Correlation between Hang Seng Index and Other Indices

After my last post of correlation between VIX and some major indices, many of my blog readers show great interest in the topic. In this post, I will study the correlation between Hang Seng Index (HSI) and other major indices. As a common sense, the most influential indices to Hang Seng Index should be indices of US stock market and indices of China stock market. In such case, I have selected S&P500, NASDAQ (NQ) , SSE Composite Index (SHC) and Hang Seng Chinese Enterprise Index (HHI) as a reference for the correlation study. The correlation coefficients between HSI with these four indices are calculated based on the daily close of each index from 3rd Jan, 2005 to 31st Oct, 2008. The results are as below :

1. S&P500 with HSI : 0.76

2. NQ with HSI : 0.82

3. HHI with HSI : 0.99

4. SHC with HSI : 0.93

My Findngs :

1. SHC has a higher correlation with HSI than S&P500 and NQ which reflects the fact that more and more chinese enterprises are selected as components of HSI and the chinese economy is now more influential to the economy of Hong Kong.

2. To my surprise, NQ is more correlated to HSI that S&P500. The reason behind may be quite interesting to study.

3. The correlation between HHI and HSI is very high which is very predictable as these two indices are in the same stock market and share some common components.

Some poeple may raise the question : "How about the US stock market and Chinese stock market?" I also calculated the correlation coefficient between S&P500 and SHC. The result is positive with a correlation coefficient of 0.76.

Correlation between VIX, Dow, S&P500, Yield

Recently the market becomes more and more volatile. Many people turn to VIX to see if there is any indication in the future trend of stock market. VIX is the ticker symbol for the Chicago Board Options Exchange Volatility Index, a popular measure of the implied volatility of S&P 500 index options. it represents one measure of the market's expectation of volatility over the next 30 day period. Generally, VIX is referred to as Fear Index which shows whether the market "fears" about the future. When VIX is high, the more "fears" the market is.

In order to have a more scientific view on the relationship bewteen VIX and common market indices, I have done an analysis between VIX and Dow (Dow Jones Industrial Average Index), S&P500 and 10 Year Treasury Notes Yield. The analysis is to calculate the Correlation Coefficient* of VIX to the other three to see how these more indices or figures are correlated. Five year data (daily close from 31 Oct 2003 to 31 Oct 2008) are taken in this analysis.

Below is the result of calculation :

Correlation between VIX , dow and 10 Year Treasure Notes Yield :

VIX & Dow : -0.02577

VIX & SP500 : -0.15889

VIX & 10 Year Treasury Notes Yield : -0.44814

Analysis of result :

1. All three are negatively correlated with VIX which means when VIX goes higher, Dow, S&P500 and Yield will goes lower. This is very close to our general thoughts. When the market has more "fears", the stock market will goes lower as people are more likely to sell their securities. On the other hand, more people will buy treasury notes which drives the yield lower.

2. On the level of correlation, S&P500 has a higher correlation than Dow which is also expected as VIX is the IV of S&P500 in the coming 30 days. However, it is a surprise that the correlation between Dow and VIX is close to zero which means they are almost non-correlated. Therefore, we should NOT use VIX to indicate the trend of Dow. S&P500 represents a broader market and the indication to its trend from VIX is more effective. However, the correlation for these both is rather low.

3. The correlation of 10 Year Treasury Notes Yield is the highest among the three. More people will park their money to the relatively safer Treasury Notes when they feel more fears. When VIX is higher, the Treasury Notes Yield is more likely to be lower.

Conclusion :

From the above analysis, we can see that VIX is not a very effective indicator of Stock Market but more indicative to Treasury Notes Yield. Higher VIX will drive a lower yield.

*Correlation coefficient is measure of linear association between two variables X and Y. The coefficient lies from -1 to 1. Correlation coefficient -1 means the set of data are negatively correlated and 1 means positively correlated. 0 means non-correlated.

