Will Indonesia experience mean reversion return in 2011?

A quick review about history, IDX IHSG eoy 2007 is 2.745,825, eoy 2008 is 1.355,407 or down 50,6% from previous year, eoy 2009 is 2.543,355 or up 86,7% from previous year and getting near it's previous high in year 2007, and finally, eoy 2010 is 3.703,512 or up 46,1% from previous year.

After this spectacular performance, analysts still present an upbeat forecast about indonesia economy. The most simple argument is indonesian company expected to enjoy good earning growth with cumulative average growth around 20% p.a. with hindsight analysis, this forecast seem achievable. This argument using BOLD asumption, Indonesia economy already decouple with the rest of the world economy. An assumption that we do not believe.

Now we turn our attention to empirical result about stock market. Finance literature find that stock market return always revert to their mean, a concept known as mean reversion. Indonesia stock market return also shows mean reversion phenomena. First, we experience golden period of stock market return in period of 1989 to 1997 before bursting because of monetary crisis. Second, dark period in 1997 to 2003 because of mass debt restructuring effort from companies and fiscal austerity measures implemented by government. And, third we experience another golden period of stock market return from 2003 until now and may be longer, because of economic recovery, including heavy reliance on domestic demand, and commodity boom. Surprisingly, this golden period occuring even subprime mortgage burst in 2008, and bring along world gdp into recession period. From empirical perspective, sub par to negative stock market return is a certainty but the question will be WHEN?

To answer the WHEN question, we turn our attention to money supply growth that significantly exceeding real economic growth and creating inflation pressure.

Source: Bloomberg.

Note: Green line denote Indonesia GDP Growth, Red line denote Indonesia CPI Growth

We do not like inflation because inflation kill peoples purchasing power, firms earning, and finally, increasing discount rate with direct consequences lower stock market valuation. From the graph above, we do see that Indonesia GDP growth start to faltering while inflation pressure accumulating. This data implies possibilities that earning growth in Q4 2010 will not as good as Q3 2010, hence create investor disappoinment.

Return expectation is one of the main input in invesment allocation, if Indonesia firm earning growth slowing, Indonesia stock market return expectation cannot be high, hence global investor may shift their allocation away to other stock market.

Concluding remark, we believe IDX will experience a correction, hopefully fast and deep correction, because first, extraordinary return in the past two year, +86,7% in 2009 and +46,1% in 2010, second, inflation already getting higher and put limit to GDP growth, and third, possibility of global investor to shifting their investment temporarily until valuation getting reasonable again.