Just a fortnight?s correction and market pundits are already questioning whether the last 10 months? stock market rally has run out of steam. Just as the Pacific Rim led world markets out of their slump at the end of 2008, so they are now leading the first true correction since the relief rally took hold last year.
On January 27, Hong Kong?s Hang Seng index became the first main developed market index in the recent cycle to suffer a correction?as defined in technical terms by the fall of more than 10%. It fell 2.4%, extending its losses since its peak in November to 12.6%.
The Greek tragedy is only adding to the global woes. Surprisingly, Greece is now being perceived as a higher risk than most emerging markets. Also, surprisingly, the cost of insuring against sovereign default is now approaching the cost of insuring against high-rated corporate default, which means that the world is at an important tipping point.
Although Indian stocks have fallen of late in sympathy with the rest of the world, I believe they should rebound post-Union budget 2010 (as the withdrawal of stimulus measures turn out to be more muted than most commentators tend to believe) and we could see some smart recovery during March and especially April this year. Globally, stocks should regain their upward momentum by the end of February.
Investors move in herds. As with wildebeest on the Serengeti, most of their movements overtime come during decisive periods when everyone herds together. Serious money is made in markets by spotting when the herd is gathering to make a decisive move. The herd made such a move last March, when markets rebounded from the crisis. It has galloped onwards ever since.
As trailing earnings have plunged and share prices rebounded over the past ten months, we have seen the fastest re-rating of global equities in the past 40 years. Valuations are clearly not looking as attractive as they were ten months ago. But neither do they look yet prohibitively expensive, especially if you believe that companies can achieve anything like a normal EPS recovery. Importantly, valuations coming out of the current earnings recession are cheaper than they were coming out of the last three downturns.
The very fact that unemployment in the US remains stubbornly high means interest rates will continue to be low, which means dollar carry trade will continue and will facilitate further investments in emerging economy stocks.
Chinese appetite
The catalyst for current fall in Hong Kong markets comes from mainland China, where the authorities continue to take incremental steps to tighten lending. Given last year?s growth in Chinese bank loans, which roughly doubled, fears of a credit bubble have arisen and attempts to rein them in make sense.
But the fear among the investing world is that the Chinese will overreact and engineer a recession or that easy money to fight the crisis will soon be a thing of the past, as most central banks begin to move away from quantitative easing.
It is true that it is China?s appetite for other countries? goods that has played a major role in driving the markets? recovery of last year. This is also behind the nascent economic recovery various countries have experienced.
China?s imports have hit a fresh record in December, slightly exceeding their peak from the summer of 2008. Chinese exports have also risen strongly and are now only 4.4% below their peak.
Then, why is China?s recovery triggering a correction in world markets?
The best explanation is that markets are no longer sure that China?s recovery is a ?good thing?. China?s exports may be crowding out competitors. Note that German and Japanese exports are still far below their peaks. Thus, it is not a reflationary force at all.
Meanwhile, its imports are largely of raw materials and basic manufactured goods. That is good for the industrialised economies that serve China (like Taiwan) and commodity exporters (like Brazil). But arguably it is too good, as both these countries have tried to limit inflows of cash.
Growth from China is far preferable to contraction. But now that Chinese buying has recovered just as many had hoped, it does appear that markets in the rest of the world are questioning whether this is what they really want.
There is also bad news from South Korea, where gross domestic product growth is slowing, contrary to expectations.
Relatively unscathed is Japan. Its Nikkei 225 tumbled with everyone else on January 26, but it is still some 5% higher than it was when the Hang Seng peaked.
Paradoxically, the Nikkei, despite Japan?s weak fundamentals, has outpaced most world stock indices in January each year. More strangely, the Yen has strengthened as of late even though the ratings agency Standard & Poor?s moved Japan?s long-term sovereign debt outlook to negative. The renewed sense that the world is risky and that profits should be taken while they are there, is helping the Yen.
Valuations using PEG ratio
The PEG ratio is the P/E ratio over the growth rate, and a PEG of less than one is generally considered good. It is an important valuation tool as it puts a company?s growth prospects in perspective along with the widely followed price to earnings ratio.
In this regard, I have created ?PEG? ratios for a number of countries using the P/E ratio of each country?s main equity market index along with 2010 estimated GDP growth rates.
India has the best PEG of all the countries analysed. It has a P/E ratio of 26.19 and estimated 2010 GDP growth of 8%. While its P/E isn?t as low as a lot of countries?, its growth rate is very high. China ranks second with a PEG of 3.66. The US ranks in the middle of the pack with a P/E of 24.53 and estimated GDP growth of 2.6%. At the bottom of the list sits Switzerland, Italy, and the UK, while Australia, Japan, and Spain have negative PEGs either due to a negative P/E ratio or negative estimated GDP growth.
Just as with stocks, the lower a country?s PEG, the more attractive it is.
(To be concluded)
?The author is a Wharton Business School MBA and CEO, Global Money Investor
