By the first half of 2026, the sharp contrast of an AI-driven K-shaped market has been met with weakness in Hong Kong stocks and consumer sectors. Structurally, the broad Hong Kong market index itself can be viewed as a "magnified version of consumption." Conversely, as the tech sector began to experience turbulence in July, Hong Kong stocks and the Hang Seng Tech Index staged a rebound, acting like the two ends of a seesaw.
Is there a pattern to this recent rally? Beyond assessing whether the AI rally is a bubble and its level of crowding, Hong Kong stocks showed signs of bottoming out in late June. We previously highlighted that, from a multi-dimensional perspective of valuation, sentiment, and positioning, Hong Kong stocks offered attractive "odds" and left-side value for absolute return investors. Now, the market has largely returned to its starting point before the sharp sell-off in early June, moving from an extreme K-shaped divergence with tech to a less extreme one. After this "filling of the gap," the question is whether there is further upside. To answer this, we must understand what drove this rebound, whether the issues that previously suppressed Hong Kong stocks have been resolved, and when they can outperform.
1. What Drove the Recent Rebound? Tech's Sharp Decline Forced a Rebalancing of Overcrowded Positions
Since the bottom in late June, the Hang Seng Index has rallied 13.2%, with the Hang Seng Tech Index rising 14.2%. Leading sectors include the lagging consumer discretionary (26.2%), healthcare (25.2%), materials (17.9%), transportation (14.8%), and media & entertainment (14.7%). Low valuations and low positioning provided the conditions for a rebound, but the primary catalyst was the forced rebalancing of crowded positions following the tech sell-off. The rebound was characterized by a clear rotation from high to low, with the internet sector, the largest weight in Hong Kong, being the main focus. For instance, consumption-related e-commerce leaders like Alibaba and Meituan rebounded more sharply, at one point gaining over 40% from their lows. In contrast, sectors that led the first half of the year, such as optical fiber, copper foil, and large language models, saw corrections exceeding 60%.
This rebound was almost entirely driven by valuation expansion, specifically risk premium, which is essentially sentiment. This occurred even as US bond yields rose. The rebalancing was also evident in fund flows. Southbound funds accelerated their inflows in July, and overseas active funds returned for two consecutive weeks starting in late July, marking the first such inflow in nearly three months. Conversely, funds from Korea and Taiwan experienced outflows, illustrating the "seesaw" effect of capital flows.
2. Where Does the Hong Kong Market Stand Now? Valuations and Sentiment Have Returned to Average
After the recent recovery, the Hang Seng Index's valuation has returned to its historical average. Its forward P/E has risen from 9.7x at the end of June to 10.8x, now above the 10-year average. However, the Hang Seng Tech Index's valuation remains relatively low, with its forward P/E at 16.9x, still below its average. From a risk premium perspective, the ERP for the Hang Seng Index has fallen to 5.4%, while the Hang Seng Tech's ERP has dropped to 2.2%. Pessimistic sentiment has also been repaired. The 14-day RSI, which was in oversold territory, has rebounded, now approaching overbought levels. Short-selling activity has cooled significantly, with the ratio of short turnover falling from 20.1% to 15%. Furthermore, the scale of share buybacks in July dropped sharply from June's record highs, reflecting the changing attitude of company insiders after the price recovery.
3. Have the Issues Suppressing Hong Kong Stocks Been Resolved?
The weakness in Hong Kong stocks in the first half of the year stemmed from three main constraints: weak domestic demand, a market structure lacking AI hardware, and tight funding conditions. The recent rebound has only clearly alleviated the third constraint. The first constraint, which is a weak domestic economic backdrop, remains largely unchanged. The consumer sector is not a major driver of the rally. The second constraint, while helping Hong Kong stocks avoid the worst of the recent tech hardware sell-off, has not been resolved. The strong rebound is mainly due to the rebalancing of capital from the volatile tech sector, with the recent weaker-than-expected US jobs data also easing pressure on the Fed.
Domestic fundamentals remain weak, and the recent Politburo meeting offered limited incremental policy support. To drive a broad-based recovery, a "924 moment" – a significant fiscal stimulus focused on consumption – is needed. The current policy stance is not strong enough to change the year's volatile range-bound pattern. While the recent structural tech rotation has been a temporary advantage for Hong Kong, its tech and internet companies still need to prove themselves through investment and model optimization to achieve an AI commercialization breakthrough, akin to a "DeepSeek moment." The turmoil in the tech sector and its crowded positioning are facilitating fund rebalancing, which is beneficial for Hong Kong stocks. The cooling of Fed rate hike expectations also provides a tailwind.
4. When Can Hong Kong Stocks Outperform? Typically, During a Rise in the Household Credit Impulse
The K-shaped divergence between tech and consumption, and between A-shares and Hong Kong stocks, fundamentally reflects the divergence in the credit impulses of corporates and households. Historically, whenever Hong Kong stocks have significantly outperformed A-shares, it has corresponded with a strengthening of the household sector's credit impulse. This is particularly evident since 2018. Over the past decade, in four of five phases where the household credit impulse strengthened, Hong Kong stocks notably outperformed A-shares. On average, MSCI China outperformed the Wind All A-share Index by 6.6% during these phases. Conversely, during periods of household credit contraction, Hong Kong stocks underperformed A-shares by an average of 2.7%. This phenomenon is tied to the market structure of Hong Kong, where over 70% of the index weight in the Hang Seng and Hang Seng Tech is exposed to domestic demand, such as internet platforms, e-commerce, and new energy vehicles. The current persistent decline in the household credit cycle explains the underperformance of Hong Kong stocks.
5. How to Position? The Hang Seng Tech Index Still Offers Better Odds; Diversify Towards Sectors with Less Fundamental Resistance
As the recent rebound in Hong Kong stocks was more about "relative attractiveness" compared to the high valuation and volatility of the tech sector, rather than "absolute attractiveness" from a profit upgrade, the "odds" have naturally decreased after valuations and sentiment have been repaired. From this perspective, the Hang Seng Index's odds are now lower than those of the Hang Seng Tech Index. The Hang Seng Tech Index, having fallen more deeply, still has a valuation at a historical low percentile, and its odds advantage has not been fully exhausted. It could show stronger elasticity in any subsequent rebalancing. However, we emphasize that fund rebalancing and low valuations can only support a tactical rebound. A sustained, broad-based recovery still requires a "924 moment" for fiscal stimulus or a "DeepSeek moment" for a tech breakthrough.
In terms of sector selection, tech remains a core theme. The AI bubble pressure index we track recently approached its historical highs, suggesting the worst of the tech volatility may be passing. However, a significant upward move would require new catalysts. Outside of tech, it is prudent to diversify towards sectors with less fundamental resistance to balance odds and risk. Sectors such as innovative drugs, some internet plays, and gold and materials that benefit from falling US bond yields are attractive. Based on our latest odds and win-rate framework, sectors like insurance, materials, electrical equipment, pharmaceuticals & biotech, and energy currently score highly.
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