Bear markets are all about contraction, as investors take into account the higher risks to earnings due a slowdown or decline in economic activity. The most visible crunch is the decline in the benchmark index. Yet, as I pointed out in last week’s newsletter, the Hang Seng index is still 10% higher than it was a year ago. Worse, according to consensus estimates, earnings for Index constituents show a 10% increase on a collective basis compared to estimates made last year for 2008, while the index’s PER is actually higher than a year ago at 15.7x (vs 15.4x). This situation must, and will, change.
The collective nominal earnings for all 43 Hang Seng Index constituents for 2008 are currently forecast to be HK$765,881 million. That’s a 3.3% increase compared with 2007’s actual income. On a weighted average basis, earnings are actually expected to contract by 1% (mostly due to the 26% decline in earnings expected at heavyweight HSBC). This is the sort of slowdown in earnings one would expect in a weakening economic environment.
However, according to data I have collected from a year ago, the forecast for 2008 earnings was HK$692,368 million. That means that analysts have raised their earnings estimates for 2008 by 10% compared with a year ago. Some of this increase has been due to the rise in profits for resource companies. Remove the five resource companies and the increase in earnings upgrade drops to 7.6%. Still, a near 8% increase in net profit from estimates made a year ago, does not seem to jive with the slowdown in economic growth expectations from a year ago.
Analysts could counter my puzzlement by pointing out that China and Hong Kong’s GDP have both risen by 6-10% in the past 12 months. This justifies the increases in their estimates from a year ago. However, economists should understand that profitability and GDP are not particularly well correlated, particularly because of the lags caused by shipments of goods, their pricing, the input costs used, businesses’ fixed costs and other operating expenses.
Interestingly, over the years, I have noticed that analysts tend to start bringing their profit estimates down before economists cut their GDP estimates, because of analysts’ ability to monitor sales and margins via their contacts with the companies they follow.
Monitoring earnings estimates can provide clues as to which sectors are going to lead the market to its inevitable cycle low, and which sectors should be the leaders on the way back up. In effect, there are four sectors in the Hang Seng Index, accounting for 30 companies, or 70% of the index’s constituents (88% in terms of market value).
Changes in 2008 consensus estimates since June 2007
The table shows the average change in estimates for the four main sectors of the index. The stand out increase in estimates since June last year is (naturally) resources, with a 27% increase. Financial and Utilities are level with an 11% increase, while Hong Kong property stocks have seen no increase in earnings estimates in the past year. In fact, estimates for property stocks and utilities (particularly China telecom stocks) have seen their growth rates pared back quite dramatically over the past year, to such an extent that both sectors are expected to report negative earnings growth in the current year. This makes some sense, because, although local property prices have been rising, this has been chiefly due to a lack of supply, while China’s telecom industry is currently undergoing a major restructuring that will disrupt profitability. The MTR (which I consider a utility) also has lower property completions this year. I suppose the surprise in the table is the strength in financials, particularly against the global background. China’s banks are expected to report strong earnings growth in 2008, partly as they use their newly acquired capital, and because they continue to defy Beijing and write loans at a rapid rate. Their strength more than makes up for flat income at Hong Kong banks (lower fees, higher expenses and provisions), and HSBC’s huge American write-downs.
As you would expect, the price performance of each sector, exactly mirrors the expectations for earnings. If there is an anomaly, it would appear the utilities have outperformed expectations. This premium performance may be due to the perception that utilities offer defensive downside protection. When the rebound comes, utilities will probably under perform.
I have to admit, the price performance of Dore (628.HK – HK$0.45), which has been my only stock recommendation this year due to its strong defensive qualities, has underperformed against a tide of good news. I thought recently that the upcoming listing of Mr. Stanley Ho’s SJM (a direct competitor) had encouraged some switching of funds away from Dore. After all, Capital Research and Management had announced a reduction in their stake in Dore last week. The sale of 10 million shares is small compared with its total holdings of 72 million shares – so this overhang will remain until it is cleared. However, there has been counterbalancing news: 1) Dore is spending another HK$2 billion to increase its stake in the Macau junket business while 2) there appears to be another delay in SJM’s listing. Both these pieces of news should be viewed as price positive, and should lift the stock from its current 12 month low.
At the time of writing, the HS Index was still trying to test its 12 month low. It will probably achieve that milestone this week. One should not underestimate the tales being told by the following two charts (one with a long term horizon, the other more short term).
The first chart plots the percentage of positive monthly returns in the trailing 12 months for the Hang Seng Index. As June is certain to close lower, the percentage will fall to the normal bear market percentage of 45%. As the current bear market is behaving in line with expectations (at least in terms of the 8 months standard duration) it is possible that the depth of the current down cycle will be in line with the 45% norm. Only if there are bear market extension, will the percentage chart move down to the 32% level. The chart would suggest that, from a monthly perspective, the bottom of the cycle is near.
% of positive monthly returns of HS Index (12 months)
The second, shorter-term, chart shows the distribution of turnover at various levels of the Hang Seng Index. What it is saying is that there the Index has been spent very little time in the 21,000 area.
Hang Seng Index price/turnover (HK$b) all time
As such, there doesn’t appear to be any support for the index in the 21,000 area, and a sharp move to the 20,900 neckline seems inevitable.
Part of the reason for the lack of interest in the 21,000 area is due to the fact that the index basically blew past this region in 2007, and spent a small number of days in the 21,000 range when the index hit its year-to-date low in mid-March. That low was triggered by the collapse of Bear Stearns. If the index moves through 21,000 again, it will likely be sparked by liquidation worries as the oil bubble bursts. This may pressure prices into oversold territory, producing the V shaped bottom the index should ideally form.
