HSBC - Equity Insights -How Bad Could It Get

12 August 2011Equity Strategy Global abc Global Research Equity Insights How bad could it get?  Some valuations are at levels not seen since the early 1980s  But the market turmoil raises the risk of recession …  … which means that analysts probably need to cut forecasts further and that sentiment will stay fragile for a while Markets have gone into freefall in the past week or so. The global index is down by 16% since August 1 and by 19% since it peaked in late April (Chart 1). That is not quite in the official bear market territory yet – but note that some European markets (particularly Germany down 25% and Italy down 24% this month) are (Chart 2). What should investors do now? Given the damage to sentiment in the past few weeks, it is hard to see markets rebounding healthily straight away. The risk that the market turmoil tips the world into a new recession and causes earnings to turn down sharply has risen. It will be a few months before the smoke clears and it becomes plain how much damage has been done. Analysts have barely adjusted their earnings forecasts yet but historically, in a recession, they tend to cut them by around 30-40%. However, valuations have become very cheap with the PB (never mind prospective PE) for Europe, for example, down to 1.1x, a level it hasn’t seen since the early 1980s. We still look for three conditions before calling for a bounce: (1) cyclical indicators, including earnings, to come down further, (2) risk events (notably European debt) to pass, and (3) capitulation. We are close to getting there with (3) but not yet for (1) and (2). In the meantime, we advise investors to buy stocks with good long-term growth prospects, relatively little short-term earnings risks that have become cheap (see our two notes Stocks to buy in uncertain times for Europe and Asia, published this week). We remain overweight the US (more defensive than Europe) and EM (growth prospects still good). Garry Evans* Strategist The Hongkong and Shanghai Banking Corporation Limited +852 2996 6916 [email protected] View HSBC Global Research at: http://www.research.hsbc.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to NYSE and/or NASD regulations Issuer of The Hongkong and Shanghai report: Banking Corporation Limited 1. Global and EM index performance, past 12m 130 ACWI 120 110 100 90 Jul-10 Source: HSBC 2. Main market performance since Aug 1 Japan India Sw itzerland Taiw an Canada Mex ico China Australia US UK Brazil Korea Spain France Russia Italy Germany GEM Disclaimer & Disclosures This report must be read with the disclosures and the analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it Oct-10 Jan-11 Apr-11 Jul-11 -25% -20% -15% -10% -5% 0% Source: HSBC To vote for HSBC in Asiamoney 2011 – http://www.asiamoney.com/polls 420 1.792 7.821 28.7 1. countries shown have a minimum weight of 0.007 3.500 71.7 0.131 2.200 10.199 51.395 32.0 0.600 34.613 4.000 39. Thomson Financial Datastream 2 .121 12.000 1.500 10.659 1.0 0.0 -1.5 -0.0 0.154 910 777 4.2 0.6 -4.784 17.538 2.0 -2.3 -0.Equity Strategy Global 12 August 2011 abc HSBC strategy recommendations Global market calls (benchmark: MSCI AC World Index.0 n\a -0.000 1.0 0.806 7.5%) Market ______ HSBC call ________ HSBC recommended current Americas US Canada Brazil Mexico Europe UK France Germany Switzerland Spain Italy Netherlands Sweden Russia Eurozone Pan-Europe Asia Pacific Japan Australia China Korea Taiwan Hong Kong India Singapore Other South Africa World (USD terms) Developed world Emerging world All-countries world Over Neutral Neutral Under Neutral Under Neutral Under Under Under Under Under Over Under Under Under Over Over Neutral Over Neutral Neutral Over Neutral Under Over (last quarter) (Over) (Under) (Over) (Under) (Neutral) (Under) (Neutral) (Under) (Neutral) (Neutral) (Under) (Over) (Neutral) (Under) (Under) (Under) (Neutral) (Over) (Under) (Over) (Neutral) (Neutral) (Under) (Over) (Under) (Over) active weight (% pts) 2.000 26.6 2.0 0.075 3.500 350 1.000 6.130 981 291 Target end-2011 level 1.0 0.300 4.130 2.700 20.000 6.7 n\a -3.5 -0.0 3.141 57 1.8 0.003 5.0 1.0 3.430 14.5 0.6 -5.0 -6.7 -0.0 -3.5 0.000 3.200 78 2.7 Industry preference Oil & Gas Mining Capital Goods Luxury Goods Food Retail Heath Care Equipment & Services Diversified Financials Tech Hardware & Equipment Mobile Telecoms Water Utilities