Hong Kong options traders have never been so bullish on the city’s stock market after surging inflows from mainland China propelled the Hang Seng Index to the biggest rally worldwide last week.
Wagers on gains for the benchmark gauge increased to the most expensive level on record versus bearish ones Friday as the measure completed a 7.9 percent weekly advance, the most among national equity gauges. Surging demand for bullish contracts has been a past harbinger of gains, with the Hang Seng index posting an average one-month increase of 1.3 percent the five times since 2005 that calls became pricier than puts.
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The mania that sent the Shanghai Composite Index to an 89 percent advance over the past 12 months is spreading to Hong Kong as Chinese investors use the cross-border exchange link to hunt for bargains in the former British colony. While a technical indicator suggests Hong Kong shares are now more vulnerable to declines than any other market, dual-listed companies in the city still trade at a discount of about 20 percent versus the mainland.
“Hong Kong will outperform China in the next couple of months,” Matthew Sherwood, head of investment markets research in Sydney at Perpetual Ltd., which manages about $21 billion, said by phone. “There’s been a lot of hot money flowing out of China, where markets have rallied strongly, into Hong Kong, which had largely missed the rally. Valuations are not expensive relative to the rest of the world.”
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Last week’s rally was the biggest since October 2011, sending the Hang Seng index to a seven-year high of 27,272.39. A gauge of Chinese companies listed in the city gained 10 percent as investors bet valuations will converge with the mainland.
Stocks in China have surged on speculation policy makers will do more to support growth in the world’s second-largest economy. Dual-listed shares are 23 percent more expensive on mainland exchanges than in Hong Kong, according to the Hang Seng China AH Premium Index. The valuation gap reached 36 percent on March 26, the widest since October 2011.
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Hong Kong shares have been largely out of favor with longer-term investors, who will face pressure to change that stance if the gains continue, said Evan Erlanson, the chief investment officer at Seres Asset Management in Hong Kong.
Options traders have taken note. One-month calls that pay out on a 10 percent rally in the Hang Seng Index cost 3.4 points more than contracts betting on a 10 percent decline. The difference, known as skew, is the widest since Bloomberg started compiling the data in April 2005. As recently as April 8, it cost more to bet on a decline.
For three-month contracts, calls have become more expensive than puts just five other times since 2005, including January and February this year and December 2014. The Hang Seng Index rallied 4.4 percent in a month when the options market turned bullish in January.
The options skew “is telling you that there’s real demand coming into Hong Kong,” said Neil Azous, founder of Stamford, Connecticut-based Rareview Macro LLC, whose firm trades options on a U.S. exchange traded fund tracking Hong Kong-listed shares. “It’s Hong Kong’s turn to play catch-up. There’s just such a frenzy going on.”
The Hang Seng China Enterprises Index of mainland firms listed in Hong Kong rose 1.7 percent at 9:44 a.m. local time Monday, while the Hang Seng Index advanced for an eighth day.
At least one technical indicator signals the gains may be overdone. The Hang Seng measure’s 14-day relative strength index climbed to 86.8 Friday, the highest since 1993 and the most among major benchmark indexes tracked by Bloomberg. Levels above 70 indicate to some traders that shares are poised to decline.
Hong Kong stocks are vulnerable once the U.S. Federal Reserve starts raising interest rates, according to Mahesh Varma, an assistant vice president at Kim Eng Securities Pvt. Higher U.S. borrowing costs get transmitted to Hong Kong’s economy through the city’s dollar peg.
“Investors are pumping funds wherever they see a price difference after the stock connect,” Varma said in a phone interview from Mumbai. “There is a risk that if the interest-rate cycle turns in the U.S., there may be some unwinding of speculative positions.”
So much money flowed into Hong Kong last week that the city’s de facto central bank had to intervene in the currency market for the first time since August 2014 to maintain its peg to the greenback.
The Hong Kong exchange had record turnover on Wednesday and Thursday as Chinese investors used up their daily 10.5 billion yuan ($1.7 billion) quota through the exchange link. Trading limits for the program will be increased, Hong Kong Exchanges & Clearing Ltd. Chief Executive Officer Charles Li said on Friday, without providing a timeframe.
“A lot of our clients are suddenly being caught out and trying to catch up on doing work on China,” Mixo Das, a Singapore-based equity strategist at Nomura Holdings Inc., said by phone. “It’s always been our base case that the A-H share gap will close, but the speed at which it’s closing is definitely dramatic.”
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