If history is any guide, investors had better buckle up and get ready to ride the Hang Seng Index down to 12,000 points.
The market's rally earlier this year has been in defiance of its usual relationship with the United States Federal funds rate, which has been jacked ever higher since last summer as the Federal Reserve got nervous about breakneck growth in the US.
Although there has been a correction since the market's peak in March, it is not enough to get stocks back in line with where they should be against interest rates.
Pacific Challenge Securities uncovered the distortion when it compiled a graph tracking the Hang Seng Index's earnings yield. (A reverse of the index's price-earnings ratio, the yield is calculated by dividing the market's earnings per share by its share prices.) 'It was quite a stable relationship. Whenever the [index] yield went above a 2 per cent premium to the Fed funds rate, that basically prompted people to buy the market. And whenever it moved to a zero premium, it was a market sell point,' Pacific Challenge research director Alan Hutcheson said.
That made sense as stocks, with their inherent risks, should provide a premium to instruments giving risk-free returns.
'Of course the relationship got completely thrown out of kilter by the Asian financial crisis when for a few months you had the [index] earnings yield exceeding the Fed funds discount rate by 6 per cent,' Mr Hutcheson said.
There was some logic to that with investors factoring in an extra premium to cover holding the Hong Kong dollar at that time.
