A Tale of Two Markets - Personal observations on the current state of the US and Hong Kong Equity Markets

Summary:

This article is a summarizes some personal observations that I have made regarding the current state of the US and Hong Kong Equity Markets. 2021 has been an eventful year for both US and Hong Kong equities.The S&P 500 has smashed multiple records in 2021, hitting record highs, one after another, culminating in the 52-Week High of 4545.85 on  2nd September 2021. 
In contrast to the superb performance of the S&P 500, the Hang Seng Index peaked early this year, hitting its 52-Week High of 31183.36 on 18th February 2021 and has been on a downward trajectory since then.
Given the stark contrast in the performance of the two stock indices over the past 52 weeks, an inquisitive investor would want to pose the following questions:

• • How does the current valuation of each index compare to historical data?

• • Given the current valuation levels, what will be the Implied Return on Investment for the S&P 500 and the Hang Seng Index?

Introduction

So far this year the US and Hong Kong equity markets have travelled along diverging paths. The US market has moved steadily upwards, drawing strength from the country's economic reopening and recovery from the Covid-19 lockdowns. Consequently, the S&P 500 has climbed a wall of worries, moving from its 52-Week Low of 3233.94 (30th October 2020) to the recent 52-Week High of 4545.85 achieved last month on 2nd September 2021. The S&P 500 closed at 4391.34 on 8th October 2021.
On the other side of the Pacific Ocean, the Hong Kong equity market's performance has been disappointing, to say the least, for the better part of the year. Earlier this year, the Hang Seng Index (HSI) hit its 52-Week High of 31183.36 on 18th February 2021. Since then, the index has followed a declining path to reach a 52-Week  Low of 23681.44 on 5th October 2021.  The Hang Seng Index (HSI) closed at 4391.34 on 8th October 2021.

Current Valuations of the US and Hong Kong Equity Markets compared to Historical Data

Notes: ^ denotes data from CNBC. ^^ denotes data from Bloomberg

From the key statistics above, the following observations can be made:

1. 1. The S&P 500 is trading at 3.519% below its 52-Week High while the Hang Seng Index is hovering at 4.883% off its recent 52-Week Low. All things being equal, I would rather invest in a market which is bouncing off its lows rather than one which is deflecting off its highs.

1. 1. The S&P500 is trading multiple times its book value, while the Hang Seng Index is being valued at approximately book value. In fact, the HSI changed hands at slightly below book value at its recent 52-Week Low. Historically, the index has traded at this kind of valuation only a handful of times and each occasion proved to be fairly rewarding for investors who waged their bets. While the typical Momentum Investor would choose to invest in markets with high relative strength, chasing after up-trends, I am basically a Contrarian at heart, preferring to invest my hard-earned money into under-valued stocks which are trading at points of "irrational pessimism".

What is the Implied Return on Investment based on the current Return on Equity and Price to Book Value Ratio?

It is observed that the S&P 500 has a higher Return on Equity compared to the Hang Seng Index. Hence, the S&P 500 deserves to trade at a higher Price to Book Value compared to the Hang Seng Index, all other things being equal.
The critical question is, what is the Implied Return on Investment for both indices based on their recent Price to Book Value and Return on Equity.

The relationship between Price to Book Value Ratio, Return on Equity is expressed by this equation:

Using the above equation, the Implied Return on Investment, K_e, for each Index can be estimated from the current Price to Book Value Ratio and  Return on Equity. The results are tabulated below.

Estimating the Implied Return on Investment based on current PBV ratio

The Implied Return on Investment for the S&P 500 and the Hang Seng Index are 6.150% and 9.891% respectively. This implies that an investment in the Hang Seng Index at current levels is expected to outperform a similar investment in S&P 500 by over 60%, at least in theory. Based on such data, a Rational Investor should be able to decide where to put his hard-earned money.

What is the Tobin Q-Ratio and what does it say about the current state of the US equity markets?

According to Investopedia, Tobin's Q-ratio was developed by Nicholas Kaldor in 1966 and made popular by James Tobin, Nobel Laureate in Economics. The Q-ratio is defined as the market value of a publicly traded company divided by the replacement cost of its assets.  Q-ratio of less than 1 means that the shares of the company is trading below the replacement cost of its assets and are an indication of under-valuation. In contrast, a Q-ratio of more than 1 is traditionally taken to indicate that a stock is over-valued.

The Q-ratio has also proven to be a popular method for gauging the valuation of the overall stock market. Advisor Perspectives provide regular updates of its estimate of the Q-ratio for the US equity markets.

In its recent update, the Q-ratio for the US market is estimated to be 1.85, a record high compared to its previous high of 1.67, reached during the heydays of the Dot Com Bubble.

Based on Q-ratio data dating back to the year 1900, the geometric mean of the Q-ratio is estimated by Advisor Perspectives to be 0.67. At its current levels, the Q-ratio of the US Equity market is trading at 177% above the said geometric mean.

While the Q-ratio is not meant to be a market timing instrument, it has proven to be useful in calling out the signs of "irrational exuberance" in the overall stock market. With the current Q-ratio, as estimated by Advisor Perspectives, at a record high, an investor would do well to take heed of the lessons of history.

Conclusion:

This article sets out to examine the current state of the US and Hong Kong Equity markets and the implications for future Expected Returns for Equities.

US Equity Markets:

• • The S&P 500 is currently trading at slightly below the all-time high recorded on 2nd September 2021.

• • The Tobin Q-ratio of the overall US stock market is at 177% above the geometric mean based on historical data dating back to the year 1900.

• • While the above observations may not necessarily indicate a secular market top, they are, however, telling signs of "irrational exuberance" in the stock market.

• • A prudent investor would do well to take heed of the lessons of history and consider taking some money off the table.

Hong Kong Equity Markets:

• • The Hang Seng Index is trading close to its recent 52-Week Low. The Price to Book Ratio is close to 1, a valuation level which historically has proven to be a good indicator of market bottoms.

• • The Implied Return on Investment for the Hang Seng Index is estimated to be more than 60% higher than that of the S&P 500, indicating that superior returns can be expected for the Hang Seng Index based on current valuation levels.

On a personal basis, I will be looking at reducing my stakes in the US markets and reinvesting the funds in the Hong Kong equity market.

Disclaimer:

This article is a record of the thinking behind a personal investment decision. It does not represent any recommendation to purchase any stock mentioned in the article. As always, readers are strongly advised to do their own due diligence before making any investment decisions.