Extreme indicator

Of all the main stock markets around the world Hong Kong has long been the most volatile. This month's worldwide equity boom has seen it performing on cue. At the beginning of this month the Hang Seng index went through 8,000. Yesterday, after a session during which it rose by 267 points, just over 3 per cent, it went through 9,000 to close at 9,031. It has risen by 64 per cent so far this year. Given the momentum behind yesterday's buying, there is every chance that the rise will continue a little longer.

If this is the stuff of the record books, it is also the stuff of the classic stock market mania. In all such market booms, from the South Sea Bubble of 1720 onwards, there is some solid basis. Here it is Hong Kong's position as the potential financial capital of what will almost certainly become the world's largest economy within a generation, coupled with impressive earnings growth during the last three or four years as the mainland economy has taken off.

Nothing wrong with that. But in investment terms the cocktail is explosive. Investors have not only the intellectually respectable argument that they are buying a stake in the future; they have the financial self-confidence based on the paper profits already achieved, mixed with a fear of missing future ones. (The latest rise seems to have been stimulated by a desire by US fund managers to diversify into non-Japanese Far East markets, of which Hong Kong is the largest.) This creates such a scramble to buy that the 'what might go wrong?' questions are for while buried. Once they do surface there is of course no time to get out.

To articulate the bear case at a time like this is to be too early. At some stage in the coming weeks or months the market will break, in a quite savage way. But anyone who says this is going to be wrong in the short term. Nevertheless, the bear case is worth articulating, for it is fundamentally correct: the top of this cycle might be 12,000, but it would be astounding if the next trough were higher than the market is today.

Because of its volatility Hong Kong has in the past taken a long time to get back to previous peaks. Investors who bought at the end of 1964 would have had to wait until 1969 before they were square. There was then an extraordinary run to the early part of 1973, but then, in common with many other equity markets, it fell until the first weeks of 1975. It took until 1980 before the market climbed back to the 1973 peak. Investors who bought in 1981 would have had to wait until 1985 before they were ahead, while people who went into the market in the autumn of 1987, just before the crash in October, would have had to wait until the end of 1992.

In dollar terms, rather than local currency, the swings would be even greater. The Hong Kong dollar rose around 17 US cents in the 1960s and early 1970s to reach reach 22 cents in the late 1970s. It then virtually halved in value so that by 1983 it was worth just 13 cents, the rate at which it has been maintained since.

Looking ahead, some of the risks are articulated in the latest International Bank Credit Analyst. It argues that there are three. First, property prices are seriously over-valued, and nearly half the earnings of companies in the Hang Seng index are derived from property. Take out property and banks, and the Hang Seng companies, instead of being valued on a price/earnings ratio of below 20, are actually on about 25, which is certainly not cheap by world standards.

Second, China's austerity programme is beginning to deflate the Hong Kong economy too, for falling import demand from the mainland will directly affect Hong Kong. Third, there is the political tension between Britain and China: a breakdown of the talks over Hong Kong's future would trigger a fall in the market at least in the short-term.

Of these, the first and third are the most immediate, for any check in property values or a breakdown of the talks would have a direct impact on the market. But the most interesting is the second: Can the air be let out of the China bubble slowly? This is a matter not just for Hong Kong but for the world.

There is no doubt that there is a ferocious credit squeeze taking place, and both investment and industrial production are falling sharply. But it is difficult to make a judgement from a distance about the severity of the impact of this squeeze: to what extent the corporate sector will respond by laying off workers and what the consequences of that will be. Meanwhile, inflation is still rising and will probably be close to 16 per cent by the end of the year.

In global terms, the Chinese economy, while growing at an astonishing rate, is still not large enough to prolong the world recession in any serious way. But it is is worth recognising that it is going into recession last of all. Most people think of Japan as the last big economy to turn down; actually it is China.

Of course the thing that checks the Hong Kong boom may be none of the above: it may simply be a break in equity markets worldwide. If and when that happens, all past experience would suggest that Hong Kong will be hit harder than any other. A break in Hong Kong, on the other hand, need not signal a worldwide share price collapse.

What makes Hong Kong particularly worth watching is that it functions as an extreme indicator of sentiment. Moods are more exaggerated, swings more violent. See yesterday's surge as an extreme example of equity fever; judge future swings in the same light.