I recall talking to a friend of mine during the 2008 turmoil, and we simply asked ourselves, “where is the bottom?” with me adamant that Hang Seng Index FV was around 15 000 – 17 000 at the worst of times, and that any falls below that representing a buying opportunity. I didn’t think this was the bottom, mind you, but that reasonably one might expect the bottom to occur at about 80% of fair value and that valuations will be hard pressed to fall further, and yielding a 25-40% trading opportunity. So, now, I am trying to cast the current market turmoil in the same light: what, and where, is FV, and how do we trade off it?
This is a discussion solely based on index P/E. If you look at the HSI, it’s at the time of writing 9.3. 9.3! S&P 500 is looking at 12.3 P/E, meaning a 32% premium, and then the S&P figure is bouncing around where it was at March ‘09! Sure, the HSI should be at a discount in bad times for the extra risk, and a premium in good times for the extra earnings, and although the market is over-reacting, things are far from looking good. 30% or more however is insane, which – mind you – doesn’t say we have hit bottom. I’ll go over the numbers a little bit on where this puts the earnings risk later when I have been bothered to mine the data. First, the forecasts:
I fundamentally believe that the HSI P/E should be around 12-12.5 (and S&P at around 14). This would mean an index valuation of 25 000 – 26 100, which is close to the 2010 top (although earnings by then were worse). So, lets say that the “safety premium” is 20% of future earnings and that this is gone. I don’t discount further because of monetary ease which will pull down the dollar, and make other currencies that HK brings in from trade relatively more expensive. So, say for round numbers sake, 10 PE. That’s a HSI at 20 850, which was incidentally where the index was brought down to during the first round of the market turmoil this time around. Lets say we can get a further 20-25% off from speculation (see argument above) and temporary earnings dips. 7.5 (current) P/E: 15 650 HSI, 8 P/E: 16 700 HSI.
*Drumroll* tada! Draw it out on the three year frame, click “Chart options > Enable Tracking”, find these levels, and see for yourselves what the technical situation looks like.
15 650 is a hair shy of what the top in January ‘09 posted, where it was also the level for the last correction in the 2008 down move, and the first correction in the 2009 up move! The upper range at 16 700 is so full with similar technicals from the period that you should take a look for yourself.
Do I feasibly believe that speculation can pull the market down to these levels? Well, where are we now? 2% above 19 000 for a few days. Check May ‘09 top and May ‘10 (actually, all of 2010) bottom. 19 000 is a perfect, linear support/resistance line, confirmed by the market action this month! With the pressure of selling available, who would want to go long, even at these levels? Since I don’t see any particular respite on the fundamental front on a global trade-partner basis, the lower range discussed might be where the market will at least pause and try to catch its breath, but the ride there will be gut-wrenching and volatility-filled. Thankfully, those market conditions don’t tend to last ever too long. The Chinese promises of further integration and financial centre emphasis will likely assist the HK market in supporting it on these lower levels, or fuel the rebound to the upper levels of the P/E valuation trade within a 6-12 month time frame, but unlikely do much in the medium term. It is also what, in my view, has prevented the market from already falling to the lower levels discussed.
I stick to my idea that fair value should be at 10 P/E with the “safety premium” gone. I will delve deeper into what exact assumptions I make and what exactly it says about perceived risks in the Hong Kong market in another post, but at the moment that gives a 20 900 HSI, and say for a range then that worst-case FV is 20 000 – 22 000, fundamental perceived support (market reacting positively to Obama September 5th speech, Europe getting a personality change and integrating further, anyone printing more money) could send the market to 25 000 – 26 100 range, and relief/overvaluation rallies could take the index towards unsustainable levels of 28 000 – 30 000 over the slightly longer term (9-18 months). Market bottom is seen at around 17 200 – 15 600, at which levels I will likely – finally – be indiscriminately bullish.