Our analysis of the previous two bear rallies — in 1998/1999 and 2001 indicates dips between 15%-22% off intermittent highs.

We had pointed out that the expected correction would be less dramatic because the starting point of the upswing was from a more depressed trough — PE multiple of 11x in March 2009, versus 16x back in April 2001.

While the market did shortly retrace to 1,045 in mid-June, this mid-cycle correction was nevertheless cut short by strong 2Q corporate results and robust macro numbers that lifted the market above our fair value of 1,190, largely on local funds continuing to buy.

Economic recovery in motion
On balance, we reckon that external catalysts for a run-up in 3Q09 were stronger than domestic ones. Signs have emerged that the global economic recovery is under way. Surveys of purchasing managers indices (PMIs) in China, Europe, and the United States and Japan all point towards greater manufacturing activity.

On a month-on-month comparison, Malaysia’s Industrial Production Index (IPI) in July 2009 expanded 7.1% for a fourth time in five months, with gains in all sub-divisions: manufacturing (+6.2%), mining (+10%) and electricity (+3.5%). July’s exports rose 8.4% as well.

Sure, there are still lingering worries over valuations but the macro environment flushed with liquidity is most conducive to the equity market.

More importantly, macro fundamentals are now pointing towards start of a growth cycle moving into 4Q09. Our economist is forecasting gross domestic product (GDP) to expand by 1% in 4Q09, after contracting by an estimated -3% in 3Q09 (1H09: -5%). We are forecasting GDP to expand by 3% in 2010.

Historical precedents
Our analysis of the previous two earnings-driven rallies after the market bottomed reveals that a trough-to-peak cycle in Malaysia has never been shorter than 12 months — despite intermittent mid-cycle corrections.

Consider the 1998/1999 rally after the Asian financial crisis in 1997 — the market rose a staggering 286% from a low of 263 in November 1998 before peaking at 1,013 in February 2000 — with a run extending over 16 months from trough.

Corporate earnings rebounded by a robust 36% in 1999 after contracting an average 40% in 1997 and 1998.

Again in 2001, the market rose by a robust 46% over 12 months, from a low of 553 in April 2001 to a high of 808 points in April 2002. Corporate earnings accelerated by a strong 24% in 2002, from just 5% in 2001.

Going by historical precedents, we believe that the market is just six months into a sustained up-cycle after rebounding from the trough in March 2009.

Balance of risk to street’s earnings estimates may well stay on upside
An earnings-driven rally needs to be underpinned by a positive revision cycle. The recently concluded 2Q reporting season was a robust one where there were more upgrades to earnings estimates and fair values than downgrades relative to the preceding quarter.

We believe an improving global economic backdrop and turnaround in growth moving into 4Q09 would mean that cyclical risk to earnings is dissipating. We expect the revision cycle to gain traction as analysts have historically underestimated the strength of an upturn in corporate earnings.

Earnings drivers of heavyweight sectors — banks and plantations — solidifying
Malaysian banks have proved to be extremely resilient, as evidenced by their strong 2Q results. With global economies on the mend and recovery gaining traction, we believe bank earnings could surprise on the upside. Already, credit charge off rates reported for 1HCY09 have — generally — been lower than expected while recovery in non-interest income has been sharper than anticipated.

Banks are also experiencing a pick-up in demand for credit with most reporting higher loan approvals for mortgages, motor HP and corporate loans.

We presently expect banks to sustain earnings in 2009F (revised from -7% prior to 2QCY09 results) and to deliver a 15% improvement in 2010F.

Growth would be driven largely by reduction in loan loss allowances due to benign rise in NPLs, recovery in non-interest income on a more buoyant capital market and stronger loans growth of between 8%-10% in 2010F (2009F: 3%-5%).

Improving industry outlook could see a return of the dividend theme as banks are well capitalised (July 2009: Industry Tier-1 ratio of 12.6% and risk weighted capital-adequacy ratio (RWCR) of 14.2%).

We are positive on the plantation sector as a shortfall supply of palm oil is expected to sustain crude palm oil (CPO) prices.

Currently, discount between prices of CPO and soybean oil is 16%. In comparison, the 10-year average price discount is 18% while the five-year average is 20%. Lowest discount achieved this year was 10% in May. We reckon CPO prices should rise to between RM2,300-RM2,500/tonne as production enters a low output period moving into 4Q09.

Auto sales turning the corner
We are overweight on the auto sector on expectations of 50% earnings growth for our auto portfolio in 2010 — on the back of a recovery in total industry volume (TIV), which comes off a low base in 2009 where we expect a 34% contraction.

