Stocks slumped and IPOs fizzled in premier China gateway Hong Kong this week in a mirror image of the U.S. dollars rise. The blue chip Hang Seng Index fell 2.8%, 609 points, to 21, 024, and the index of Chinese companies plunged 4.4%, 559 points, to 12,056. On Thursday, the Metallurgical Corporation of China (Hong Kong no. 1618) plummeted 12% from the offer price of its massive IPO.

"The market still really depends on the performance of the U.S. dollar," Conita Hung, director of Delta Asia Securities, told the Weekly Report. "The dollar rebounded, so that put pressure on Hong Kong stocks."

In general, she said, a rising dollar drains liquidity from stocks as money flows from equities and commodities to bonds. And with U.S. interest rates at rock-bottom levels, investors borrowed dollars to sink into equities and commodities. But Hung noted that when the dollar rises investors may have to take that money out to cover short positions in the dollar.

Among the major casualties this week were Mainland banks and insurance companies. Commodity players also lost as prices fell for commodities such as gold and oil.

Hung expects the dollar to strengthen further next week. "If the dollar continues to rebound, the Hang Seng Index could test 20,300," she said. That would be a drop of 3.4%. But she is confident the market will find strong support at that level and bounce back as high as 21,300.

Another factor next week will be the beginning of a long holiday in China as Mainland exchanges and businesses close for the National Day and Mid-Autumn Festival from Oct. 1 through 8. The Hong Kong market will shut down Oct. 1. The long holiday might focus attention on Chinese retail and hotel stocks, giving them a short-term bounce, Hung said. Among the possible beneficiaries she listed are cosmetics firm Sa Sa International (178), sports and leisure apparel and footwear player Li Ning Co. (2331) and Shanghai Jin Jiang Hotels (2006).

By Gene Linn

China stocks led the Hong Kong market to new heights this week as major factors lined up in favor of the bulls. Blue-chip Hang Seng Index rocketed more than 1,000 points higher Wednesday and Thursday to a year-high of 21,769. Turnover also swelled to impressive proportions. The index pulled back slightly Friday, but still gained 2.2% for the week to 21,623. The index for Chinese companies gained even more, 2.8% to 12,615.

Encouraging economic news and rising stock markets in China and the U.S. attracted ample foreign funds to the Hong Kong exchange. “Both tides ran well,” Howard Gorges, vice chairman of South China Brokerage, told the Weekly Report. He said even the calendar favored bulls: Sentiment is strong ahead of China’s National Day on October 1.

Gains spread across the board. Chinese properties rebounded and banks and metals stocks rose on recovery hopes.

Analysts have periodically wondered if the market has gained too much to fast since lows in March, but this bull looks like it has room to run, at least in the short term. “Next week the feeling is the rally will keep going,” Gorges said. Chinese leaders seem to want everything to run smoothly up to National Day and the one week holiday in early October.

Aside from the possibility of unexpected bad news, the main drag on the market could be a rash of upcoming IPOs, which could suck up some of the liquidity.. Heavily oversubscribed China Metallurgical, the second largest IPO in the world this year at over US$5 billion, will launch next week.

Continued rebound in A-shares on Mainland exchanges drove Hong Kong to a new year-high close this week. Chinese heavyweight components led the blue chip HSI index up 842 points, 4.1%, to 21,161. Building on sharp increases the final two trading days of last week, blue chips ended at the highest level this year. The index for Chinese companies jumped 4.3%, 507 points, to 12,268.

Although the rise was impressive, turnover remained well below the bull market’s take-off period in May and June.

Hong Kong stocks followed A-shares up this week, just as they dropped along side Mainland counters two weeks ago. “The influence of A-shares is the most important factor,” Francis Lun, general manager at Fulbright Securities, told the Weekly Report.

The connection between A-shares and Hong Kong stocks is clear, but not direct. Aside from a limited opening to big institutional investors, A-shares are off limits toHong Kong and foreign investors. But often the same factor that moves A-shares also drives Hong Kong stocks. That’s understandable given that 60% of turnover inHong Kong comes from China-related stocks. In the current case the common factor is the Chinese economy.

Worry that Chinese authorities would tighten economic policies pushed markets in the Mainland and Hong Kong lower, Lun said. But Beijing pointedly stated last week that the loose economic policy enacted to fight a serious recession would continue. The release of positive Chinese economic statistics Friday was another boost.

