12 August 2011

Equity Strategy Global

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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 hasnt 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 garryevans@hsbc.com.hk 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

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HSBC strategy recommendations

Global market calls (benchmark: MSCI AC World Index; countries shown have a minimum weight of 0.5%) 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) 2.2 0.0 n\a -0.2 0.0 -2.0 0.0 -1.3 -0.7 -0.5 -0.5 -0.7 n\a -3.6 -5.6 -4.0 0.6 2.8 0.0 1.5 0.0 0.0 0.8 0.0 -6.0 6.0 0.0 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 1,121 12,199 51,395 32,219 5,007 3,003 5,613 4,792 7,966 14,676 277 905 1,538 2,154 910 777 4,141 57 1,806 7,736 19,784 17,131 2,821 28,659 1,130 981 291 Target end-2011 level 1,430 14,500 71,000 39,000 6,300 4,100 8,000 6,500 10,700 20,500 350 1,130 2,075 3,000 1,150 870 5,200 78 2,200 10,000 26,000 20,000 3,600 34,000 1,420 1,270 365 % 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) 0.0 3.5 0.0 0.0 -3.6 -3.7 0.0 3.7 1.9 -1.7 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, Thomson Financial Datastream

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How wrong can the consensus be?

With the lead indicators such as the US manufacturing ISM falling but still pointing to growth, the jury remains out on whether this is a soft-patch in economic activity or the start of a new recession. The problem is that we are unlikely to get a conclusive answer on this for a few more months. So we need to consider the worst case scenario for earnings in the event the global economy does enter a new recession. Analysts have barely pared back their earnings forecasts yet. In the US (Chart 3), thanks to a strong Q2 earnings season (with 71% of companies beating forecasts), the consensus continues to look for 17% growth this year and 15% next. Europe (Chart 4) looks less healthy. The consensus has cut the 2011 forecast by 6% over the past three months and, in the Q2 earnings season, the beats:misses ratio so far (with about three-quarters of companies having reported) is as low as 43:48. This years growth is now forecast to be only 5%, compared to 14% back in January. In emerging markets (Chart 5), analysts continue to see earnings growth as robust, with 14% growth forecast for both this year and next. Asia ex Japan is similar 13% this year and 14% next. In GEMS, 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.

3. 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, Reuters Thompson Datastream, IBES

4. 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

5. Consensus EPS forecast: Emerging markets

140 120 100 80 60 40 20 0 2011 Sep-10

Source: HSBC, Reuters Thompson Datastream, IBES

We can stress-test for a possible recession scenario by looking at how wrong consensus forecasts have been going into previous recessions.

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Chart 6 shows the difference between actual earnings and the consensus forecast 12 months earlier. On average, for the period since 1988 for which we have data, analysts have been 9% too optimistic. Mostly their forecasts were too high because they missed recessions (the biggest misses were in 1990, 2001 and 2008). 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, their forecasts were too cautious.
6. Analysts earnings forecast accuracy All Country World

7. Analysts earnings forecast accuracy, by region

0% -5% -10% -15% -20% -25% -30% ACW US Europe Asia ex Japan Japan Dev EM

Source: HSBC, Reuters Thompson Datastream, IBES

20% 10% 0% -10% -20% -30% -40% -50% 88 90 92 94 96 98 00 02 04 06 08 10

Source: HSBC, Reuters Thompson Datastream, IBES

What does this say about recessions? In normal recessions, 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. The 2007-9 recession was worse than that, with analysts at the worse point over-estimating by 37% in the US, 43% in Europe and 47% in Asia ex Japan. 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), then the likely miss to current earnings forecasts would be about 30-40%.

The degree of excess optimism varies from country to country (Chart 7). Analysts were most accurate with their forecasts in emerging markets (although, unsurprisingly, the volatility here is greater) and most over-optimistic in Japan. In both the US and Europe, the over-estimation averages about 7% over time.

How cheap can markets get?

