(Updated 11 January 2009 to accomodate latest economic data)
Readers are also invited to read a related article Malaysian Stock Exchange: Where is the KLCI heading dated 27 April, 2009.
For explanations of the above chart and other charts I have derived, please read on.
The extreme gyrations and the collapse of the financial markets we saw on Wall Street in the past months have indeed been a heart wrenching experience for most investors all over the world including traders on Bursa Malaysia. Other people, even how remotely connected they are to Wall Street, could not afford to ignore this debacle. Somehow, they will be affected, either in the form of the looming business slow down, their abilities to secure loans or even the security of their jobs.The impact to the world is definitely very serious and could be devastating in some countries.
In Malaysia, it is a blessing in disguise that we have already experienced our very own financial meltdown ten years ago and have already adjusted to the situation. Malaysia’s balance of payment as been in surplus for almost ten years, enabling the country to accumulate large foreign exchange reserves. As a result, our banking system is much stronger now. These factors will definitely help to cushion our economy from the Wall Street fall out.
The short term flow of fund in and out of our country may present limited risk, as most of these funds have left the country earlier because of the political uncertainty. Moreover, we should not expect the normally highly leveraged hedge funds to create havocs as in 1997 since many of them have already closed down or unwind speculative positions because of the global credit squeeze.
Even then, we cannot entirely escape the impact of the Wall Street meltdown.
The risks we face now is the very structure of our economy which is highly dependent on external trade. Malaysia’s external trade is very much dependent on the United States, which accounts for 15.9% of our direct export market. In fact, after taking into consideration indirect exports through Singapore and othe east Asian countries, total export to US may be in the region of 30%. Thus, a recession in the United States will significantly reduce malaysia’s economic growth in 2009 or even in 2010.
Of immediate interest to most of us now is how the meltdown of the Dow Jone Industrial Average(Dow Jones) impact Bursa Malaysia. I will analyse this aspect first and other factors such as the impact of GDP growth and foreign exchange rate on KLCI will also be similarly analysed.
Since mine is still not a familiar name in the areas of finance, let me introduce my credibility to analyse and discuss this topic. First, my personal profile can be accessible on this blog. Second, this is my area of expertise and special interest. I have spent more than 25 years developing and maintaining multiple regression models of the KLSE Indices which I use privately, and serve as a guide in making investment decisions for myself and the small number of private companies that I manage. I have passed through many periods of economic recession since the 70’s. My personal investment achievement have been above average with a return of 20% p.a. for the last 25 years.
This is only meant to be a scholarly article intended as a contribution to the body of knowledge in the areas of finance. Investors and potential investors may be tempted to follow my investment method, but please be aware that this article is not an investment advice. There are inherent risks in investments and I will not take any responsibility for any loss incurred (or profits made). Neither do I take any fees for this article.
The multiple regression models study the impact of a few factors on the Kuala Lumpur Composite Idex(KLCI), the the Kuala Lumpur Industrial Index and the Kuala Lumpur Finance Index. Among the factors I have selected and found having significant correlation with these indices are GDP growth and Dow Jones Industrial Average(Dow Jones). Of immediate interest to the public right now is the impact of the current meltdown on Wall Street as measured by the wild fluctuations and sharp drops in the Dow Jones.
Dow Jones is now seeing its steepest decline since the Great Depression of 1929. It plunged a total of 43.7% just within a period of one year from 14,000 points in October 2007 to a low of 7882 points on October 10 this year. This is a situation we have never seen before in our lifetime. I believe many of us are aware that this was triggered by the financial crises in United States, following the subprime housing loan problems that they suffered recently. Malaysians are more familiar with our own problem ten years ago when Non Performing Loans(NPL) triggered our own financial crises. What we saw in Malaysia ten years ago was just a miniature version of what the United States experience to day. What is worse is that it is starting to infect the world financial system.
The current debacle in the United States is the inevitable results of US government follies in the financial management of their economies. United states economy has been expanding for almost 20 years covering two decades of unprecedented growth. There was no doubt IT revolution spearheaded growth during this period, but a period of prosperity as usual leads to a period of complacency, arrogance and greed. Complacency and misplaced overconfidence infected the government financial administrators.
In response to popular opinions, the Federal Reserve always reduced interest rates to prop up their economy. The artificial props has been going on far too long that it encouraged banks to lend money to borrowers who otherwise could not afford it, giving rise to huge subprime loans. This situation of artificial economic expansion was compounded by greeds on Wall Street that discouraged good governance in the financial sector, giving rise to numerous ‘sophisticated’ financing instruments such as derivatives and the emergence of highly leveraged institutions like the hedge fund. Even the banking system itself abandoned the normal banking principles and adopted a much lower capital adequacy ratio. The inevitable result is the creation of a huge financial bubble which we now see is collapsing, an event better known as the US Subprime Mortgage Crisis.
