By Shaun Cochran
CLSA Korea researcher
The process of markets cooling off dramatically in the last several weeks represents a fundamental reevaluation of growth expectations. From a starting point of assuming global growth was robust, markets are now asking the question, is a developed world recession about to unfold? Clearly the odds have risen in recent weeks.
In this analyst’s opinion odds are probably better than even money for at least one of the developed world’s major, heavily indebted, economies to slide into recession over the next six month.
Of course recessions themselves are notoriously difficult to pinpoint and are unlikely to descend upon Asia with anywhere near the veracity that they might attack the developed world. Nonetheless we will know the answer to this question over the next two quarters. From an investment perspective the pertinent question is whether the fall in markets thus far has embedded enough risk in the price to make buying attractive.
At CLSA we occasionally trot out our cyclically adjusted PE (CAPE) analysis for some long-term perspective. In recent years we have conducted this analysis more to question the pervasive bullishness that was cheering full multiples against often peak cycle margins. However, today we can use CAPE analysis to test its potential for reigniting bullish sentiment.
Korea is trading on 0.75x sales, 10.8x OP and 13.8x NP on a cyclically adjusted basis. That is close to, but slightly above long term averages. As such we can say that cyclically adjusted valuations are no longer a reason to be structurally skeptical. On the other hand, as we are yet to dip meaningfully below the long term average they are also not a reason to be bullish. When valuations present neural conclusions one most look to the momentum of both the fundamentals and the market itself.
Starting with the market the KOSPI closed on Friday the 19th at 1,745, putting the index 22 percent below its 2nd May peak of 2,229. The index has violated its 50 and 200 day moving averages. At these levels the market has become deeply oversold. From Friday’s close there was 17 percent upside to the (falling) 200-day moving average.
Regardless of the macroeconomic outlook the now falling 200 day moving average would serve as a logical counter-trend technical rally target. For if we look at each bear market Korea has experience since the Asian crisis (2000, 2002, 2007) they all broke below the 200 day moving average before staging a counter trend rally from oversold conditions. Each failed near the 200 day line.
From a fundamental stand point growth for all of Korea’s major trading partners is disappointing to the downside. Locally this weakness will transfer into export volumes and thus domestic industrial production. This is at a time when residual inflation has refused to break down.
The moderation of growth will provide some inflation relief both here and in the developed world, however, a failure to see signs of renewed growth momentum in coming months would be an ominous sign.
The best performing sectors since the market peaked have been textiles, food and beverage and drug and medicine. The worst performing sectors were the cyclicals: technology, securities, transport equipment and chemicals. However at the moment investors are caught uncomfortably between deteriorating fundamentals and deeply oversold markets.
To mitigate these risks we have been looking to shift cyclical exposure to sectors that are seeing lower margins relative to long term averages and trading on attractive cyclically adjusted multiples.
These sectors are banks, steel and technology and will offer better participation in any technical market recovery than purse defensives, however less down side in the event that a recessionary outlook is confirmed.
However if one cannot gain conviction in the growth outlook over the coming months, any test of the 200 day moving average would then represent the last chance to reach for the helmets in the form of the defensive That will probably focus on the, until recently, much maligned telecom and utilities sectors, not to mention even more widely despised…cash.