Hong Kong's small-cap rally is showing no sign of letting a little thing like valuations get in its way. After a 28 per cent surge last month, the Hang Seng Composite Small Cap Index traded on Monday at 27 times trailing earnings, the highest in data dating back to 2010 and more than double the multiple for bigger equities. With stocks from China Merchants Land to Coolpad more than doubling in the span, volatility on the measure soared to the highest in more than three years. As mainland Chinese investors pump cash into the city, their preference for small caps is becoming more pronounced. Confidence that Beijing would keep the rally going with stimulus was everywhere, Convoy Asset Management said. "Liquidity is going into the market, and small caps are going to keep surging," said Cedric Ma, a Hong Kong-based senior investment strategist at Convoy. "What we're seeing is gains not due to the fundamentals or the earnings aspect, but more on the macro environment." The Hong Kong small-cap gauge surged 33 per cent from March 27 to Monday, as the market began to rally after the mainland regulator made it easier for some mainland fund managers to buy equities listed in the city. That is more than twice the advance by the Hang Seng Composite Large Cap Index. While mainland investors did not have direct access to small caps through the Hong Kong-Shanghai stock link, they were buying them through a separate quota programme, Hu Xiaohui, chief strategist at SWS Research, said last month. The gains come even as the mainland economy slows, with March data including industrial production, exports and retail sales missing analyst estimates. A factory gauge for April published on Monday showed the lowest reading in a year. The central bank cut the amount of cash lenders must set aside as reserves by the most since 2008 last month, following two reductions in its benchmark lending rate since November. Policymakers were recognising that the slowdown was becoming a risk, and there was lots of room to cut interest rates further, said Stephen Ma, senior portfolio manager at LGM Investments. Still, it was odd for the smallest stocks to be rallying while the economic outlook was so gloomy, he said. "Usually people buy small caps when the macro economy is doing well," Ma said. "This time around you can say it's the Eastern version of Western QE." While Hong Kong's small stocks are expensive relative to their own history and to the city's largest companies, they're cheaper than US and mainland counterparts. The Russell 2000 Index traded at 46 times trailing profits on Friday, while the ChiNext index of small-cap shares in Shanghai and Shenzhen was priced last week at a multiple of 98. "This rally we saw in the small caps certainly is justified," said Raymond Chan, chief investment officer for Asia-Pacific equities at Allianz Global Investors. "In the Shenzhen market, the valuation there is crazy and a little bit too high - even some of the global small caps are trading at high multiples." Jun Yang Securities chief executive Kenny Tang said there was a reason for the small cap rally on both sides of the mainland-Hong Kong border: those companies were the biggest beneficiaries of all the cash sloshing around the mainland's financial system, getting easier access to credit. The People's Bank of China central bank reduced reserve requirements by a further half a percentage point last month for banks with loans to small enterprises, in addition to the 1 percentage point cut for all lenders. The steepness of the small-cap ascent concerns Grace Tam, a global market strategist at JPMorgan Asset Management. The stocks were overpriced and too risky, she said. "This could be really dangerous because when things turn around it could shoot down," she said. The small-cap gauge slid 2.9 per cent at the close in Hong Kong yesterday, while the benchmark Hang Seng Index retreated 1.3 per cent. The Shanghai Composite Index sank 4.1 per cent. Investors who had targeted the most obvious beneficiaries of the recent rally were now looking elsewhere, including small caps, said Alex Wong, a Hong Kong-based asset-management director at Ample Capital. "We are seeing the index losing momentum, so that means people are not willing to push big caps higher," Wong said. "People are diversifying in small caps to get return."