However, we expect the HK market sentiment to improve gradually from 2Q12 and anticipate a round of market rebound afterwards due to the following: (1) the European debt crisis will abate after the peak period for debt payments; (2) once reining in the inflation pressures, the Chinese government will unveil a series of easing policies, such as loosening bank credit, slashing RRR and increasing infrastructure construction expenditure, in order to maintain economic growth. These policies will give support to the HK-listed China stocks; (3) H-share profits are expected to continue to grow 11.9% y-o-y in 2012; and (4) the HK market has reflected the bulk of the negative news and is attractively valued.

According to Bloomberg, the average PE multiples for the HSI and the HSCEI in the past ten years were 15.5x and 13.9x respectively. Now, the HSI is trading at PERs of 10.1x for FY11F and 9.3x for FY12F, while the HSCEI is trading at PERs of 8.3x for FY11F and 7.4x for FY12F, at the lower end of their respective historical PE bands. We forecast the 12-month target to be 22,055 for the HSI and 12,159 for the HSCEI, implying 11x and 9x 2012 EPS respectively.

Eoin Treacy's view In a troubled year for stock markets generally, China's have been notably weak. This was initially because of the government's scheduled release of previously non-tradable shares which increased supply and weighed on the market. Heightened reserve requirements forced the banks to raise capital which also added to supply. Policy has been focused on discouraging speculative interest in the property market and this has resulted in correction.

Sentiment is fragile, so while the overhang of new supply above the market has dissipated and valuations have returned to historically attractive levels, a catalyst is required to tempt investors to participate. In a policy driven market such as China's a clear signal from the government that they are willing to support the market through easing interest rates, lower reserve requirements and / or increasing public spending could act as such a catalyst.