What happened to Hong Kong stocks? A sharp pullback under multiple blows and losing all over the world; the decline in risk appetite is the main reason.

Since the mid-high point in February, Hong Kong stocks have declined as a whole. The initial pullback is no different from the volatility of A shares, which is essentially a pullback after the expected inclusion of too much and the high valuation of the core leading stocks. After March, Hong Kong stocks deviated from A shares, especially Hang Seng Technology and gem, which were caused by multiple factors such as anti-monopoly and education policies, stamp duty increase, South Korean fund explosion and external market fluctuations.

The market took a sharp turn for the worse in late July, with stronger-than-expected regulatory policies as a direct cause, with panic and capital outflows further amplifying volatility. The Internet and education bear the brunt, but other sectors are not immune.

Overall, since the February peak, Hang Seng Technology has retracted 38 per cent, returning to the level of June last year. MSCI China has fallen 27 per cent, Hang Seng state-owned enterprises have fallen 25 per cent to approach the epidemic low, and the Hang Seng Index has adjusted slightly but also 17 per cent, a performance that puts Hong Kong stocks at the bottom of the world.

After dismantling the driving forces, it can be found that the head company and the decline in risk appetite are the main drag, compared with almost flat profits and positive contribution to risk-free interest rates.

Where is the valuation correction? Back below the average, some industry stocks even return to historical lows.

After a recent sharp correction, the valuation of the Hong Kong stock market has returned from its original relatively high position to below average or even relatively low:

1) comparing the history, take the MSCI China index as an example, its dynamic valuation of 10.5 times is 0.4 times below the long-term historical average; if you focus on the new economy sector, the current valuation of 13.0 times is the low since the massive listing of the new economy in 2018.

2) horizontal comparison, the current PEG of Hang Seng Technology is significantly lower than that of gem and NASDAQ. The discount of MSCI China to MSCI Asia, except Japan, has also expanded to ~ 7%.

3) compared with other assets, MSCI China dividend yield / Treasury yield is twice the standard deviation of the average since 2010.

4) sector: the valuations of the food retail, consumer services and media entertainment sectors have fallen below the average since 2006, while some old economies such as real estate, energy, banking and insurance are at the bottom of the historical range.

5) at the level of individual stocks, quite a number of stocks have returned to less than 1 times the standard deviation of the historical average, especially for large companies affected by policies.

By comparing the cases of BABA and Tencent, we find that BABA's valuation performance since the beginning of the year is more resilient than Tencent, which to a certain extent shows that the policy landing is an important stabilizing factor. In addition, considering that static comparative valuations do not take into account the potential earnings downward impact, we conducted stress tests on overall market and individual stock valuations under different earnings downside scenarios, and found that for most stocks, even if there is a 10% earnings reduction, valuations are still significantly below average.

What is the trend of funds under market fluctuations? There is a large outflow to the south, and overseas is relatively stable.

Hong Kong stocks as an offshore market, the changes in their capital flows are also crucial to the market trend, and recent market fluctuations have further increased investors' concerns about the capital side. We found that:

1) southbound funds were generally stable before July, but there was a record outflow in July. Although the market has been pulling back since mid-February, southbound funds have remained stable. This situation was broken in July, with southward capital outflows totaling 53 billion yuan in July, the largest one-month outflow since the opening of the Shanghai-Hong Kong Stock Connect. At the industry level, 84 per cent of outflows are concentrated in new economy sectors, such as information technology and optional consumption, with outflows dominated by Tencent, Meituan, HKEx, Weimeng Group and CNOOC. We expect that recent statements to regulate and stabilize the market may play a positive role in stabilizing southbound funds.

2) overseas capital inflows have been generally stable since the beginning of the third quarter of last year, and in fact there was no significant outflow as feared by the market until last week, which may be due to slower changes with overseas funds and more value-oriented investment. However, due to the long decision-making mechanism of some long-term funds, it is still worth paying attention to whether there will be capital outflows caused by recent policy changes in the future.

How to rebound after a sharp fall? Combination of oversell rebound and scarce high quality leaders

Although there are still policy uncertainty disturbances, in the short term, some technical and valuation indicators point to excessive pessimism in the market, such as abnormal magnification of trading, increased proportion of short selling, substantial capital outflows, market oversold and so on. If there is a marginal improvement in policy and sentiment, it may push the market to stabilize and rebound.

Based on this, we believe that Hong Kong stocks may gradually enter the "layout period".

It is recommended to focus on rebounding from the following dimensional layouts:

1) if you overfall a stock, the resilience of the rebound may be greater.

2) pessimism is counted as too much and mistakenly killed, while the fundamentals are sound and the quality leaders are scarce.

3) in line with China's inherent long-term trend areas, including science and technology hardware, new energy vehicle industry chain, new energy, high-end manufacturing and high-quality consumption and pharmaceutical leaders.