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Enjoy the Battle between ‘Peak in 1H’ vs. ‘Peak in 2H’
What is important is not when the KOSPI reaches its peak nor how high the peak will be, but rather checking the gap between the present and average market PERs
Enjoy the Battle between ‘Peak in 1H’ vs. ‘Peak in 2H’
  • By matthew
  • January 15, 2010, 15:13
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It was a dramatic rebound. The KOSPI and the KOSDAQ, which had plunged to 938.75 and 261.19, respectively following the collapse of Lehman Brothers in September 2008, closed the market at 1682.77 and 513.57 in 2009, and increase of 79% and 97%, respectively. Could this sunny mood continue during 2010? Although giving a clear answer to this question is not simple, most market watchers predict that the upward trend of the Korean stock market will continue.

Peak-in-1H vs. Peak-in-2H

Forecasts of what the peak and bottom values will be and when the market will peak and touch the low in 2010 differ enormously among market watchers. There is, so to speak, a battle between those who predict ‘up-in-1H-and-down-in-2H’ and those favoring ‘down-in-1H-and-up-in-2H’ (from this point these groups will be referred to as ‘peak-in-1H advocates’ and ‘peak-in-2H advocates,’ respectively). At the same time, there is also a battle between optimists and conservatives regarding the peak and bottom points of the KOSPI: optimists forecast a high of 2100 while conservatives say it will be around 1800. The following table represents this complicated battlefield.

Peak-in-1H advocates argue that as in 2009, the stock market will continue to show an upward trend during the first half of 2010 because the exit policy will be implemented after the second half at the earliest, and 70% of government expenditure will be released within the first half of the year. They point out, however, that the stock market is likely to slow down from the second half because following the government’s injection of money into the economy is exhausted, the weak private sector alone cannot sustain robust recovery.

However, peak-in-2H advocates argue that the stock market will be corrected during the first half of 2010, and that the KOSPI will start to rise from the second half when the global economy shows certain recovery. They say that although the KOSPI will overshoot a bit in early 2010, it will soon be back on track and be corrected during the first half.

Meanwhile, optimists argue that the KOSPI will show a robust rising trend during 2010 as foreign investors are looking towards the undervalued Korean stock market. Presently, MSCI Korea 12m Fwd PER is 9.8, lower than 10.9, its long-term average since 1994. Therefore, if the Korean market reverses back to its long-term mean, it should break through the 2000 point-level at least once.

Conservatives on the other hand are arguing that the KOSPI might not cap the 1540 level. The reason behind this apprehension is based on, “the recent boost of the financial market has been fueled by affluent liquidity provided by the public sector.” Hence, when the central bank starts to withdraw liquidity, the stock market will not be able to maintain a strong upward trend. Moreover, pessimists are also wary about the possibility of a double dip recession and other disasters, such as the bubble burst in the Chinese economy, the worsening of Eastern Europe’s financial crisis and the drastic fall of the commercial property market.

A reasonable prudent optimism

People obviously become panic-stricken following a disaster, and therefore, following the global financial crisis in 2008, pessimism and bleak prophecies are bound to attract a lot of attention, as in the Minerva case in 2009, where an amateur Internet economist with the nickname Minerva became popular for having written a dismal forecast of the Korean economy and stock market before his arrest for slander and alleging government policy. However, if a pleasant upward tendency continues, people are more inclined to be optimistic. People are currently enjoying the economic recovery despite still suffering from the global financial crisis. As a result, the general trend among stock market analysts seems to be prudent optimism, in which they are basically optimistic but can change, or are prepared to, into conservatives or even pessimists immediately after seeing even the smallest writing on the wall.

In retrospect, seemingly the most comfortable and easy position “prudent optimism,” has always been reasonable. Warren Buffett, the legendary investor, is always optimistic. He apparently firmly believes in the strong regeneration power (that is, ‘the reversion to the mean’) of the capitalist financial system. For this reason, he injected a staggering USD five billion into Goldman Sachs during the financial turmoil in 2008, the worst economic crisis since the Great Depression. But, why did he choose Goldman Sachs? He chose it because he is also a sophisticated investment analyst. He is well-known for reading, examining and remembering the financial statements of a number of companies: the foundation of his optimism and prudence.

From the perspective of “prudent optimism,” not only will the KOSPI show an upward trend in 2010 but it will continue thereafter. However, we must keep in mind that according to Vitaliy Katsenelson, an investment manager and author of “Active Value Investing,” the US stock market is likely to be a range-bound one for quite a time, at least until around 2020. It should also be noted that the Korean stock market has been consistently in sync with the US market. Therefore, investors should think long-term and act short-term. In other words, “While enjoying KOSPI’s rise for a while, be prepared for the downturn” and manipulate a ‘buy-at-low-PER/sell-at-high-PER’ strategy.

PER over KOSPI

Using market PER as the valuation target has an advantage compared to a price index target like the KOSPI. As time passes and the earnings of listed companies on the stock market grow, the specific price index target becomes less meaningful, as it was created when the earning power of these companies was lower or higher. Thus, even as the price index goes up, if their earnings power increases at a faster pace the stock market cannot reflect it, resulting in undervaluation.

As of December 30, 2009, as the MSCI Korea 12m Fwd PER is 9.8, below its long-term average 10.9, the KOSPI has a considerable reason to break through the historical average PER 10.9 level to reverse to the mean. When market PER is below average, investors are more likely to buy, while when PER is above average, investors are more inclined to sell. For this reason, BOA Merrill Lynch forecast the KOSPI in 2010 to peak at around PER 10.9. However, as something’s reversion to the mean means it goes from a point below average to a point above average, the real peak of the KOSPI is likely to be over PER 10.9.

Think long-term but act short-term

As Karl Popper, an Austrian philosopher teaching at the London School of Economics, said, “We cannot forecast the future.” Nonetheless, we can at least try to forecast the future market by analyzing past market trends and accounting for the tendency of reversion to the mean when making an analysis. In addition, as a number of economists are pointing out, if we can include variables such as greed, ups and downs of the economy, and natural or man-made disasters, as always existing constants in long-term perspectives, we can focus on the market itself when forecasting future market trends. Yet, it should be noted that this principle can only be applied from a long-term perspective. Therefore, we need to be a prudent optimist, believing in the robust regeneration power of the capitalist financial system, and thus, think long-term but act short-term.

In conclusion, although the KOPSI is expected to break through the historical average PER of 10.9 in 2010, it will see a downward trend soon because the market is bound to continue to move above and below the historical average. I Investors should keep an eye on the gap between the current and average PER values.