Source: HSBC.000 20.2 0.150 870 5.219 5.0 S&P 500 S&P/TSX Bovespa Bolsa FTSE 100 CAC 40 DAX 30 SMI IBEX 35 FTSE MIB AEX OMX RTS EUROSTOXX 50 FTSE Eurofirst 300 TOPIX S&P/ASX 200 MSCI China KOSPI TAIEX Hang Seng SENSEX STI JSE All-Share MSCI DM MSCI EM MSCI AC Blue-chip index current level 1.100 8.8 0.966 14.0 6.6 -3.736 19.270 365 % from change 28% 19% 38% 21% 26% 37% 43% 36% 34% 40% 26% 25% 35% 39% 26% 12% 26% 37% 22% 29% 31% 17% 28% 19% 26% 29% 26% Source: HSBC. Thomson Financial Datastream Global sector calls (benchmark: MSCI AC World Index) Sector Energy Materials Industrials Consumer Discretionary Consumer Staples Health Care Financials IT Telecom Services Utilities _____________ HSBC call______________ current (last quarter) Neutral Over Neutral Neutral Under Under Neutral Over Over Under (Neutral) (Neutral) (Neutral) (Under) (Under) (Under) (Over) (Over) (Over) (Under) HSBC recommended active weight (% pts) 0.676 277 905 1.9 -1. IBES 5. Asia ex Japan is similar – 13% this year and 14% next. In emerging markets (Chart 5). Consensus EPS forecast: Europe ex UK 200 180 160 140 120 100 80 Jan-09 May-09 Sep-09 Jan-10 2010 Jan-09 Sep-09 Jan-10 May-09 May-10 May-10 2010 2011 Source: HSBC. Reuters Thompson Datastream. IBES 4. Reuters Thompson Datastream. analysts continue to see earnings growth as robust. The problem is that we are unlikely to get a conclusive answer on this for a few more months. in the Q2 earnings season. the consensus continues to look for 17% growth this year and 15% next. So we need to consider the worst case scenario for earnings in the event the global economy does enter a new recession. This year’s growth is now forecast to be only 5%. 3 . In the US (Chart 3). The consensus has cut the 2011 forecast by 6% over the past three months and. Europe (Chart 4) looks less healthy.Equity Strategy Global 12 August 2011 abc How wrong can the consensus be? With the lead indicators – such as the US manufacturing ISM – falling but still pointing to growth. analysts have not really cut forecasts at all: the 2011 forecast is just 2% of its peak from May and the 2012 forecast just 1% off. Analysts have barely pared back their earnings forecasts yet. In GEMS. thanks to a strong Q2 earnings season (with 71% of companies beating forecasts). Reuters Thompson Datastream. the jury remains out on whether this is a soft-patch in economic activity or the start of a new recession. Consensus EPS forecast: Emerging markets 140 120 100 80 60 40 20 0 2011 Sep-10 Source: HSBC. compared to 14% back in January. 3. with 14% growth forecast for both this year and next. IBES We can stress-test for a possible recession scenario by looking at how wrong consensus forecasts have been going into previous recessions. Consensus EPS forecast: US 120 110 100 90 80 70 60 50 40 Jan-09 Sep-09 May-09 2010 Jan-10 May-10 2011 Sep-10 Jan-11 2012 Sep-10 Jan-11 Jan-11 2012 May-11 2012 May-11 May-11 Source: HSBC. the beats:misses ratio so far (with about three-quarters of companies having reported) is as low as 43:48. analysts have been 9% too optimistic. As of Wednesday this week. Analysts’ earnings forecast accuracy. with analysts at the worse point over-estimating by 37% in the US.7x. Analysts were most accurate with their forecasts in emerging markets (although. unsurprisingly. since the MSCI indexes began in 1988. 2001 and 2008). Reuters Thompson Datastream. for instance. 43% in Europe and 47% in Asia ex Japan. therefore. But they also chronically over-estimated earnings in the expansion of 1993-9 – although in other expansions such as 2003-7 and the past two years. then the likely miss to current earnings forecasts would be about 30-40%. In both the US and Europe. IBES 20% 10% 0% -10% -20% -30% -40% -50% 88 90 92 94 96 98 00 02 04 06 08 10 Source: HSBC. The 2007-9 recession was worse than that. The degree of excess optimism varies from country to country (Chart 7). only for three months in October-December 2008 (Chart 8). How cheap can markets get? We have been arguing for some time that equity markets look very cheap and that.Equity Strategy Global 12 August 2011 abc Chart 6 shows the difference between actual earnings and the consensus forecast 12 months earlier. the over-estimation averages about 7% over time. Mostly their forecasts were too high because they missed recessions (the biggest misses were in 1990. On average. to a degree at least. If