Warren Buffett's Latest Essay on New York Times

Undoubtedly, Warren Buffet is the best practitioner in Value Investing by now. In his latest essay "Buy American. I am" dated 16th October, 2008 for The New York Times. He outlined the basic and most essential ideas of Value Investing. Below are some of the major points abstracted from his essay :

"A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now."

"Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over."

If you want to have a full idea of his essay, you may click the following links for full details :

http://www.nytimes.com/2008/10/17/opinion/17buffett.html?_r=2&ref=opinion&oref=slogin&oref=slogin

Take a look. You will be most benefited.

Warren Buffett Comments on China

Recently, Warren Buffett mentioned in an interview on CNBC that he has tried to bid on one Chinese stock but was not accepted. This has become a very hot topic in Hong Kong media and everyone is interested in finding which stock it is. But very few people are interested in what Warren Buffett has told CNBC in the interview. Actually Mr Buffett also talked about his view on China economy and its future which is very meaningful for us. The name of the program is :

"THREE HOURS WITH WARREN BUFFETT - LIVE FROM OMAHA" ON CNBC'S SQUAWK BOX WITH BECKY QUICK, FRIDAY, AUGUST 22, 2008.

You may find the full part of his interview on CNBC.com (http://www.cnbc.com/id/19206666/). For those who are interested in his view on China, you should pay attention to TRANSCRIPT/VIDEO PART ONE and TRANSCRIPT/VIDEO PART SIX. Mr Buffet has told Becky about China that "But it's a terrific--it's going to be a terrific area for business. So, under the right circumstances, you could see us with a lot of money there."

It seems that Mr Buffett is very optimistic about China's Economy and its future!

Stock market as weighing machine

Facing the recent fluctuations in stock markets around the world, many investors were heavily affected. Very few people can really ignore the price fluctuations of stocks. This is really a good test for a value investor. One article from Warren Buffet may help us in facing such situation. In 1978, he wrote an article noting that the Dow had dropped 20 percent in the prior six years, book value had risen 40 percent, and these stocks were earning about 13 percent on book value. The Dow was trading at or below book value for parts of 1979. On 21st December 2001, Warren Buffet wrote another article in Fortune to respond to his previous article. Some of the contents are abstracted as below :

"At the time of the [1978] article, long-term corporate bonds were yielding about 9.5 percent. So I asked the seemingly obvious question : "Can better results be obtained, over 20 years, from a group of 9.5 percent bonds of leading American companies maturing in 1999 than from a group of Dow-type equities purchased, in aggregate, around book value and likely to earn, in aggregate, about 13 percent on that book value?" The question answered itself." "Now, if you had read the article in 1979, you would have suffered - oh, how you would have suffered! - for about three years. I was no good then at forecasting the near-term movements of stock prices, and I'm no good now. I never have the faintest idea what the stock market is going to do in the next six months, or the next year, or the next two." "But I think it is very easy to see what is likely to happen over the long term. Ben Graham to us why : "Though the stock market functions as a voting machine in the short run, it acts as a weighing machine in the long run." Fear and greed play important roles when votes are being cast, but they don't register on the scale."

Let's don't forget the famous sentence :

"Though the stock market functions as a voting machine in the short run, it acts as a weighing machine in the long run."

Bull's Eye Investing

Recently, Mr Cho (曹仁超) of Hong Kong Economic Journal (信報) - a highly respected investor in Hong Kong - has highly recommended Bull's Eye Investing Strategy as the right investment strategy for the present and coming stock market which should be more appropriate that the long adopted Buy-and-Hold strategy.

The Bull's Eye Investing Strategy was proposed by John Mauldin in his book "Bull's Eye Investing - Targeting Real Returns in a Smoke and Mirrors Market" published in 2004. In his book, he has illustrated a lot of statistics from differnt aspects to suggest that the coming 20 or more years will be a secular bear market. In this period, the performance of stock market will be similar to the period of Dow Jones performance from 1964 to 1981 within which the Dow Jones Index just moved within a range and posed a gain of around one-tenth of 1 percent though the GDP actually grew 373 percent. Therefore, he has pointed out that investors should focus on absolute return instead of relative return and adopted the Bull's Eye Investing Strategy.

