While investor sentiment is still fairly fragile, it is slowly recovering. However, we strongly believe that the current rally in equity markets is a reaction to the extreme oversold situation earlier and increase of risk appetite by global investors as volatility declines. For us, although confidence could have improved as: (i) Fed is likely to revise U.S. interest rate in a less aggressive manner, (ii) Ringgit has strengthened against US dollar, (iii) Brent Crude prices are stabilizing, (iv) Crude Palm Oil prices are trading higher, and (v) both external equity inflow and domestic liquidity have improved, a broad-based earnings growth story is still missing and market valuation remains a major deterrent. As such, our Range-Trading view remains unchanged. With the underlying risk-on risk-off market nature, we strongly believe that the equity market is likely to continue its roller coaster demeanor. However, as investors' risk appetite has increased, we believe there is a need to revise up our B.O.W./S.O.S. trading range from 1,600/1,690 to 1,635/1,725 while maintaining our index target of 1,725. Our index target is backed by FY16E/FY17E earnings growth rates of 3.6%/7.6% representing 19.6x/18.1x to our FY16E/FY17E earnings estimates.

The Good ... Based on our U.S. Presidential Election (PE) Study for the period 1984 to 2012, Dow Jones Industrial Average (DOW) merely registered negative returns in 1984, 2000 and 2008. In other words, excluding the Tech-Boom Burst and Global Financial Crisis in 2000 and 2008, it is reasonable to believe that DOW is likely to remain supportive in the year of PE. On the domestic front, we also saw Excess Liquidity (EL) picking up from the trough in Jan16 and currently stood at >RM200b. Coupled with the underlying favourable trend of foreign inflow, improved domestic liquidity should provide the much-needed boost to the local equity market. Our Monte Carlo Simulation Study also suggests that there is high chance, say >35%, for FBMKLCI to surge above 1,800 with an average movement of 1,750 until year-end. Together with favourable Simulation outcomes for: (i) Ringgit, (ii) Crude Palm Oil, and (iii) Brent Crude Oil with decent chances (~25%-30%) to test RM3.80, 3,000/tonne and USD45/barrel, respectively, we reckon that the investment sentiment should continue to improve from here. Nonetheless, we also foresee a few caveats that could potentially limit the upside.

... and the Ugly. Tactically speaking, 2Qs normally are weaker than 1Qs and we may see a quieter or thinner trading market due to: (i) Muslim Fasting Month, which start on 6 June until 5 July, as well as (ii) The 2016 UEFA European Championship (or UEFA EURO 2016) held from 10 June to 10 July. Besides, from a valuation stand point, the FBMKLCI is currently trading at lofty valuations of 19.5x/18.0x to our FY16E/FY17E earnings estimates. From another perspective, as FBMKLCI is merely traded at a 1% discount to consensus target price of 1,735, this can be interpreted as a sign of "overbought". This is because the discount of FBMKLCI to its consensus target has overcome the +1SD level (above its 3-year average) suggesting a toppish market as per its historical movement. Even from a regional perspective, we also notice that Forward PER of FBMKLCI is traded at 11.4% higher on average than regional indices. While the "valuation premium" is still far lower than its historical peak of 21%, it has, nonetheless, capped index upside from here as there is no strong reason to substantiate such premium.

End-2016 Target unchanged @ 1,725. Based on the blended Top-Down and Bottom-Up approaches, we peg our end-2016 index target at 1,725, implying FY16E/FY17e PERs of 19.6x/18.1x. For Top-Down approach, we assign a target FY17E PER of 17.5x, hence 1,690. Bottom-Up approach values FBMKLCI at 1,760 based on our analysts’ inputs. Our index target is backed by our 2016 real GDP growth forecast of 4.5% as well as FY16E/FY17E earnings growth rates of 3.6%/7.6% (vs. estimates of 3.9%/8.1% in 1Q16 and consensus estimates of 5.6%/8.9%).

