How to time equity investments?

Investment returns are highly correlated to the risks that they are exposed to. Investors look for risk rewards characteristics of investments to determine an investment portfolio that best suits their individualistic risk appetites.

Risk seeking Vs Risk aversion
Based on the risk appetite, investors can be classified into risk averse, risk neutral and risk seeking. Risk seekers would potentially invest in securities, which offer the greatest returns while exposed to an extremely high level of credit risk and market risk. Investing in more speculative stocks in the equity market with the aim of short term profit making is a typical example of risk seeking.

Risk averse investors will opt for treasury bills issued by the Government, which are considered to have zero credit risk. Risk neural investors would like to balance a strike between the risk and rewards.

Yields on Treasury bills will have lower returns compared to other investment securities with similar maturities. The key reason is treasury bills are issued at the full faith and credit of the Government in each country.

A traditional mismatch between risk and rewards in Sri Lanka
However, Sri Lankan treasury bills are an exception. They have a historical track record of providing higher rate of interest compared to the fixed deposits with similar maturities. Hence, a traditional risk reward mechanism does not exist in a local context. Historically high level of budget deficit driven by high fiscal spending on defense and fuel subsidies, led Government to borrow aggressively in the domestic market pushing the interest rates higher. This has been the rationale behind the high interest rates on treasury bills. Due to the high level of Government borrowing from the local money markets, private sector borrowings and investments are often crowded out. A historically high borrowing rate has been a hurdle for private sector investments.

Alternative investment opportunities in a Sri Lankan context
Moving back to the topic, majority of the retail investors in Sri Lanka are comfortable depositing the money in fixed deposits and treasury bills. Equity markets are a substitute for fixed deposits and treasury bills. However, the equity participation rate is considerably lower due to the lack of awareness of the equity market.

Relationship between interest rates, inflation and stock market growth
Looking back at the last 10 years of historical data in Sri Lanka, it is clear that money market investment in many years provided investors with a negative real return. Real returns exclude the element of inflation from the nominal returns of investment and provide a better basis to compare between investment returns in the process of investment decision making.

Suppose, if the interest rate is 10% for a fixed deposit and the average annual inflation is 12%, by investing in the fixed deposit an investor is losing 2% per year, after factoring in the inflation. Hence, the real return is negative 2%. This is a call for investors to look at alternative forms of investments such as equity markets.

When the interest rates on deposits is lower than or same as or marginally higher than the rate of inflation, investors exit from the fixed deposits and invest in real estate and equity markets. Hence, there will be new cash inflow to the equity market (switch from fixed deposits to equity shares), this will generally lead to a bull run in the equity market.

Conversely, if the real return is significantly positive (deposit rates are higher than the rate of inflation), then investors will queue up in banks to deposit money in fixed deposits. This will trigger a sell off in equity markets, dragging down the stock market indices and returns.

Effect of margin trading on equities in Sri Lanka
In the mean time, if the interest rates are high on borrowing, margin trading on equities will not be attractive. This puts investors again on the existing mood, triggering a margin sell off in the equity markets. Likewise if the borrowing rates are kept below the inflation rate, margin trading will look lucrative. As a result, equity markets will see a considerable growth.

It is clear that a country’s macro economic climate and key variables such as interest rates and the rate of inflation will play a significant role in the equity market. If the Central Bank of Sri Lanka increases the interest rates to keep the inflation under check, it will badly reflect in the company share prices as investors will switch investments from equity to fixed deposits and treasury bills. Likewise, if Central Bank is comfortable with the rate of inflation and it wants to facilitate the economic growth, the interest rates will be reduced. This will transfer wealth to equity markets, triggering more demand for company shares and will push the returns higher. Hence, it is important for an investor to decide when to enter the equity markets and when to exit.

We have undertaken a historical evidence check to evaluate the relationship between real interest rates and Colombo stock market growth. It was noted that stock market indices rose when the real return on fixed deposits were negative or marginally positive. Likewise, when the interest rates were increased to control the inflation, stock prices have been hit hard.