we assume that a recession next year would be more like a normal recession (given that we are starting from a much lower level of activity than 2007). analysts tend to be about 30-40% too optimistic for the year ahead in the US and Europe and rather more than that in Japan and emerging markets. Analysts’ earnings forecast accuracy – All Country World 7. the structural worries about the global economy were. priced in. the 12-month forward PE for the All Country World Index reached 9. by region 0% -5% -10% -15% -20% -25% -30% ACW US Europe Asia ex Japan Japan Dev EM Source: HSBC. It has been cheaper than this. 4 . their forecasts were too cautious. the volatility here is greater) and most over-optimistic in Japan. for the period since 1988 for which we have data. 6. Reuters Thompson Datastream. IBES What does this say about recessions? In normal recessions. as argued above. 1974-1984 (when it averaged only 9. Currently.4x. this was not priced in. be very wrong. Japanese valuations remained sky-high: the prospective PE in 1994-5 averaged 55x and did not drop below 20x until 2002 (Chart 9). P/trailing E might not help very much. how cheap would markets look? There are two alternatives measures we could look at: price-to-historic earnings (for which we have data going back to 1870) and price/book (data from 1975). If we assume that Of course. But price/book is often a useful guide to valuation bottoms in earnings recessions. While there may be similarities in the way that bond yields fell or growth proved to be anaemic. compared to a long-run average of 14. book value declined from peak to trough by only 25%-30% in big markets (in a more normal recession. 10. IBES earnings could fall. Even during the Great Depression 1930-9. Reuters Thompson Datastream. the big difference is that. S&P500 1870-2011 (with average & std devs) MSCI AC WORLD As an aside. There are two objections that can be made to using the forward PE since 1988: (1) it relies on analysts’ forecasts which might. the US is on 12.1x trailing earnings.5x). Reuters Thompson Datastream. IBES We clearly need to test current world and US valuations further. Chart 10 shows PE (using trailing earnings) for the S&P500 going back to 1870 (using Robert Shiller’s data for the period prior to the 1980s). Trailing PE. four or five years after its bubble burst. 1940-54). Even in the big recession of 2007-9. PE averaged around 17x. Prospective PE for All Country World Index (with average) 30 25 20 15 10 5 0 88 90 92 94 96 98 00 02 04 06 08 10 Source: HSBC. the decline is around 15-25%). Japan (with average) 30 25 20 80 70 60 50 40 30 20 10 0 88 90 92 94 96 98 00 02 04 06 08 10 MSCI JAPAN - 15 10 5 0 1870 1890 1910 1930 1950 1970 1990 2010 Source: HSBC. It has been cheaper than now only in late 2008-early 2009. Robert Shiller Source: HSBC. if earnings disappoint by as much as we suggested above that they might. 9. Forward PE. one argument worth dismissing at this point is how similar the US looks now to Japan in the mid 1990s. and (2) the world was in a secular bull market for much of the period since the mid-1980s. and that we need to go back further than 1988 for comparison. In the mid-1990s.Equity Strategy Global 12 August 2011 abc 8. 5 . in Japan. Both show that valuations are not quite as cheap as they were in the 1974-1984 period but that they are still very low by historical standards. and during and for a period after wars (1915-26. In the 1975-1985 period. ROE averaged 10% during that period. In the 1975-1985 period. it averaged only 0. We don’t have the data for the 1970s readily to hand. Currently. there may be times (such as now. is the cyclically-adjusted PE (CAPE – also sometimes called the Shiller PE). Is it logical to value the current level of the market off earnings that collapsed? We would prefer to use a trend-adjusted PE (TAPE) and. It has been cheaper than this for one month in early 2009 but. 6 . 