2Q16 Investment Strategy. Timing-wise, we aim to Buy On Weakness (B.O.W.) if and when the index dips below 1,655 and Sell On Strength (S.O.S.) as it surpasses 1,725. As for preference in sector allocations, we have assigned OVERWEIGHT calls for: (i) Construction, (ii) Power Utility, and (iii) Gloves sectors. At the same time, we label: (i) Automotive, (ii) Healthcare (Hospital), and (iii) Property as UNDERWEIGHT. The other sectors are rated as NEUTRAL.

2Q16 Top Picks. After taking all the above-mentioned factors into consideration, coupled with input from analysts, we have selected: (i) CBIP (OP, TP: RM2.49), (ii) DLADY (OP, TP: RM56.40), (iii) KIMLUN (OP, TP: RM2.10), (iv) KLK (MP, TP: RM25.25), (v) KOSSAN (OP, TP: RM8.00), (vi) MALAKOFF (OP, TP: RM2.07), (vii) MITRA (OP, TP: RM1.77), (viii) PESTECH (OP; TP: RM7.43), (ix) SKPRES (OP, TP: RM1.76), and (x) TENAGA (OP, TP: RM16.49) as Top Picks for the current quarter. We also like 2 non-Shariah compliant counters, namely; GAB (OP, TP: RM16.36) and RHBCAP (OP, TP: RM6.23).

Caught Us by Surprise! The recent development of global and local equity markets can probably best to be described as "Risk-On, Risk-Off". Late last year, global and regional markets, including Malaysia, mostly declined as represented by their benchmark indices. However, starting late-Feb16/early-Mar16, those equity indices saw >5% rise on average (see Figure 1). We believe the current advance of the global equity markets is riding on the U.S. Federal Reserve’s (Fed) Chair, Janet Yellen’s dovish tone of late, promoting investors to believe Fed is reluctant to go ahead with more aggressive interest rate hikes after its first hike, after a good seven years, in December last year (see Figure 2). It is clearly seen that the Dollar Index, DXY, has weakened by >4% since early-Mar16 (see Figure 3). Alongside with the swift rebound of Brent Crude Oil (from the new multi-year low of USD29.31/barrel on 20 Jan16 to USD38.67 as of end-Mar16), a total of RM6.1b foreign capital flowed into the local equity market in the month of March, offsetting the net foreign outflow of RM0.5b in the first two months of 2016 (see Figure 4). To be frank, the recent reversal of foreign capital flow had caught us by surprise. Based on our Modern Portfolio Theory (MPT), the model suggested to continue "short-sell" FBMKLCI as of end-Feb16 (see Figure 5).

What Now? Of course, with the strengthening and outperformance of Ringgit Malaysia (see Figure 6), the proposed portfolio weighting for FBMKLCI has improved as of end-Mar16. Albeit lagging behind, we did sense changes in investors' investment strategy. Recall that in our earlier strategy reports, we have highlighted that the combination of strengthening Ringgit and Crude oil prices, coupled with lower market volatility (see Figure 8-9), have caused a series of profit-taking activities in export-driven counters, especially glove makers and an emergence of trading interest in Oil & Gas stocks. Besides, we have also seen investors positioning for catch-up plays in underperforming stocks, i.e. Banking, Gaming (casino) and Property. From Figure 10, it is clearly seen that KL Finance Index (KLFIN) and KL Property Index (KLPRP) have outperformed FBMKLCI in late-1Q16. Based on our observations, banking stocks were recently on investors' radar probably due to their relatively stronger fundamentals, despite asset quality issue remaining a concern, coupled with relatively lower valuation and under performance. Casino stocks like GENTING (MP, TP: RM10.04) advanced 24.4% and outperformed FBMKLCI by >20% in Mar16, inline with the recent strong rebound in regional gaming stocks (see Figure 11). Property stocks, on the other hand, were sought after by investors as market started pricing in higher expectations on more property market-friendly measures in conjunction with the appointment of new Bank Negara (BNM) governor in end-Apr16.

