How Useful are the E/P Ratio and the Spreads between the E/P Ratio and Interest Rates in Forecasting Hong Kong Stock Market Conditions?

The earnings-price ratio (E/P ratio) of the Hang Seng Index (HSI) and the spreads between the E/P ratio and interest rates are widely used by market practitioners to forecast the stock market outlook. This paper studies their usefulness as indicators of future Hong Kong stock market conditions. Based on simple regression models, this paper finds that the E/P ratio and the spreads are not particularly useful for forecasting the returns or the excess returns of the Hang Seng Total Return Index. Trading rules based on the out-of-sample forecasts or the historical extreme values of the E/P ratio and the spreads, which provide market-timing signals for deciding whether to invest in the HSI or to switch to the 1-month Exchange Fund Bill, can reduce the volatility of the portfolio investment without significantly lowering the average return. Some central banks' financial stability reports include measures of whether stock markets are overvalued by looking at E/P ratios. However, the results in this paper show that the ratios are not useful in assessing the extent to which there is an overvaluation in the Hong Kong stock market in the short run.