11. therefore. not since 1984.33x (but.5x. that ROE for European companies this year is forecast to be 14%.8x (Chart 12). as we have often argued) where earnings can grow above trend for a while. It is on 14. only a little below the long-run average of 15. in fact. since the current level of earnings for the US at roughly at its historical trend.65x. the current level of the US market does not look that cheap. driven by sales to emerging markets and with costs under control. is nothing more that the current price divided by the 10-year average of earnings (usually adjusted for inflation). That takes it back (with a two-month exception in early 2009) to the level of 1985. Second. but we would bet ROE then was significantly lower. Price/book ratio: US and Europe ex UK 12. then again. While that is usually true. US earnings.74x. First. By the CAPE. (It is worth remembering. but which we find of limited value. This sounds sophisticated but. though.) The US does not look quite so cheap on a PB basis. with log trend 7 6 5 4 3 2 1 0 75 78 81 84 87 90 93 96 99 02 05 08 11 Source: HSBC. against 16% over the next 12 months). 13. Reuters Thompson Datastream. IBES One valuation measure that bearish investors often use. Cyclically adjusted PE (with average & std devs) 40 35 30 25 20 15 10 5 0 1880 1900 1920 1940 1960 1980 2000 Source: HSBC. IBES 120 US US 100 80 60 EUR ex UK 40 20 0 88 90 92 94 96 98 00 02 04 06 08 10 Source: HSBC. with a PB currently of 1. US PB averaged 1.Equity Strategy Global 12 August 2011 abc Chart 11 shows price/book for the US and Europe ex UK going back to 1975 (and. Reuters Thompson Datastream. before then. however. Robert Shiller There are a number of problems with the CAPE. Europe ex UK is on a PB of 1.10x. capturing the historically low valuations of the 1970s and early 1980s). this is almost identical to the historical PE. the 10 years of historical data includes the big earnings drop of 2008-9 (Chart 13). the assumption behind the CAPE is that earnings are always mean reverting. by the NBER’s official definition. are at such depressed levels. But that means it is still indicating expansion. This would make it the third shortest expansion since 1930 (and probably really the second shortest since many view the 1980-1 expansion. published in early July. But we will need to watch the data carefully over the coming months for signs that growth expectations continue to fall. and investor capitulation to set in. having fallen from a peak of 61. while this one has so far gone on for only five. How much will the events of the past few weeks affect consumer and corporate sentiment and spending decisions? That is very hard to judge. autos and houses (Charts 15 and 16). Second. for example. How big is the risk of a US recession? Obviously that is our economists’ call. US manufacturing ISM and US recessions 70 65 60 55 50 45 40 35 30 50 60 70 80 Recessions Source: HSBC.9. It is currently at 50. having lasted only 26 months. this expansion is still very short by historical standards. the US manufacturing ISM – which we regard as the best single indicator of the cycle – almost certainly will fall further. the level of activity in the US remains at a very subdued level. As we have argued previously. we have argued that there were three conditions that needed to be fulfilled for markets to bottom:. without it signalling a recession (when it would typically drop to 40 or below). HSBC’s economists have not slashed their growth forecasts (they still look for 2. Where do we now stand on the others? 14. as a mis-dating by the NBER). in 1985.Equity Strategy Global 12 August 2011 abc So where from here? Since our Q3 Quarterly. for example. We have dealt with analysts’ forecasts above. 7 . that lasted only 12 months. the economy is partly driven by psychology. But we would make a couple of observations. as typically happens in a full-blown recession. Mid-cycle dips often take the ISM below 50 (see Chart 14) as. the midcycle dip in the ISM typically lasts nine months.5% GDP growth for the US and 3. Bloomberg 90 00 ISM 10 Cyclical indicators In the end. 1998 without necessarily signalling a recession. 1996. that it is hard to imagine them falling sharply from here.4 in February. For the moment. It is quite possible for the ISM to fall further. risk events to pass.4% for the world in 2012 – far from recession conditions). The two largest consumer purchases. Not least. cyclical indicators to dip further (including analysts cutting their earnings forecasts). First. and 3) the VIX index of S&P500 implied volatility.Equity Strategy Global 12 August 2011 abc 15. Source: HSBC. 2005. perhaps not soon. however cheap they have got. But. 8 . SAAR (mn vehicles) 25 20 15 10 5 0 70 75 80 85 90 95 00 05 10 We would see the US’s squabbles over the debt ceiling as less of a problem. until they