“Banks led the way,” Lun said of this week’s surge. “That is because measures to stimulate the economy specifically target the banking sector.”

There is enough oomph left in the bull to push the market higher next week, according to Lun. But the focus may shift to local Hong Kong banks, such as Wing Hang (302) which may attract a big investment from Mainland banking giant ICBC.

Like everyone else in Hong Kong, Alex Yuen, head of research for Guoco Capital Limited, is in a hurry. A walk from the reception area of Guoco in a gleaming 73-story building to a small conference room quickly becomes a sprint. But once seated Alex spends better than a half hour talking with me about his views and experience regarding China-related stocks.

Let's start with the good stuff. The Hong Kong market's average PE for the last 10 years is 16 times - just where it is now. "For the rest of the year we forecast a high of 21,600," Alex said. "The market is now at about 21,000, so there's not much upside." However, Guoco is forecasting EPS growth of 15 - 20% in 2010. Assuming the same PE multiple of 16, the end of 2010 would see the blue chip index at 25,600, up about 22% from mid-September.

Alex's conclusions carry the weight of experience. He looks young to me (although an increasing number of people do these days) but he has 19 year's experience researching and analyzing the Hong Kong market. That is forever in Hong Kong, where Chinese stocks began to list 16 years ago, where the British hand over to China was 12 years previous, and the Asian financial crisis and U.S. financial breakdown were only 12 and 1 year ago respectively.

Here are some other nuggets from his comments that might be of interest to foreign investors:

*Average retail investors would do well to consider Hong Kong China-related Exchange Traded Funds (ETFs) and indexes. The biggest China-related ETF is A-50 Tracker, which is not open to U.S. citizens because of China's capital market restrictions. But they can deal in an ETF tracking China companies listed in Hong Kong (Hong Kong No, 2828). Another fund follows the blue chip index (2800).

Guoco Capital itself does not generally work with average investors. Most of its clients are wealthy investors referred by other arms of the sprawling parent company, Hong Leong Group. Quite a few are ethnic Chinese from Malaysia, reflecting Hong Leong's Malaysian base.

*Once you pick a stock or ETF, don't set it and forget it. The huge swings in prices in the last 19 years taught Alex you shouldn't fall in love with your China stock. Buy and hold equals hold and lose.

*Major Chinese investment institutions are setting up bases in Hong Kong. This will not only increase liquidity, it is likely to boost volatility. Young, mostly 30-something, Chinese fund managers lack experience. "They are not so sophisticated in risk control."

*While Alex is bullish about the Hong Kong market for the medium term (say five years or so), he is not so sure about further into the future. China is determined to make Shanghai's financial sector a major international player after 2020, challenging Hong Kong

The Hong Kong market, the key gateway to Chinese stocks, ended this week on a high note, erasing losses from earlier in the week and pushing the blue chip index back above 20,000. For good measure, previously sluggish turnover showed some life.

A breathtaking rise Friday afternoon helped the blue chip Hang Seng Index (HSI), with its mix of local and Chinese heavyweights, gain 797 points, 4.1%, in the last two days of the week to 20,319, The index dropped as low as 19,522 on Wednesday. The index of Mainland companies did even better, jumping 5.1%, 569 points, Thursday and Friday to 11,761. Daily turnover soared to Hong Kong dollar 75.5 billion Friday, from the 55-billion level earlier in the week.

As U.S. markets moved sideways, the main catalyst for the surge was stabilization of A-shares in Shanghai and Shenzhen. Worry over possible Mainland economic tightening had helped drive A-shares down more than 20% in the last two weeks.

However, there is reason to think the late week surge is not the restart of this summer's earlier remarkable bull run. Rather it could be part of a pattern of big investors jumping in the market at low levels and pulling out again to let the market drift back down.

That's what Alex Tang, research director at Core Pacific Yamaichi, suggested to the Weekly Report. He noted that daily volume has dropped from about 79 billion HK$ during May's sharp rises to about 70 billion in July and August. Turnover in the first three days of September averaged an anemic 55 billion. "Turnover is a key indicator showing the direction of the market," Tang said. "All in all, shrinking turnover is a clear indication major buyers are taking a wait-and-see attitude, looking for re-entry points."

One sector that might be particularly attractive to buyers is banking. Hong Kong-listed Chinese banks expect higher interest rate margins and more income from fees in the second half of 2009, Tang said. And during Friday's sharp rise, banks did very well. ICBC (Hong Kong number 1398), for example, gained 4.6%