Correction could be on way

PUBLISHED : Sunday, 14 November, 2010, 12:00am
UPDATED : Sunday, 14 November, 2010, 12:00am

No one likes a party pooper, so casting doubt on the continuation of the bull run in Hong Kong's and other stock markets is unlikely to receive universal acclaim.

Nevertheless, many people with long experience in equities are sceptical of the sustainability of this bonanza at a time when the general economic situation is so dire. Indeed, the downturn in share prices last week might turn out to be an indication that the market is set for a correction sooner than the bulls expected.

What we have seen in the months since September has been a classic case of money looking for the least worst home. The investor consensus focused on the equity markets as the right destination and share prices have risen, not because people believe in the intrinsic strength of the listed companies, but because they are unimpressed by other forms of investment.

Logic suggests that a market rally fuelled largely by sentiment as opposed to fundamentals is inherently unstable. Yet there is no telling how long sentiment can prevail over logic.

In Hong Kong, shares have risen in a more or less continuous manner by around 20 per cent since the beginning of September until last week, when the gains slipped backed to around 13 per cent. And as chart 1 shows, this rise more or less exactly mirrors the ascent of the Dow Jones Industrial Average.

These two markets have traditionally moved in tandem, not least because of the fixed link between the Hong Kong and US dollars. The chart also shows that over a five-year period, the correlation has grown stronger and, as ever, the lead was taken in the United States, with Hong Kong playing rapid catch-up.

Therefore it is illogical to believe somehow Hong Kong will depart from this trend even though economic fundamentals in the SAR are markedly better than in the US.

History shows us the only time there is a major departure from this trend is when, as happened during the Asian economic crisis, Hong Kong's shares fall sharply while American shares proceed in an orderly procession. It rarely happens the other way round.

Again, there is a logical explanation for this in as much as Hong Kong is an open market, heavily reliant on international as opposed to domestic trading while the US market is essentially driven by domestic investors.

Although bullish sentiment abounds on Wall Street at present, many of the more shrewd market observers are saying this bull run cannot last once the temporary blip in corporate profitability ends. In other words, when companies are no longer rebounding from unusual lows caused by the recession.

With the impact of the recession out of the way, the next round of corporate reporting will begin from a higher base. There is a contrary view here, which focuses on the performance of financials, where earnings gains are strong and should have a profound impact on share prices as a whole. At the end of the day, it is always profitability that matters; bull runs cannot be sustained on sentiment alone.

Bill Hester, an analyst at Hussman Econometrics Advisors, has looked at share prices and their correlation with economic recoveries since 1955 and shown that in the past nine rebounds, the crucial price-earnings ratio (which measures share prices relative to corporate earnings) left US share prices on an average of 16 times their earnings on the Standard & Poors 500 Index.

Historically in the US, a price-earnings ratio of 13.5 times has been regarded as the point at which shares represent fair value. The DJIA is currently trading at over 14 times, slightly above this level but not necessarily comfortably.

This more demanding valuation of shares could only be justified if indications from the real economy were more favourable, but they are not. Inflation-adjusted growth is falling, sales to end-users are down and consumer spending won't pick up.

In Hong Kong, shares are trading at a price-earnings ratio of around 15. Chart 2 shows this level is well below the uncomfortable highs reached in the later part of 2007, when local share prices took a major holiday from reality, trading at a price-earnings ratio of around 25 times. We are now slightly above the normal price earnings ratio, which in Hong Kong has traditionally been higher than that of the US, but only marginally so.

More worryingly for those concerned about getting a reasonable return on their investment without selling shares, the yield on local stocks is now very low indeed. It stands at just over 2 per cent, which is way below the long-term average.

This may be because companies are increasingly cautious in their dividend policies, but also suggests that the caution might be justified because company directors are reluctant to distribute profits in an environment where future profits are likely to fall.

Having said all this, it needs to be pointed out the Hong Kong stock market is broadly in line with other major markets around the world; even Japan has fallen into line

Therefore there is no case for suggesting the Hong Kong market's rise in the past few months is cause for special attention. On the contrary, the current sentiment surrounding equity investment appears to be universal. The investment herd is still looking for a better home for its cash.

Where Hong Kong is maybe different - and this should be the major argument for market bulls - is that the local bourse is increasingly dominated by mainland corporations operating in a buoyant economy where profitability remains sound.

The mainland's continued economic growth, surging into double digits, is the subject of daily commentary, but does anyone seriously believe that growth of this kind is sustainable forever?

Indeed, does history not show us that every single major expansion is likely to be followed by a sharp reversal? Who can make a reasonable case that China will somehow escape this iron rule of economic development?

As ever, investors are interested in the macro picture, but wisely remain focused on their own holdings and it is here that prudence should take hold.

If, as a consequence of being in the equity market, individual investors are considering whether they should take profits or wait for a better return, they need to act.

Those who have set realistic targets for profit should not be bothered about whether someone else ends up making a bit more because, the fact is, a share sold is a profit locked in whereas paper gains on shares mean nothing and when things turn the other way, the rush for the exit is always more crowded than the rush for the entry.