For a country with multiple problems it is amazing to see its stock market declared the best performing in Asia and the fifth best performing market in the world, in 2016.

With an annual rate of return of around 45pc, should we be proud?

The academic belief is that markets are driven by fundamentals and stock prices follow a random path. Similar to a coin toss, stock prices are unpredictable.

In an efficient market one cannot consistently generate abnormal returns using past stock data or publicly available information. In simple words unless one has access to private information one cannot consistently generate above average returns.

The return on average will be what is commensurate with the risk of the stock. But the Pakistan Stock Exchange (PSX) defies all of the above academic beliefs.

Perhaps it is markets like these which economist John Keynes had in mind when he referred to financial markets being driven by ‘animal spirits’, or when former FED chairman Alan Greenspan used the term ‘irrational exuberance’ to refer to overvalued stocks .

This then brings us to the question, is this growth due to improvement in fundamentals? Or is it a speculative bubble of which everyone is aware but it still continues to grow.

With an annual rate of return of around 45pc, should we be proud?

For a country with an annual GDP growth rate of 4.7pc it looks impressive that its stock market continues to outperform those of its neighbours, India and China (both economies expanding at more than 6pc per annum).

Both countries have economic indicators which outperform those of Pakistan.

PSX is a high risk market, with intra-day volatility much higher compared to other markets. A more realistic method of comparing its performance would be the Sharpe Ratio, which compares the return per unit of risk.

For foreigners, the PSX does appear to be a market which consistently generates high returns. As the market is virtually immune to global events, it is ideal for portfolio diversification for those for whom high market risk is not a problem.

The PSX is a perfect example of capitalism: wealth circulating in a few hands, the rich getting richer and the poor getting poorer.

Time and again the government uses the stock market as an example of its economic performance. But where is the trickle-down effect of the stock market? A few individuals use it to multiply their wealth. How many new IPO’s have taken place in the recent year? Has the saving rate gone up?

The real estate sector and the stock market are the primary tools for the elite to increase its wealth and whiten black money.

Let me address two important arguments in favour of the PSX.

While the fundamental value of the stocks is increasing, prices are simply reflecting those values; the P/E ratio of the stocks is still lower compared to those in other countries.

Looking on the fundamental argument: stock valuation is a subjective process and even when applying the widely utilised ‘dividend-discount model’ (taking stock as a going concern) expected dividends (or FCFE in case of no dividends) have to be estimated along with other parameters (which are sometimes assumed).

Similarly the all-important discount rate has to be calculated based on the systematic risk (beta) of the stock. The whole process can be easily manipulated to produce fundamental values as per preferences.

Regarding the P/E argument, a P/E ratio depends on the present value of the growth opportunities available to a firm. A firm with zero or no growth opportunities available will have a P/E ratio of 1.

But to say for example that Google has a P/E ratio of 26 so the tech firms in Pakistan should also have a P/E ratio of 26 is a completely illogical argument.

The government in its own its defence can bring the argument that the economic outlook is improving which is reflected in Pakistan’s improved ratings. True, rating is complex process, but one must keep in mind the case of Enron and AIG which had an ‘AAA’ rating (highest available) one day before default. These companies awarded the ‘AAA’ rating.

At the end of the day the rating companies are just the inbuilt defence mechanisms of capitalism and the banking industry.

—The author is a former faculty member of the Lahore University of Management Sciences and the Karachi School of Business and Leadership.

Published in Dawn, Business & Finance weekly, January 16th, 2017