The stock market

The Hong Kong stock market has had a bull run for the past year, especially in the second half. The Hang Seng Index has shot through the roof without any major setback, thanks to stark inflow of hot money, driven by the speculation of further appreciation of renminbi and optimism toward the Chinese economy. Buying was particularly strong among Chinese counters. The H shares, of Hong Kong-listed Chinese enterprises, have launched one big leap after another, going hand in hand with the recovering A-share market in China's bourse.

Fund supply has been abundant in China, the U.S. and around the world, due to a long accumulation of wealth over the past few years and prevailing low levels of interest rates. In China, the exports grew strongly and people get rich very fast. In the U.S., money is flowing to China for the weakening of the U.S. dollar. Nations rich in natural resources have their windfalls by the expensive crude oil and natural gas as well as other commodities.

The surplus of funding was reflected by the low interest rates in long-term bonds in the U.S. Fund flow is a very important factor for short-term and medium term. We had strong liquidity in every market boom.

The funding was such much that even an increase in demand, introduced by the initial public offering of several leading Chinese banks, could not jeopardize it. It is noteworthy that fund flow is a tsunami by its influence. Fund flow is even more flexible than tsunami because it not only goes here and there, but it could also swell fast through lending. However, the dark side is the killing fund flow could make when it pulls away in a market slump.

Two threats.

The U.S. economy is seen to slow down this year. Low interest rates compared with inflation has encouraged borrowing to invest and to consume. The ease of liquidity had fueled the price advances of the houses and the encouraged consumers to spend on credits. Debt repayments, including those for mortgages, by households as a percentage of personal disposable income were at their highest levels since the data was available in 1980. If the housing market undergoes a significant downturn, American consumption would sharply reduce. That could severely affect the exports of China and other Asian economies, and more significantly, cool down the investment sentiment in Hong Kong.

Another threat is China's bad debts. Chinese banks were financially healthy in appearance after cleaning a large chunk of aged non-performing loans before listing and raising new capital through listing. The lending exercises of the state-owned banks are still largely driven by government policy without the clear assessment of credit risks. Such lending practices would inevitably lead to the emergence of new non-performing loans, not to mention that official statistics about the outstanding non-performing loans would likely be underestimated. There has been a progress for China to develop tertiary industry. The entry of the World Trade Organization which has forced China to speed up the opening progress of its financial industry for limited foreign ownership is positive. Besides, the listings of China's leading banks were also important steps. However, even after these measures have been taken, China's financial system is far from bulletproof. The banking industry is one for the most advanced economy with well established operational and surveillance systems. Turbulence has to occur along the learning curve of the economic development.

The U.S. housing market and China's financial system are the two major threats, i can think of , that could bring a significant and prolonged gloom to the Hong Kong stock market.

However, even before these threats realize, the market could easily come to a downturn merely because of unsustainable valuation. The current valuations of leading H shares have become too high. H-shares in general are priced at over 20 times its earnings. China Insurance (2628), China's biggest insurance company, has a 2006 prospective PE of 50 times, which is still unbelievably high. ICBC (1398), China's biggest bank, has a 2006 prospective PE of nearly 30 times, which has discounted optimistic expectations on future earnings growth.

The HSI has been priced at about 15-16 times prospective PE, which mistakenly gives wrong impression that the market is fairly valued. In fact, the surge in prices has been narrowly confined to China stocks. And the overheating of this large sector is enough to cause damages. There is no guarantee that the laggards have to catch up with the leaders before the current bull phase completes.

The market downturn as a result of the overheating of the stock market, as indicated by the valuations, could happen without prior notices. Then the contraction of fund flow would closely follow. The investment sentiment would swing from optimism to pessimism. The U.S. and Chinese economic potential weaknesses, if they come true, might serve as reinforcements of a bear market.

As an educated, but not so dearly engaged, investor, i would not worry too much about a potential market downturn. i keep investing and holding value stocks, with earnings prospects and fairly price-earnings multiples. HSBC (5), at around 12 times prospective PE, remains a long-lasting favorite. i also recommended Aeon Stores (984) in an earlier article.

A long-term consistent investment on value stocks, unaffected by any market emotion, is a reliable means. The Hong Kong stocks have been growing steadily since 1970's, and will continue to grow, in the long-term, as earnings accumulate. Investing disciplinarily is easier said than done. That's one of the reasons why losers far outnumber winners.Sometimes, an investor should be more detached from the feelings of the majority. Warren Buffett leads a simple live in the remote Nebraska in the U.S., and, it was said, does not have Internet access in his office.

Disclose of interest: i am holding shares in HSBC and Aeon Stores.

Copyright Quam