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Tom Holland

It's 'risk off' time again in the financial markets.
As traders and investors bail out of anything seen as remotely risky and head for the perceived safety of US Treasury bonds, Asian stocks, currencies and commodity markets are all plunging in unison.
Hong Kong's Hang Seng stock index is no exception. Yesterday it fell by a painful 4.85 per cent, taking the market back down to levels last seen in July 2009, when investors were still reeling from the collapse of Lehman Brothers the year before.
After such a heavy fall, bolder spirits will be wondering whether Hong Kong stocks now offer a juicy buying opportunity.
Putting a value on the market can be tricky, however. Two of investors' favourite valuation measures - the price to earnings ratio and the dividend yield - are showing conflicting signals.
But in any case, both measures are flawed.
On a price-earnings ratio of less than 10, the Hong Kong market may look like a screaming bargain. 
But although price-earnings ratios are widely followed, the volatility of company earnings through the economic cycle mean they can be a poor indicator of long-term value.
As a result, canny investors from Benjamin Graham - who pretty much invented stock analysis - onwards have recommended looking at earnings over longer time periods, not just the most recent year.
Graham himself recommended looking at average earnings over a five to ten year time horizon.
In Hong Kong, the earnings cycle - adjusted for the impact of inflation - typically lasts around seven years. So taking all the historical data I have, I've calculated a cyclically-adjusted price-earnings, or Cape, ratio for the Hang Seng index based on a seven-year moving average of earnings. You can see the results stretching back to the beginning of 1980 in the first chart. 
After yesterday's decline, the Hang Seng was valued at a Cape of 13.7. As the chart shows, that's certainly cheap, given that the market's long term average Cape since 1980 is 21.
But there have been episodes when the market has been considerably cheaper. In the depths of the Asian crisis in 1998 the Hang Seng's Cape fell to 11.4. During the 2003 Sars outbreak, it dropped to just 10.6. And in the stock slump of the early 1980s it fell as low as 10.4.
But longer term investors shouldn't be too discouraged by the thought that the market could fall further in the near term.
A look at index returns since 1980 shows that anyone brave enough to buy when the Hang Seng's Cape was as cheap as it is now or even cheaper would have been well rewarded for their courage.
On average, over the following thee and a half years - half an earnings cycle - they would have made a capital gain of 97 per cent.
Similarly, to get a clearer picture of valuation we also need to tinker with the dividend yield.
Generally, the higher the Hang Seng's dividend yield, the cheaper the market. On that basis, on a yield of 3.8 per cent at the moment, the market doesn't look especially cheap, given that the yield topped five per cent in both 1998 and 2009. But we can't look at the dividend yield in isolation. After all, the yield on the Hang Seng may not be particularly high right now, but with interest rates almost at zero, yields on everything else are low too. That's why investors have been rushing into non-yielding assets like gold.
So to get a better idea of the stock market's value, we need to compare its dividend yield with the return on other assets.
The second chart shows the dividend yield on the Hang Seng index in the form of a spread to the yield on 10 year US Treasury notes.
Usually, the yield on stocks is lower than that on bonds, so the spread is negative. But with the ten year Treasury note yielding just 1.8 per cent, right now the Hang Seng is yielding fully two percentage points more than Treasuries.
As the chart shows, the Hang Seng has only been this cheap once before since 1973, and that was in the depths of the 2008 financial crisis. Over the following two years it rebounded by 126 per cent.
The only other time the dividend yield spread came anything close to its current level was after Hong Kong's 1973 stock market crash. Then the market also went on to double over the next two years.
There is nothing to guarantee a rebound of the same magnitude this time around of course, but if you are plucking up the courage to buy into the stock market now, you can comfort yourself with the thought that history is definitely on your side.



If you're brave enough to buy stocks, history is on your side