Market Strategy - Rising risk of a PE reversion to mean, 7 Jul 2015

We are cutting our end-2015’s fair value for the FBM KLCI from 1,880 to 1,650 by lowering the implied PE to 15x – based on the long-term mean. We had previously pegged our fair value to one standard deviation above the mean PE strictly because of liquidity reasons. The market has been trading within one standard deviation above its post-2008 global financial crises mean of 15.7x over the last two years.

External liquidity conditions may no longer be supportive of valuations as the passage of time to a hike in the US Fed Funds rate narrows in 2H15. Our view is that the market has not fully priced-in an upcycle in the Fed Funds rate: the expected move in interest rates may lead to a re-pricing of equity markets. Without acceleration in earnings momentum to take over from liquidity as the next share price driver, it is unlikely that the market can still justify its higher PE relative to mean. A positive reversal in the negative earnings cycle may be delayed to 2016, we believe.

There are also other risk factors resurfacing to trigger a PE reversion to the mean. Domestically, there are several macro trends unfolding with the associated repercussions on valuations, the timing of a reversal in the prolonged negative earnings revision cycle, and portfolio de-risking. At the top of our fundamental concerns are the waning domestic macro cycles – particularly private consumption in the face of rising inflationary expectations post-GST, select retrenchments, and staffing cutbacks from big corporates.

Furthermore, a high base in 1Q15 where private consumption grew by 8.8% makes quarter-on-quarter comparison look bad. While some normalisation in spending patterns due to the waning impact of GST implementation is expected in 2H15, the gradient of recovery is flat at best. The weaker private consumption trend casts some downside risk to our GDP estimate of 5.2% for 2015 (government’s estimate: 4.5%-5.5%).

We believe that the market needs to navigate a changing external liquidity landscape and a weaker earnings backdrop which has yet to demonstrate signs of a bottoming. Our cautious prognosis suggests that further market correction from a PE reversion to the mean appears imminent. We are anticipating a recovery to be pushed back to 2016, for which we are assigning a fair value of 1,750 for the FBM KLCI, vs. our fair value estimate of 1,650 for this year. Strategy-wise, we believe that there will be a greater premium for earnings certainty, strong corporate management, as well as beneficiaries of a weak ringgit in 2H15. Kindly see the enclosed report for further details.

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