We have been arguing for some time that equity markets look very cheap and that, therefore, the structural worries about the global economy were, to a degree at least, priced in. As of Wednesday this week, for instance, the 12-month forward PE for the All Country World Index reached 9.7x. It has been cheaper than this, since the MSCI indexes began in 1988, only for three months in October-December 2008 (Chart 8).

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8. 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, Reuters Thompson Datastream, IBES

earnings could fall, and that we need to go back further than 1988 for comparison, 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). 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. Chart 10 shows PE (using trailing earnings) for the S&P500 going back to 1870 (using Robert Shillers data for the period prior to the 1980s). Currently, the US is on 12.1x trailing earnings, compared to a long-run average of 14.4x. It has been cheaper than now only in late 2008-early 2009, 1974-1984 (when it averaged only 9.5x), and during and for a period after wars (1915-26, 1940-54). Even during the Great Depression 1930-9, PE averaged around 17x.
10. Trailing PE, S&P500 1870-2011 (with average & std devs)

MSCI AC WORLD

As an aside, one argument worth dismissing at this point is how similar the US looks now to Japan in the mid 1990s, four or five years after its bubble burst. While there may be similarities in the way that bond yields fell or growth proved to be anaemic, the big difference is that, in Japan, this was not priced in. In the mid-1990s, Japanese valuations remained sky-high: the prospective PE in 1994-5 averaged 55x and did not drop below 20x until 2002 (Chart 9).
9. Forward PE, 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, Robert Shiller

Source: HSBC, Reuters Thompson Datastream, IBES

We clearly need to test current world and US valuations further. There are two objections that can be made to using the forward PE since 1988: (1) it relies on analysts forecasts which might, as argued above, be very wrong; and (2) the world was in a secular bull market for much of the period since the mid-1980s. If we assume that

Of course, if earnings disappoint by as much as we suggested above that they might, P/trailing E might not help very much. But price/book is often a useful guide to valuation bottoms in earnings recessions. Even in the big recession of 2007-9, book value declined from peak to trough by only 25%-30% in big markets (in a more normal recession, the decline is around 15-25%).

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Chart 11 shows price/book for the US and Europe ex UK going back to 1975 (and, therefore, capturing the historically low valuations of the 1970s and early 1980s). Currently, Europe ex UK is on a PB of 1.10x. It has been cheaper than this for one month in early 2009 but, before then, not since 1984. In the 1975-1985 period, however, it averaged only 0.74x. (It is worth remembering, though, that ROE for European companies this year is forecast to be 14%. We dont have the data for the 1970s readily to hand, but we would bet ROE then was significantly lower.) The US does not look quite so cheap on a PB basis, with a PB currently of 1.65x. That takes it back (with a two-month exception in early 2009) to the level of 1985. In the 1975-1985 period, US PB averaged 1.33x (but, then again, ROE averaged 10% during that period, against 16% over the next 12 months).
11. Price/book ratio: US and Europe ex UK

12. 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, Robert Shiller

There are a number of problems with the CAPE. First, the 10 years of historical data includes the big earnings drop of 2008-9 (Chart 13). 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, since the current level of earnings for the US at roughly at its historical trend, this is almost identical to the historical PE.
13. US earnings, 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, Reuters Thompson Datastream, 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, Reuters Thompson Datastream, IBES

One valuation measure that bearish investors often use, but which we find of limited value, is the cyclically-adjusted PE (CAPE also sometimes called the Shiller PE). This sounds sophisticated but, in fact, is nothing more that the current price divided by the 10-year average of earnings (usually adjusted for inflation). By the CAPE, the current level of the US market does not look that cheap. It is on 14.5x, only a little below the long-run average of 15.8x (Chart 12).

Second, the assumption behind the CAPE is that earnings are always mean reverting. While that is usually true, there may be times (such as now, as we have often argued) where earnings can grow above trend for a while, driven by sales to emerging markets and with costs under control.

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So where from here?

Since our Q3 Quarterly, published in early July, we have argued that there were three conditions that needed to be fulfilled for markets to bottom:, cyclical indicators to dip further (including analysts cutting their earnings forecasts), risk events to pass, and investor capitulation to set in. We have dealt with analysts forecasts above. Where do we now stand on the others?

