Proof that the American bubble knows no bounds, Pakistan's asset markets have been in a near vertical climb since shortly after 9/11, when President Pervez Musharraf decided to back the U.S. war against terrorism in neighboring Afghanistan and later Iraq. (see chart)

Musharraf's decision led to millions of dollars in aid from U.S. and British taxpayers flooding the nation of 150 million people. This in turn helped attract investment from overseas Pakistanis and retail investors to pile into the country's equity market. State-run companies began listing on the national stock exchange, helping to further boost investor confidence. The rapid rise in turn attracted droves of middle class and first-time investors, encouraged by a booming economy, low interest rates and better corporate earnings.

The Karachi Stock Exchange (KSE) became one of the hottest speculative emerging markets over the past three years, rising over 10-fold in just 42 months. In the end it became a speculative haven, latest home of the greater-fool theory, and source of hopes and dreams for easy money. The parabolic gains over the past three years demonstrate the signature pattern of yet another global blowout mania, and it appears that now that the top is in. According to Elliott Wave International (EWI), the index fell 29% in just 9 trading days after the peak. The speed of the advance, the momentary break of the top parallel trend channel and rapid reversal are classic signs of a major peak.

An article in the Pakistan Daily Times states that now that the market has peaked, a consensus has emerged in Pakistan that the KSE was the most manipulated stock market in the world, a gamblers' house rather than a place for investment. In a familiar echo of the NASDAQ bust of 2000, investors criticized big brokerage houses for not serving the interests of small shareholders. According to the article, up to 98% of investors are illiterate and totally dependant on the trends exhibited by large investors rather than calculating the risk factor on their own. Needless to say, the last place illiterate investors belong are in a speculative market, yet that is precisely the type of activity that attracts the uneducated masses, leading to just such a mania.

The above chart of the KSE was featured in the current issue of the Elliott Wave Financial Forecast (April 2005), and the chart was published the day of the top in the Short Term Forecast (March 16). EWI points out that this is one more piece in the emerging puzzle pointing to a swift reversal in the world's appetite for risk. Globally, interest rates are rising and equity markets falling as nervous investors reduce their exposure to risky investments.

Big Picture Outlook

How far will the market fall and what will the consequences be for Pakistan and the world? Market panics tend to look very similar on the chart, but the aftermath and their effects on the real economy are unpredictable. For a clue of how far Pakistan's market will fall, all we need do is take a look at other speculative boom/bust markets, such as 1929 or 1987 in the DJIA, or more recently, Thailand's SET crash in the 1990's or the NASDAQ crash of 2000.

We all know that Black Tuesday, 1929 foreshadowed the Great Depression (but did not cause it, per se). But after 1987's even larger crash, fears ran rampant that the US economy would head into a similar slump, which never materialized. Thailand's SET hit its peak in 1994 and went into a steep decline, but it was not until 3-1/2 years later that the gravity of the decline was realized and the Thai Bhat was forcibly devalued by the strict and unforgiving invisible hand of the market. This in turn sparked the Asian Financial Crisis that would shake the confidence equity markets around the world, including the in U.S. Overall, the market scares of 1997 and 1998 were just blips on the radar for the NASDAQ, which went on to power up 86% in its final ejaculation into March 2000. The spectacular drop of close to 80% has yet to have any spectacular effects on the real US economy, judging from current statistics. It is likely that these effect have merely been postponed, rather than averted, by the Fed's rapid monetary easing following the crash.

Thailand's 1997 devaluation led to a regional contagion that affected neighboring countries and even led to physical violence in several of the more adversely affection regions. Pakistan's problems will likely have a similar contagion effect as global investors pull out of emerging markets that may now be seen as riskier in light of Pakistan's crash. Already the iShares Emerging Market Index (AMEX: EEM) has fallen close to 10% in under a month.

And finally, let's not forget about the effect on the venerable Dow Jones Industrial Average, which has held up like a star over the past 5 years. In fact, it is trading in the same range as it did in the big top year of Y2K. But before we become too complacent, let's remember that even the Dow was badly shaken by the Asian Financial Crisis, plunging precipitously in 1997 on news from a far off, seemingly unrelated economy. The Dow plunged again in 1998 on the Russian debt default, reaffirming the fact that no event, no matter how seemingly remote, is too far away to affect the US stock market and economy. Furthermore, as we know from Elliott Wave analysis, markets are fractals, meaning that identical patterns can play out over different time scales, whether that be minutes, days, years or decades. The Dow seems to have escaped the rapid boom/bust which fell the Nasdaq, but when looked at from a different scale (see chart), the form of the pattern is quite similar. From this perspective, it appears that we are just rounding the top of a massive, multi-year dead cat bounce in the Dow.

It is important to keep this in mind today as we think about the possible effects that a small, seemingly insignificant economy such as Pakistan could have on markets in the US. The global economy is now simply too interconnected to think that any nation, including one as large as the US, is immune to such shocks. The Dow held up well in 1997 and 1998 when the market was in an up trend and the economy growing. This time, the trend is down, and the economy is on less stable footing. Another concern is that as more and more wealth is destroyed in Pakistan via a continued market slide, the need to find scapegoats as an outlet for anger and frustration will become very real. It is not a far stretch to imagine the Pakistani people blaming the stock market crash on some kind of US conspiracy, which would engender even more hostility towards America in an already volatile region.

The events in Pakistan bear close attention for potential ripple effects through the global economy. From my perspective, this is just one more troubling development among many that have the potential to cause real havoc on US stock markets in the near future. By many measures, domestic (i.e. US) conditions are deteriorating rapidly, which will add increased pressure over the coming weeks, especially as corporate earnings are announced later this month. It appears that the market is in a very vulnerable position, and news of any kind could spark a big sell off. These are conditions I will be watching especially carefully over the next few weeks.

© 2005 M.A. Nystrom
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