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.