14. US manufacturing ISM and US recessions

70 65 60 55 50 45 40 35 30 50 60 70 80 Recessions
Source: HSBC, Bloomberg

90

00 ISM

10

Cyclical indicators
In the end, the economy is partly driven by psychology. How much will the events of the past few weeks affect consumer and corporate sentiment and spending decisions? That is very hard to judge. For the moment, HSBCs economists have not slashed their growth forecasts (they still look for 2.5% GDP growth for the US and 3.4% for the world in 2012 far from recession conditions). But we will need to watch the data carefully over the coming months for signs that growth expectations continue to fall. Not least, the US manufacturing ISM which we regard as the best single indicator of the cycle almost certainly will fall further. It is currently at 50.9, having fallen from a peak of 61.4 in February. But that means it is still indicating expansion. Mid-cycle dips often take the ISM below 50 (see Chart 14) as, for example, in 1985, 1996, 1998 without necessarily signalling a recession. As we have argued previously, the midcycle dip in the ISM typically lasts nine months, while this one has so far gone on for only five. It is quite possible for the ISM to fall further, without it signalling a recession (when it would typically drop to 40 or below).

How big is the risk of a US recession? Obviously that is our economists call. But we would make a couple of observations. First, this expansion is still very short by historical standards, having lasted only 26 months, by the NBERs official definition. This would make it the third shortest expansion since 1930 (and probably really the second shortest since many view the 1980-1 expansion, that lasted only 12 months, as a mis-dating by the NBER). Second, the level of activity in the US remains at a very subdued level. The two largest consumer purchases, for example, autos and houses (Charts 15 and 16), are at such depressed levels, that it is hard to imagine them falling sharply from here, as typically happens in a full-blown recession.

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15. US auto sales, SAAR (mn vehicles)

25 20 15 10 5 0 70 75 80 85 90 95 00 05 10

We would see the USs squabbles over the debt ceiling as less of a problem. 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), at least there was a decision and some sort of medium-term plan to cut the deficit along with a supportive central bank. Moreover, the US dollars position as the worlds FX reserve currency means the problem is much less urgent. Are these problems going to go away? In Europe, perhaps not soon. In our view, there need to be moves towards greater fiscal unity (see Fixing the eurozone 8 August by HSBCs chief economist, Stephen King). The debt situation for the three peripheral eurozone members has not been solved. The ECB needs to be more accommodative. We would like to think that markets will push policymakers to take more decisive action. But, until they do, we continue to be cautious on European stocks (where we remain underweight), however cheap they have got.

Source: HSBC, Bloomberg

16. 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, Bloomberg

Capitulation
Perhaps the one box we can tick is investor capitulation. In our last Quarterly, we introduced an HSBC investor sentiment index, which combines the one-month moving average of 1) the American Association of Individual Investors (AAII) weekly survey, 2) the put/call ratio for equity options on the Chicago Board Options Exchange, and 3) the VIX index of S&P500 implied volatility. The index has given useful buy signals at most market bottoms, both during recessions (2003 and 2009) and intra-cycle (1998, 2005, 2010), although it did perhaps forgivably send too early a buy signal in 2002 and 2008 (Chart 17). The signal at market tops is rather more complicated: sentiment seems to wane before stocks peak, as in 2007.

Risk events
In many ways, 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. The proposal to cut Greeces debt, in effect, by around 20% was considered by the market as plainly insufficient. The summit also failed to make any proposals for Ireland and Portugal, 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. The European Central Banks 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.