2006 stock market growth – key drivers
2006 was a fantastic year for the share market where the All Share Price index (ASPI) shot up by 42%. In 2006 Sri Lankan Central bank adopted an expansionary monitory policy to facilitate economic growth. As a result Sri Lankan real GDP expanded by a healthy 7.7%. However, this was done at the expense of inflation. Interest rates were kept low despite worries over high inflation. Investments in fixed deposits were bleeding cash due to low interest rates and high inflation (negative real returns). An additional key driver for the ASPI growth in 2006 was margin trading. Banks were lending money at lower interest rates and this made investors to borrow money from banks to invest in equities. Macro fundamentals were very weak and were further dampened by the Central Bank’s move to facilitate growth at the expense of inflation.

Drastic fall in the stock markets in 2008 – key drivers
In the latter part of 2007 and throughout 2008 when the inflation accelerated to an un- acceptable level Central bank started to tighten the monitory policy by increasing the interest rates and introducing stringent credit criteria for bank lending. Due to the loose monitory policy in 2006, inflation hit 23% in 2008, a figure still considered by economists as significantly understated. Inflation calculation in Sri Lanka has not been accurate due to the consumer price index weighting.

Due to the tight monitory regime in the later part of 2007 and 2008, banks were collecting fixed deposits at 20-24%. Additionally, banks were involved in an extremely cautious lending and temporary overdrafts were provided to businesses at 40%. Treasury bills were issued at an average rate of 20%. This led a permanent sell off in the equity where the ASPI fell by 41% in 2008 followed by a dip of 7% in 2007. In addition, earnings of listed corporates were negatively affected with high interest rates on borrowing. This led value investors too exiting the market. This significantly wiped out the gains made in the equity market in 2006.

Effective timing in equity markets is a must
The above is a very good example of policy effects in equity markets. Equity markets are generally based on investor sentiment rather than key fundamental drivers. Therefore, there are a lot of arbitrage opportunities for investors exist, who are capable of timing their investments efficiently. When to enter and exit the equity market is the key challenge.

Bull markets Vs bear markets
When the investor sentiment is high and market is already in a bull mood, it does not always indicate a sell call, although a technical correction is generally inevitable. Likewise, in a bear market when the investors are jittery about the market outlook, still the bottom fishing may not be always rewarding. It’s very difficult to catch a falling knife; it requires great skills, knowledge and experience. But, still could be painful.

The way forward
According to the March 2010 Central Bank monitory policy review, the average annual inflation as of Feb 2010 was contained at 3.1% and year over year change in consumer price index increased to 6.9%. According to the policy review, it is clear that Central Bank is comfortable with current rate of inflation and will not hike the policy rates at least during the 1st half of 2010. Currently Central Bank adopts an expansionary monitory policy with lower interest rates to facilitate the economic growth. However, if this continues, inflation fears will be mounting. Lower interest rates and higher rate of inflation will trigger sustainable growth in the equity markets where the fixed deposits are not attractive and margin trading becomes less expensive.

Moreover, the stock market also depends on how fast the lower interest rates on borrowing turn to positively affect company earnings. Lower interest rates are beneficial to companies in two ways. Firstly lower borrowing rates will trigger consumer demand and would support company profits. Secondly, if the company has high level debt in its balance sheet, it will benefit from lower interest rates and the P&L effect could be considerable.

Therefore, the stock market will see sustainable growth (at least modest growth) post election, if the central bank continues to hold its policy rates. But, in contrast, when Central bank starts to increase its policy rates to control inflation, Colombo stock market will start to tumble.

However, it is evident that the Central bank currently wishes to maintain its easing monitory policy stance. Sri Lanka is forecasted to grow at an average of 6.4% over the next three years, with high growth forecasted in 2012.

We have to wait and see how central bank manages the country’s growth expectations while managing the inflation risk. This will have a greater impact on general economic environment as well as on equity markets.