TIV has shown three consecutive months of sequential growth since May — signalling that the worse is probably over for the sector — with year-on-year contraction having been more moderate than expected. New launches from end-2009 will give a boost to 2010 sales.

Perodua is launching their MPV in November, with Proton Holdings Bhd expected to experience full-year impact of its Exora MPV and launch of a replacement for the Waja in May 2010.

Tan Chong Motor Holdings Bhd will be launching its Teana and SUV models (CKD). Toyota (UMW Holdings Bhd) is expected to introduce one full model change in 2010.

Malaysia’s laggard status
Admittedly, Malaysia is not the preferred play in an environment where recovering global economies are leading to a revival in Asian exports — while economic data outpaces expectations and equity markets in the region are rising.

Malaysia is perceived to be a “low-beta” market. Unlike Korea and Taiwan, which are highly leveraged to the recovering US economy — given the high weighting of technology, steel and other cyclicals in their equity markets — earnings at FBM KLCI are more domestic-centric.

In addition, the FBM KLCI’s exposure to the reflating commodity cycle is not as broad-based compared to the Jakarta Composite Index (JCI) with its listed coal, plantation and other mining companies. As such, it is thus not surprising that Malaysia has lagged rising markets in the region.

Structural reforms under Najib administration
However, we see some encouraging signs of reforms and execution of cornerstone infrastructure projects. Since becoming Prime Minister in March 2009, Datuk Seri Najib Razak has announced several market-friendly policy measures to restore confidence in the market.

Consumption spending — particularly — auto and property sales has been robust, while growth in loans may re-accelerate. Even though the market rally thus far has been primarily driven by local funds, Najib administration’s focus on executing growth-oriented policies could reignite foreign interests in the market.

Budget 2010: Infrastructure spending to accelerate
Pump-priming for growth has traditionally been achieved by fiscal spending on large infrastructure projects, with associated multiplier effect on other sectors of the economy. We believe that Malaysia’s infrastructure spending will continue to be the cornerstone for near-term growth under the Najib administration.

Accelerated infrastructure spending via timely execution of its pump-priming initiatives may be critical to ensure continuity of rule under the coalition government of the ruling Barisan Nasional, we believe. Infrastructure spending has significant effects on the underlying economy via links to other sectors.

Based on our channel checks with contractors, we understand the federal government is expected to dish out a slew of construction contracts to kick start growth in 4Q09. The Edge weekly reported earlier this month that the RM3 billion Penang Outer Ring Road project could be revived.

This comes on the heels of earlier reports indicating that tenders for cable transmission works under the Bakun Hydroelectric project — worth an estimated RM10 billion — could be out by 1Q10. Based on our estimates, there are some RM62 billion worth of infrastructure jobs in the pipeline.

We expect more clarity on the government’s infrastructure spending in the upcoming Budget 2010 to be announced in October 2009. As it is, the federal government via Syarikat Prasarana Negara Bhd (SPNB) is looking to raise the first tranche of its RM2 billion in Islamic bonds by the end of the year.

SPNB is targeting to raise some RM4 billion in initial capital to roll out extension works for the Kelana Jaya/Sri Petaling LRT line.

Construction could commence as early as 1Q10, implying that actual awards for the various packages will soon be tendered out by 4Q09.

Consensus PE valuation at one standard deviation above mean
Historical comparison of FBM KLCI’s valuation bands has been distorted by discontinuation of the former Kuala Lumpur Composite Index, which comprised 100 constituent stocks. Instead, Bursa Malaysia has introduced its new 30-stock FBM KLCI index as a new market barometer. Based on consensus earnings on these 30 stocks, the market is trading at a forward multiple of 16.4x, or one standard deviation above mean of 14.5x. The trough PE was 9x in October 2008 while peak PE was 18x in May 2007.

Fair value for FBM KLCI raised from 1,190 to 1,350 — based on forward PE of 16.5x on 2010’s earnings — or at one standard deviation above mean PE of 14.5x. At 15x on 2010’s earnings (AmResearch estimates), the valuation is not expensive, in our view.

A favourable liquidity backdrop, above trend-average earnings growth and a robust revision cycle are supportive of further multiple expansions, in our view. We forecast corporate earnings to expand by a robust 17% in 2010 (2009: -5%) or more than two times faster than its trend-average growth rate of just 7% in 2000-2009.

Structural reforms under the Najib administration may also reignite foreign interests.

Interest rate hike is a key risk but with inflation remaining muted, monetary tightening and an associated reversal in liquidity would not be a near-term concern. Macro environment is equity-friendly at least until 2H10.

This article appeared in The Edge Financial Daily, September 15, 2009.