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17. HSBC investor sentiment index

1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 -2.5 -3.0 -3.5 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

7.4 7.2 7.0 6.8 6.6 6.4 6.2 6.0

Sentiment index
Source: HSBC, Thompson Reuters Datastream

S&P 500 (log, RHS)

Currently, sentiment has collapsed to the level of intra-cycle correction bottoms such as mid-2010 or 1998, but not to the level of a big cyclical bottom such as 2009 or 2003. The VIX (which reached 48 this week) and the put/call ratio (which got over 1x) are at very bearish levels. The AAII survey, however, showed a surprising rebound in the latest weekly numbers, with 33% of retail investors expecting stocks to rise over the next six months, up from 27% the previous week. Perhaps some investors believe the market now represents good value or maybe the survey just lags a little. Remember, too, that since we use a one month moving average to smooth out volatility, the numbers are a little slow to react.

So, 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, or a fullblown recession. The problem is that we are unlikely to get a conclusive answer on this key question, at least in the near-term.

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Disclosure appendix
Analyst Certification
The following analyst(s), economist(s), and/or strategist(s) who is(are) primarily responsible for this report, 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, 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, which depend largely on individual circumstances such as the investor's existing holdings, risk tolerance and other considerations. Given these differences, 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; and (2) from time to time to identify short-term investment opportunities that are derived from fundamental, quantitative, technical or event-driven techniques on a 0- to 3-month horizon and which may differ from our long-term investment rating. HSBC has assigned ratings for its long-term investment opportunities as described below. This report addresses only the long-term investment opportunities of the companies referred to in the report. As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at www.hsbcnet.com/research. Details of these short-term investment opportunities can be found under the Reports section of this website. 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. Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations. Investors should carefully read the definitions of the ratings used in each research report. In addition, because research reports contain more complete information concerning the analysts' views, investors should carefully read the entire research report and should not infer its contents from the rating. In any case, ratings should not be used or relied on in isolation as investment advice.

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 stocks domestic or, as appropriate, regional market established by our strategy team. The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon. The performance horizon is 12 months. 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*). For a stock to be classified as Underweight, 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*). Stocks between these bands are classified as Neutral. Our ratings are re-calibrated against these bands at the time of any 'material change' (initiation of coverage, change of volatility status or change in price target). Notwithstanding this, and although ratings are subject to ongoing management review, expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change. *A stock will be classified as volatile if its historical volatility has exceeded 40%, 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. However, stocks which we do not consider volatile may in fact also behave in such a way. Historical volatility is defined as the past month's average of the daily 365-day moving average volatilities. In order to avoid misleadingly frequent changes in rating, however, volatility has to move 2.5ppt past the 40% benchmark in either direction for a stock's status to change.

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Rating distribution for long-term investment opportunities

As of 11 August 2011, the distribution of all ratings published is as follows: Overweight (Buy) 52% (27% of these provided with Investment Banking Services) Neutral (Hold) Underweight (Sell) 36% 12% (20% of these provided with Investment Banking Services) (19% of these provided with Investment Banking Services)

Analysts, economists, and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenue. For disclosures in respect of any company mentioned in this report, please see the most recently published report on that company available at www.hsbcnet.com/research. HSBC Legal Entities are listed in the Disclaimer below.*

Additional disclosures
1 2 3 This report is dated as at 12 August 2011. All market data included in this report are dated as at close 10 August 2011, unless otherwise indicated in the report. HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its Research business. 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. Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential and/or price sensitive information is handled in an appropriate manner.

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Disclaimer
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Global Equity Strategy Research Team

Global
Garry Evans Global Head of Equity Strategy +852 2996 6916 garryevans@hsbc.com.hk Daniel Grosvenor +852 2996 6592 daniel.grosvenor@hsbc.com.hk

Asia
Garry Evans +852 2996 6916 Steven Sun +852 2822 4298 Vivek Misra +91 80 3001 3699 garryevans@hsbc.com.hk stevensun@hsbc.com.hk vivekmisra@hsbc.co.in

EU and US
Peter Sullivan Head of Equity Strategy, EU and US +44 20 7991 6702 peter.sullivan@hsbcib.com

Europe
Robert Parkes +44 20 7991 6716 robert.parkes@hsbcib.com

CEEMEA
John Lomax +44 20 7992 3712 Wietse Nijenhuis +44 20 7992 3680 john.lomax@hsbcib.com wietse.nijenhuis@hsbcib.com