows that the three main factors are: (i) earnings growth and dividends; (ii) liquidity; and (iii) sentiment.

The previous administration chose to borrow mainly from banks, thus raising the absolute levels of public sector debt. There is no reason why this should be the case

In the short term, sentiment and liquidity usually tend to dominate stock market’s behaviour while over time, it is the fundamental earnings growth of companies that determines market valuation.

The present predicament of the stock market is primarily related to confidence and liquidity. This is an area where the government can and should play its role in creating a conducive environment that fosters investment and thus sustainable economic growth.

One measure would be to encourage government controlled financial institutions to invest a larger portion of their excess liquidity in the stock market. Historically, whenever financial institutions have stepped in to support the market during a crisis (such as during the global financial crisis of 2007-8), they have amply profited over time.

Neither an individual nor a community or nation can live beyond its resource capacity. It is in this context that the option for improving market liquidity via public financial

institutions has been suggested. No new resources are required; it is only a matter of changing the asset allocation profile of their investment portfolio.

Another area where the government initiative can encourage liquidity flow into the stock market relates to commercial banks’ exposure to capital market participants and their own investment in publicly listed equities.

The level of exposure was severely curtailed during the 2007-8 financial crisis. The State Bank of Pakistan (SBP) can run stress tests on commercial banks’ balance sheet and risk profile impact to see how these behave when exposure limits to the equity market is slightly increased.

Given that capital market institutions (PSX, NCCPL and CDC) have, over the last ten years, greatly improved their risk management functions under strict guidance and regulatory oversight by the Securities and Exchange Commission of Pakistan (SECP), I am reasonably confident that the suggested stress tests will show that the risk profile of commercial banks will not significantly increase if their exposure limits to the equity market is enhanced a little.

Based on data provided by a leading domestic securities firm, at the record peak of the stock market in May 2017, the Price-Earnings Ratio (PER) was around 10.3X, Price-Book Ratio (P/B) was 1.9X while the dividend yield was 4.8 per cent. Recently, in October 2018, the market’s forward (FY18/19) PER is 6.7X, the P/B ratio is 1.2X and the dividend yield is 7.4pc.

More interestingly, when the floor of the market was removed in mid-December 2008 in the aftermath of the global financial crisis, the market PER was 6.4X, P/B was 1.4X and the dividend yield 7.6pc,

Today’s macroeconomic situation, while serious, is relatively better than in December 2008 with GDP growth still reasonably robust, electricity shortage especially to industry significantly less and the new government taking initial steps to stabilise the external front.

Public sector institutions’ entry into the stock market will likely provide them with handsome returns on their investment over a 12 to 24-month time period and at the same time, boost liquidity in the market that will help with trading activity and build investor confidence.

The third policy action pertains to the development of domestic debt capital market. Significant investment has been made and will continue to be made in the country’s infrastructure.

The previous administration chose to borrow mainly from banks, thus raising the absolute levels of public sector debt.

There is no reason why this should be the case. There are ample savings in the private sector and these can be allocated towards the country’s infrastructure development if project-bonds are issued to the public and these bonds are listed on the stock market.

This will also attract a significant amount of international capital into the country which would help the external account. Further, listing the debt of infrastructure projects will provide transparency, investor-public scrutiny of the projects and thus lead to improved governance.

Building confidence and stabilising the stock market is imperative because this is where both public sector and private sector projects can raise significant long-term risk capital.

The writer is a former managing director of PSX. He is the CEO of Capital Markets International Advisors

Published in Dawn, The Business and Finance Weekly, October 29th, 2018