WITH a stimulating China story behind it and having been driven by a deluge of liquidity, the Hong Kong market has defied gravity. The Hang Seng index stands at above the 11,000 mark and the overall sentiment remains buoyant. However, with the building up of substantial profit-taking pressure and certain unpredictable factors looming, will the spectacular rise of the market continue in 1994? Since the beginning of this year the HSI has doubled. On the other hand, the constituent's EPS are estimated to have increased an average 23 per cent, meaning that P/E expansion has accounted for a 63 per cent gain on the index. The HSI's current P/E of 20.5 is at the high end of its 15-year range, while a corporate-earnings growth forecast of 15 per cent compound for the next two years is lower than the 20 to 30 per cent in the 1980 and 1987 bull markets. We therefore believe the market is fully valued at its existing level. A bull market usually comprises three phases. We believe the Hong Kong market has entered the third phase, which is characterised by a relatively high P/E; sharp increases in short periods of time; second and third liners gaining dominance; and active participation by retail investors. However, there are no signs that the bull phase will terminate immediately. Compared with 1987, the level of retail participation is still quite subdued and the small companies are less expensive than the blue chips. We therefore believe the market is inthe initial stage of the third bull run. The recent buying interest from Japanese and US investors appears to be sustainable and the market's upward momentum should be brisk. This additional liquidity, together with the overwhelmingly upbeat local sentiment, is expected to push the market higher in the coming months. Based on our estimated 1994 HSI EPS of 640 and a P/E of 19 to 20 times, the market has the potential to reach the 12,000 to 13,000 level next year. However, when the market is trading at the high end of its P/E range, it is more susceptible to any bad news. Potential undesired events that can trigger a major adjustment include: non-renewal of China's MFN status with the US; further weakening of the renminbi; and political or social unrest in China. We recommend investors to be slightly underweight at 10,500 to 12,000 and to reduce holdings aggressively if the HSI touches 12,000 - 9,000 to 9,700 will be an ideal level to pick up stocks. Conglomerates, properties and red chips are our most favoured sectors. Percy Au-young is research director of DBS Securities Hong Kong.