do. Moreover. the US dollar’s position as the world’s FX reserve currency means the problem is much less urgent. Bloomberg 16. there need to be moves towards greater fiscal unity (see Fixing the eurozone 8 August by HSBC’s chief economist. we introduced an HSBC investor sentiment index. The summit also failed to make any proposals for Ireland and Portugal. We would like to think that markets will push policymakers to take more decisive action. or to increase the European Financial Stability Fund (EFSF) to a size sufficient to allow it to see off speculative moves against Italy and Spain. by around 20% was considered by the market as plainly insufficient. Bloomberg Capitulation Perhaps the one box we can tick is investor capitulation. The European Central Bank’s subsequent stubborn refusal to carry out full-hearted credit easing and liquidity injection (in contrast to the position of the Fed) has exacerbated the situation. The ECB needs to be more accommodative. both during recessions (2003 and 2009) and intra-cycle (1998. In our view. US new housing starts (‘000 units SAAR)) 3000 2500 2000 1500 1000 500 0 60 65 70 75 80 85 90 95 00 05 10 Source: HSBC. Are these problems going to go away? In Europe. we would argue that the recent dramatic sell-off was triggered by the failure of the EU summit at the end of July to tackle the European sovereign debt issue properly. as in 2007. US auto sales. in effect. The proposal to cut Greece’s debt. 2) the put/call ratio for equity options on the Chicago Board Options Exchange. although it did – perhaps forgivably – send too early a buy signal in 2002 and 2008 (Chart 17). Stephen King). The signal at market tops is rather more complicated: sentiment seems to wane before stocks peak. 2010). The debt situation for the three peripheral eurozone members has not been solved. we continue to be cautious on European stocks (where we remain underweight). Risk events In many ways. The index has given useful buy signals at most market bottoms. at least there was a decision and some sort of medium-term plan to cut the deficit – along with a supportive central bank. which combines the one-month moving average of 1) the American Association of Individual Investors’ (AAII) weekly survey. While these were a reminder of how dysfunctional US politics has become (and the negotiations over coming months on the details of spending cuts are also likely to be unedifying). In our last Quarterly. up from 27% the previous week.5 -1. HSBC investor sentiment index 1. Remember. 9 . but not to the level of a big cyclical bottom such as 2009 or 2003.6 6.0 -0. Thompson Reuters Datastream S&P 500 (log.0 -3. with 33% of retail investors expecting stocks to rise over the next six months.0 Sentiment index Source: HSBC.4 6.5 -2.5 1. that since we use a one month moving average to smooth out volatility.2 6. or a fullblown recession. showed a surprising rebound in the latest weekly numbers.2 7. RHS) Currently.4 7. however. The VIX (which reached 48 this week) and the put/call ratio (which got over 1x) are at very bearish levels.Equity Strategy Global 12 August 2011 abc 17. at least in the near-term. Perhaps some investors believe the market now represents good value – or maybe the survey just lags a little.5 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 7.0 0.0 -2. whether capitulation has truly set in depends – like many of the other factors we have highlighted in this note – on whether you believe this is just a (particularly nasty) mid-cycle correction.8 6. The AAII survey. the numbers are a little slow to react.0 -1. So.0 6. The problem is that we are unlikely to get a conclusive answer on this key question.5 0.5 -3. sentiment has collapsed to the level of intra-cycle correction bottoms such as mid-2010 or 1998. too. and (2) from time to time to identify short-term investment opportunities that are derived from fundamental. Investors should carefully read the definitions of the ratings used in each research report. In order to avoid misleadingly frequent changes in rating. *A stock will be classified as volatile if its historical volatility has exceeded 40%.to 3-month horizon and which may differ from our long-term investment rating. Notwithstanding this. As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at www. The performance horizon is 12 months. expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change. However. Stocks between these bands are classified as Neutral. technical or event-driven techniques on a 0. Historical volatility is defined as the past month's average of the daily 365-day moving average volatilities. as appropriate. Our ratings are re-calibrated against these bands at the time of any 'material change' (initiation of coverage. quantitative. and although ratings are subject to ongoing management review. risk tolerance and other considerations. and/or strategist(s) who is(are) primarily responsible for this report. Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations. volatility has to move 2. HSBC has assigned ratings for its long-term investment opportunities as described below. however. economist(s). Rating definitions for long-term investment opportunities Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis: For each stock we set a required rate of return calculated from the cost of equity for that stock’s domestic or.Equity Strategy Global 12 August 2011 abc Disclosure appendix Analyst Certification The following analyst(s). HSBC believes an investor's decision to buy or sell a stock should depend on individual circumstances such as the investor's existing holdings and other considerations. For a stock to be classified as Underweight. 10 .5ppt past the 40% benchmark in either direction for a stock's status to change. HSBC has two principal aims in its equity research: (1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12-month horizon. ratings should not be used or relied on in isolation as investment advice. certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) and/or any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was. In any case. In addition. is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report: Garry Evans Important disclosures Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions.hsbcnet. Given these differences. regional market established by our strategy team. because research reports contain more complete information concerning the analysts' views.com/research. Details of these short-term investment opportunities can be found under the Reports section of this website. investors should carefully read the entire research report and should not infer its contents from the rating. stocks which we do not consider volatile may in fact also behave in such a way. if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility. The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon. This report addresses only the long-term investment opportunities of the companies referred to in the report. which depend largely on individual circumstances such as the investor's existing holdings. change of volatility status or change in price target). the stock must be expected to underperform its required return by at least 5ppt over the next 12 months (or 10ppt for a stock classified as Volatile*). For a stock to be classified as Overweight. the implied return must exceed the required return by at least 5ppt over the next 12 months (or 10ppt for a stock classified as Volatile*). HSBC's analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBC's Investment Banking business. please see the most recently published report on that company available at www.com/research. economists.* Additional disclosures 1 2 3 This report is dated as at 12 August 2011. 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Stockholm. stored in a retrieval system. directors and employees may have positions in any securities mentioned in this document (or in any related investment) and may from time to time add to or dispose of any such securities (or investment). It may not be further distributed in whole or in part for any purpose. All enquires by recipients in Hong Kong must be directed to your HSBC contact in Hong Kong. hk Asia Garry Evans +852 2996 6916 Steven Sun +852 2822 4298 Vivek Misra +91 80 3001 3699 [email protected] CEEMEA John Lomax +44 20 7992 3712 Wietse Nijenhuis +44 20 7992 3680 john.abc Global Equity Strategy Research Team Global Garry Evans Global Head of Equity Strategy +852 2996 6916 [email protected] wietse.com.lomax@hsbcib. EU and US +44 20 7991 6702 [email protected] .com Europe Robert Parkes +44 20 7991 6716 robert.hk Daniel Grosvenor +852 2996 6592 daniel.hk [email protected]@hsbc.hk [email protected] EU and US Peter Sullivan Head of Equity [email protected]@hsbcib.com.co.com.