Then what exactly Bull's Eye Investing Strategy is? In page 262 of his book, John has summarized this strategy with a few words as below :

"The essence of Bull's Eye Investing is quite simple. Target your investments to where the market is going, not to where it has been. Steady, stable, sure. Buying something that is undervalued, perhaps grossly undervalued, and waiting for the value to be seen by others is the way to real returns. Buying what everyone else is buying, after it has already risen in value, is why most investors simply do poorly"

To me, Bull's Eye Investing is simply another form of value investing. The key is still buy something which is undervalued. However, should we stick with the Buy-and-Hold strategy? In this issue, I have a different view from Mr Cho with the following reasons :

1. John's book is mainly focused on US stock market for which the future performance will be different from Hong Kong and China stock market. Even John himself also suggested investors to diversify their investments in other market other that US market. To me, the future of Hong Kong stock market should be on the Chinese enterprises which have a bright future of development. The China enconomy is now similar to the Hong Kong enconomy in the 70's and great development and change is expected to come. Buy-and-Hold strategy will be very suitable for this kind of market. We have already had many examples in Hong Kong that even a general citizen can accumulate huge amount of wealth from 70's up to now with this strategy.

2. Value investing is more focused on selecting the right company to invest. As Warren Buffet has said, you should treat yourself as one of the owner when you buy the shares of a company and prosper together with its future development. Simply focus on overall performance of stock market is not the key to value investment. Buy-and-Hold also does not mean you buy the stock and hold it. You have to do your own analysis and buy the stock when it is undervalued. Therefore Buy-and Hold strategy should still be the right strategy for value investing in any form of market.

Hong Kong Stock Market - From A PE Perspective

Traditionally, PE ratio is a useful measure of the valuation of a company. Recently investors have been diverted to other means of measures such as PEG, PB ratio and ROA etc such that the high valuation of stocks in the past few years can be explained in a more reasonable manner. However, the importance of PE in evaluating the stock market should not be ignored. PE ratio gives the meaning of the number of years you can earn back your investment (the price you paid) given that the earning does not change for the given years. In reverse, the PE gives the earning yield such that investors can compare the yield with other type of investments to see if such investment is worth.

How is the application of PE in evaluating Hong Kong stock market? I have plotted a graph of monthly PE of Hang Seng Index (a widely adopted indicative index for Hong Kong stock market) for the period of Jun 1974 ~ Jun 2008 which is shown at the top of this blog. From the above graph and data, I have the following findings which may be useful in formulating investment strategy for Hong Kong stock market :

a. The average PE over the period is 14.58 with a Standard Deviation of 3.6. This means 68.27% of the data points lies within PE ratio from 10.98 to 18.18 (1 SD). 90% of data points lie within PE ratio from 8.68 to 20.48 (1.645 SD). This gives us a hint that whenever the monthly PE of HSI goes beyond 20.48, it is more likely that the market is overvalued and there is 90% chance the market will turn downwards. This is the moment of last tango. For those monthly PE of HSI goes below 8.68, it will be a real bargain to buy.

b. The lowest of point of PE for each high-low cycle is becoming higher and higher which means the market is willing to accept a higher PE for HSI in the recent years which may be explained as more and more Chinese enterprises were selected as components of HSI which are mainly growth stocks and investors may be more willing to buy at a higher PE.

c. From a simple glance of the graph, I would rather start buying at around PE ratio of 10 for which the risk has been significantly reduced.

In conclusion, I will suggest investors to buy when HSI dips below PE ratio of 10 and avoid stocks when HSI goes up above PE ratio of 20.5.

As a reference for today (17th July 2008), HSI close at 21735 with a PE ratio of 13.19 which is below the mean by 1.39.