Impact of Dow Jones on KLCI
Now let us examine the impact of Dow Jones on the Kuala Lumpur Composite Index(KLCI) This can be explained by multiple regression model derived by testing time series data over a period of 22 years from 1985 to 2007. A complete model for the KLCI, Kuala Lumpur Industrial Index(KLII) and the Kuala Lumpur Finance Index(KLFI) is explained at the end of this article so that, for the time being, we can just concentrate on the simpler aspects. The KLII and KLFI were tested over a longer period of time, ie. 38 years from 1970 to 2007.
From the equation under para. Complete Model Equations at the end of this article, by keeping all the other variables constant, the 6000 point drop(from 14000 down to 8000 points) in Dow Jones from October 2007 to October 2008 accounts for a drop of 207 points in KLCI as shown in the chart below:
Since the actual drop in KLCI during the above mentioned one year period was was 443 points, the equation result explains that 207 points(1407-1200) of the drop was directly caused by the fall in Dow Jones, while the remaining difference is explained by other variables included in the equation, including a small error term. A further drop in Dow Jones from the existing 8000 to 6000 point level, would result in another drop of 100 points in the KLCI.
Dow Jone is only one of the factors that affects the KLCI directly. Another factor is the economic growth (GDP two quarters ahead) and this is included as a variable in the MODEL-Klci equation. The correlation between KLCI and GDP growth is shown in the chart below:
From the above chart, with the GDP growth expected to drop to 2% in 2009 from the current year’s 6%, the KLCI will fall 75 points as a direct consequence.
The impact of the drop in GDP growth is very much expected, in view of the current recession in the US economy. This is separate from the direct effect of Dow Jones to the Composite Index.
The Chart below shows the correlation between KLCI and the RM/USD exchange rate.
Kindly note a very strong negative correlation between between these factors, which indicate that the recent weakening of the exchange rate from RM3.20 to RM3.50 caused a fall of 170 points of the KLCI, from 1372 level to 1202. A further weakening of the exchange rate to, say RM3.80 would cause another drop of the KLCI by 137 points, but a more serious weakening of the ringgit is not likely because of the reasons mentioned earlier.
For the benefits of people familiar with multiple regression analysis, I write below the complete model equations and the necessary explanations.
Technical Analysis : Complete Model Equations
The above charts have been derived from model equation MODEL.Ln.klci which is based on empirical analysis of quarterly data for a period of 23 years from 1985 to 2008. The model was built up on the hypothesis that the Kuala Lumpur Composite Index is dependent upon a few factors, including Dow Jones Industrial Average and economic growth of Malaysia. KLCI is a new index introduced more recently than other indices, so the earliest available data started that year.
Data of many variables were tested and those found not significant were dropped from the equation. I tried both actual data and the log e form of the data and found the later series provided best results.I eventually zeroed in on five factors which best fit the equation for KLCIand give reliable results as follows:
MODEL Ln. KLCI = 0.14+0.6647Ln.X2+0.1317Ln.X3+0.1069Ln.X4+0.3100Ln.X5-1.4671Ln.X6
(4.03) (3.00) (3.09) (2.01) (6.75)
R Squared = 0.85
No. of observation=88
Note: R-squared value of 0.85 means 85 % of the variations in the values of KLCI can be explained by this model equation.
Figures in brackets are T-Values, where 2 and above indicates significance within a confidence interval of 95% for each independent variable.
The historical Chart below shows the Actual KLCI and the Model KLCI for the period 1985 to 2008. Kindly note the closeness of the model to the actual data.
MODEL Ln. KLII = 0.353+0.576Ln.X2+0.214Ln.X3+0.120Ln.X4+0.376Ln.X5-1.179Ln.X6
(9.35) (4.38) (4.55) ( 4.36) ( 5.77)
R Squared = 0.94
No. of observation = 150
Note:* R-squared value of 0.94 means 94 % of the variations in the values of KLCI can be explained by this model equation.
*T values of 4 and above indicates significance within a confidence interval of 99% for each independent variable
MODEL Ln.KLFI =-0.833+0.879Ln.X2+0.149Ln.X3+0.062Ln.X4+0.518Ln.X5-1.933Ln.X6
(10.67) ( 2.31) (1.76) (4.5) ( 7.09)
R Squared= 0.95
No. of observation 150
Note:* R-squared value of 0.95 means 95 % of the variations in the values of KLCI can be explained by this model equation.
*T values of 1.76 indicates significance within a confidence interval of 92% and T values of 2.3 and above, a significance above 97% for each independent variable
In all the model equations, X 2=Capital indicator, X3=adjusted growth indicator, X4=inflation rate(CPI), X5= Dow Jones, X6=USD exchange rate
KLCI=KL composite Index
KLII= KL Industrial Index
KLFI= KL Finance Index.
The above is the first part of the article covering the Model construction. In the second part I will focus on how the models were used in guiding investment decisions.
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