A Better Tomorrow? Are underlying trends and market developments suggest that the worst is over? We do not discount such possibility judging from the declining volatility of both U.S. and local equity markets (refer back to Figure 8-9). Besides, we also believe external market condition, led by U.S., could be less hostile. Based on our U.S. Presidential Election (PE) Study for the period 1984 to 2012, Dow Jones Industrial Average (DOW) merely registered negative returns in 1984, 2000 and 2008 (see Figure 12-13). In other words, excluding the Tech-Boom Burst and Global Financial Crisis in 2000 and 2008, it is reasonable to believe that DOW is likely to remain supportive in year of PE. On the domestic front, we also saw Excess Liquidity (EL) picking up from the trough in Jan16 and current stood at >RM200b (see Figure 14). Coupled with the underlying favourable trend of foreign inflow, improved domestic liquidity should provide the much-needed boost to local equity market. In fact, based on our Monte Carlo Simulation Study, there is high chance, say >35%, for FBMKLCI to surge above 1,800 with an average movement of 1,750 until year-end (see Figure 15). Together with favourable Simulation outcomes for: (i) Ringgit, (ii) Crude Palm Oil and (iii) Brent Crude Oil with decent chances (~25%-30%) to test RM3.80, 3,000/tonne and USD45/barrel (see Figure 16-18), respectively; we reckon that investment sentiment should continue to improve from here.

The Caveats... Nonetheless, we also foresee a few caveats that could potentially limit the upside. Tactically speaking, 2Qs are normally weaker than 1Qs (see Figure 19) and we may see a quieter or thinner trading market due to: (i) Muslim Fasting Month (or Ramadan), which start on Monday the 6th of June and will continue for 30 days until Tuesday the 5th of July, as well as (ii) The 2016 UEFA European Championship (or UEFA EURO 2016) held from June 10 to July 10. Besides, from a valuation point of view, FBMKLCI is trading at lofty valuations of 19.5x/18.0x to our FY16E/FY17E earnings estimates. In fact, as of end-Mar16, FBMKLCI closed at 1,717.6, fast approaching our index target of 1,725. Our index target of 1,725 is based on the average of …

• Top-Down: 1,690 @ 17.5x FY17E PER,
• Bottom-Up: 1,760, representing 18.5x FY17E PER.

Our index target of 1,725 is slightly more conservative than the consensus index target of 1,735 and backed by FY16E/FY17E earnings growth rates of 3.6%/7.6% (vs. estimates of 3.9%/8.1% in 1Q16 and consensus estimates of 5.6%/8.9%) and our 2016 real GDP growth forecast of 4.5% (see Figure 20-21).

Furthermore, as FBMKLCI is merely traded at a 1%-discount to consensus target price of 1,735, this could be interpreted as a sign of "overbought". This is because the discount of FBMKLCI to its consensus target has overcome the +1SD level (above its 3-year average) of -2% and is in the midst of testing the +2SD-level of 0.7%. Based on our observation, the index tends to turn toppish when the discount surpasses the +1SD-level (see Figure 22).

Even from a regional perspective, we also notice that the Forward PER of FBMKLCI is traded at 11.4% higher on average than regional indices (see Figure 23). While the "valuation premium" is still far lower than its historical peak of 21%, it has, nonetheless, capped index upside from here, as there is no strong reason to substantiate such premium.

2Q16 Investment Strategy While investor sentiment is still fairly fragile, it is slowly recovering. However, we strongly believe that the current rally in equity markets is a reaction to the extreme oversold situation and increase of risk appetite by global investors as volatility declines.

For us, although confidence could have improved as: (i) Fed is likely to revise U.S. interest rate in a less aggressive manner, (ii) Ringgit has strengthened against US dollar, (iii) Brent Crude prices are stabilizing, (iv) Crude Palm Oil prices are trading higher, and (v) both external equity inflow and domestic liquidity have improved, a broad-based earnings growth story is still missing and market valuation remains a major deterrent.

