Bullish mood precursor of 'interesting times'

The bulls are back. Led by Alan Butler-Henderson, Asian strategy director for Barings Securities, they are saying that the Hong Kong stock market is set for significant gains before the end of the year.

The market is some 38 per cent higher than at its lowest point in the year and 18 per cent up on the year. A couple of weeks ago there was great excitement as the key indicator, the Hang Seng Index, broke through the psychologically important 10,000-point barrier.

Mr Butler-Henderson, the most bullish of the bulls was talking about the Hang Seng Index soaring away to 12,000 points before the year end. This was brave talk, as became clear within days of the rise above 10,000 - it is now down to 9,680 points and falling.

Sentiment cannot have been helped by some recent number-crunching from the stockbrokers Salomon Brothers. This showed that, based on the latest interim company results, Hong Kong companies offered the lowest earnings growth in the region.

Earnings per share (EPS) rose in Hong Kong by a meagre average of 8 per cent, compared with the best performing country, South Korea, where the average interim EPS rise was 76 per cent. Indonesia turned in average EPS growth exceeding 40 per cent and the Philippines was up more than 30 per cent.

Moreover, according to Salomon Brothers, Hong Kong is likely to have the lowest prospective EPS growth for the region. It is forecasting a modest 11 per cent rise for this year, which is somewhat low compared with other estimates but not wildly out of line.

Halfway through the year, The Estimates Directory, which publishes averages of all brokers' forecasts, concluded that the consensus estimate for average corporate earnings growth in 1995 was 15 per cent, falling to 13 per cent for 1996. This compares with an average earnings growth just exceeding 13 per cent last year, which is well below previous years.

Behind the uninspiring earnings figures lies an economic slowdown, which is not reflected in official forecasts that have the Hong Kong economy growing by some 5 per cent this year.

The reality is that the growth statistics are artificially boosted by an unusually high level of inventories. If the value of these were stripped out, the economy would be in recession.

The impression of gloom is most prevalent in the property market and this is mirrored in the stock market, which, at its core, is simply a reflection of the property market. Some 40 per cent of the market's capitalisation is accounted for by property, but that understates the extent to which non-property sector shares are dependent on property earnings and have an asset base heavily biased towards property holdings, or, in the case of banks, heavily weighted by property loan portfolios.

The Hong Kong property bubble is slowly deflating. Depending on which estimates are to be believed, the market as a whole is down by 20 to 30 per cent in the space of a couple of years.

On the one hand this releases some funds for share investment, as punters are disinclined to put their money in property. On the other it means that earnings and asset values of companies are heading for even more substantial falls as the effect of the property downturn works its way on to the balance sheet. Yet little of this gloom is penetrating the minds of the pundits who eagerly await the fall of United States interest rates and assume that this will give a boost to the market.

As matters stand the current rating of the market, on a prospective basis, averages between 11 and 12 times earnings. In really bullish times, such as 1986, the market was on an average price/earnings (p/e) ratio of over 19 times. After the 1987 crash the average p/e fell to around 12 times. In 1990, 1991 and 1992 it hovered cautiously around 13 times, surging in 1993 to averages above 20 times, bumping back to around 11 times last year.

It is not necessary to make a fetish of price/earnings ratios to realise that they have something to say about how investors see the market. The recent rises in share prices have pushed average p/es up to a point where the 1993 boom started. However, the 1993 bull run was accompanied by strong earnings growth and low interest rates.

It is also worth noting that average p/es for blue chips are now higher than for the index as a whole, whereas in 1993 the blue chips were rated lower than the market as a whole. This suggests that the more frothy days of speculation have receded, with investors concentrating on shares seen as being more steady.

With a slump in earnings growth and interest rates remaining high, it is hard to understand why there is so much optimism around. However, this is a market driven by liquidity or, to put it more crudely, by the volume of spare cash looking for a home.

In this respect it is useful to look at just how little of that cash is being attracted to the Hong Kong stock market. Most market analysts focus on the value of transactions passing through the stock exchange when they discuss market turnover. However, the more telling statistic is the volume of shares traded.

The stock exchange has recently released figures which show that the Hong Kong market's turnover is falling as the number of listings rises. By mid-year the ratio of the average volume of shares traded to the number of shares issued had fallen to 34.7 per cent, this compares to a five- year high of 77 per cent in 1993, falling to just under 75 per cent last year, and ratios of 60 per cent or more at the beginning of the decade.

In other words the volume of shares traded is falling sharply, even though the capitalisation of the market is rising. This is not necessarily bad news for investors. Thinly traded markets can produce good returns but they tend to be more volatile and more easily swayed by a small band of determined players taking a position in the market.

Thus the conditions exist for the return of what the Chinese call "interesting times", a term rarely used for good news.