More upside to come after technical correction

April 21, 2015 18:30
Investors may take a break as the Hang Seng Index consolidates between 26,000 and 28,000 points. Photo: HKEJ

The mainland equity market is mainly driven by government policy, so investors have to understand the mindset of the government instead of merely relying on public information and looking to financial institutions’ moves.

The A shares have rallied sharply in the past three months, and so have H shares in the past two weeks.

Investors are excited to see daily records being set in prices and trading volume. The long-awaited bull has arrived.

However, investors are worried whether the bull has run too fast and gone out of control.

Daily turnover in the Hong Kong market surpassed HK$250 billion (US$32.3 billion) last week, and combined turnover on the Shanghai and Shenzhen markets reached 1.5 trillion yuan on Friday. The record turnover is about three times that of the peak turnover on US markets.

However, the breathtaking rally has prompted China's top securities regulator to tighten margin trading rules.

The China Securities Regulatory Commission (CSRC) rolled out measures on Friday to tighten rules on margin lending and promoting the use of short selling.

The CSRC also banned so-called umbrella trusts that provided cash for margin trading. Under the practice, investors are allowed to borrow against the value of common shares held at a brokerage.

The authorities placed limits on margin trading in high-risk small stocks that trade over the counter rather than on exchanges.

Following the news, Hang Seng futures and A50 futures dropped over 3 percent, which stoked fears of a deep correction over the next two weeks.

The market has been acting abnormally recently, and investors found many past strategies did not work at all.

For example, the negative correlation between the HSI Volatility Index and the Hang Seng Index (HSI) has broken down.

The HSI Volatility Index soared over 28 while the HSI surged past 27,500.

In an extreme market scenario, the negative correlation between the US dollar and the gold price also disappeared when the US dollar index strengthened over 98.

Undoubtedly, the Hong Kong market rally is driven by government policy this time.

Is the run-up on shaky ground?

By imposing the measures on Friday, the central government intends to maintain a healthy market rather than clamping down on it.

The Hong Kong market still has two or three rounds of rally going forward.

The market has gained about 10 percent in the first round, which started April 8.

Apart from government policy, the view of institutional investors is also critical.

Will they expect the HSI to rise further to 31,000 or 32,000 points?

Or do they intend to wait and enter the market when the impact of the government measures wears off?

Investment banks will adopt a strategy of “sell first, buy later” or “press lower and push higher”, which means they will press the market down to a relatively low level before entering it to reap huge profits.

Over the past two weeks, the HSI has rallied to 27,000 points, and the price-earnings ratio increased from 11 to 13.

I believe the market has a further 25-30 percent upside, based on the valuation gap between mainland and Hong Kong stocks.

Mainland mutual funds will gradually enter the Hong Kong market, and about HK$300 million in hot money will flow into the city by June.

It will be joined by HK$60 billion to HK$80 billion in foreign funds, as the Hong Kong dollar has constantly hit the strong side of its trading band against the US dollar recently.

So, as much as HK$400 billion to HK$500 billion will flood into Hong Kong shares by June.

The Hong Kong market will extend its rally on the back of the massive inflow of money.

The future market direction largely depends on government policy and money flows.

The market will rebound dramatically after going through a correction this week.

This article appeared in the Hong Kong Economic Journal on April 21.

Translation by Julie Zhu

[Chinese version中文版]

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adjunct professor in the Department of Finance at HKUST Business School