As such, our Range-Trading view remains unchanged. With the underlying risk-on risk-off market nature, we strongly believe that the equity market is likely to continue its roller-coaster ride. However, as investors' risk appetite has increased, we believe there is a need to revise up our B.O.W./S.O.S. trading range from 1,600/1,690 to 1,640/1,730.

Investment strategy wise, investors should adopt a cautiously positive stance towards local equities but focus on areas with the best chance of delivering growth (such as Construction). Both Resource and Non-resource cyclical sectors (i.e. Banks, Plantations, Oil & Gas and Property), which offer the best exposure to the recovering investors’ sentiment, are preferred if and when the benchmark index dips towards lower-end of the trading range. At the higher-end of the trading range, we, however, prefer to stick with defensive and resilient sectors (i.e. Consumer, including Sin sub-sector, MREITs and Power Utility).

From a more tactical approach, we reckon that investors may consider accumulating some under-performing stocks such as DRB (YTD: -14.5%, UP, TP: RM0.80) and UMW (YTD: -12.3%, UP, TP: RM4.89) as alpha/dark-horse selections. While the tide is turning against export-driven counters, we believe some of these stocks' sharp price corrections could be overdone as their fundamentals remain solid and earnings are relatively muted to forex movement. As such, we view the recent price weakness as opportunities to accumulate two of our Top Picks - KOSSAN (OP, TP: RM8.00) and SKPRES (OP, TP: RM1.76) - are selected based on this tactical angle. On the flipside, DLADY (OP, TP: RM56.40) is one of the few beneficiaries of the strengthening Ringgit.

On a separate note, while some market observers reckon that the Consumer Sin sector could attract investors' attention due to the Euro Cup, we do not see strong evidence from the past. From Figure 24, it is clearly seen that there is no significant change in the trend pre-and-post Euro Cup. Nonetheless, we still like Consumer Sin stocks such as GAB (OP, TP: RM16.36) for their resilient business and decent dividend payouts.

MPT in Sector Allocations Process - Stock-Picking Remains The Key for Outperformance

Thus far, we have assigned OVERWEIGHT calls for: (i) Construction, (ii) Power Utility, and (iii) Gloves sectors. At the same time, we label: (i) Automotive, (ii) Healthcare (Hospital), and (iii) Property as UNDERWEIGHT. The other sectors are rated as NEUTRAL (see Figure 25-27 for details).

Given that the underlying market is range-bound in nature, we believe the "right" sector allocation is key in outperforming the benchmark index. Hence, in this quarter, we try to employ the MPT concept into our sector allocations process. Assuming a portfolio manager aims to ...

• allocate resources based on the weighting of FBMKLCI and FBM100,
• based on historical price and consensus target movements as of end-Mar16, and
• maximise expected return at a given risk level.

Table in Figure 28 clearly illustrated the "right" ingredient contents. In a nutshell, we notice that the suggested weights of various sectors are skewed toward FBM100. Besides, we also notice higher allocations to alpha stocks, which reinforced the approach of Stock-Picking.

2Q16 Top Picks After taking all the above-mentioned factors into consideration, coupled with input from our analysts, we have selected: (i) CBIP (OP, TP: RM2.49), (ii) DLADY (OP, TP: RM56.40), (iii) KIMLUN (OP, TP: RM2.10), (iv) KLK (MP, TP: RM25.25), (v) KOSSAN (OP, TP: RM8.00), (vi) MALAKOFF (OP, TP: RM2.07), (vii) MITRA (OP, TP: RM1.77), (viii) PESTECH (OP; TP: RM7.43), (ix) SKPRES (OP, TP: RM1.76), and (x) TENAGA (OP, TP: RM16.49) as Top Picks for the current quarter. We also like two non-Shariah compliant counters, namely; GAB (OP, TP: RM16.36) and RHBCAP (OP, TP: RM6.23). We like the former for its resiliency and dividend while the latter is deep in value, in our view. (Please refer to Figure 29 for brief comments on individual counters.)

Source: Kenanga Research - 5 Apr 2016