Hong KongÆs benchmark Hang Seng Index (HSI) could trade sideways from current levels as most investors may not add new capital to the market before the holiday season kicks in, according to Merrill Lynch, which nevertheless maintains its positive view on the market.

ôWe argue that further downside to the HSI from current levels should be limited in the near future, Merrill Lynch says in a report, noting that liquidity is still staying in the market, short selling pressure has peaked, Hong Kong continues to attract attention, and the earnings revision ratio is strong. Merrill Lynch believes the HSI, which closed at 28,658.42 on 3 December, is trading at a fair valuation at current levels and Hong Kong is an overweight in its model portfolio.

In the past month, the HSI has had a volatile performance and dropped 9%. Investors are worried about the US subprime fallout, rising oil prices and the Chinese governmentÆs efforts to stem liquidity outflow to Hong Kong by delaying the qualified domestic retail investor (QDRI) program and clamping down on underground financial institutions in Shenzhen, Merrill Lynch says.

Merrill Lynch recommends that investors stick with blue chip companies. It favours big property developers, large banks and conglomerates. Keith Yeung, its property analyst, expects a 50% rise in residential prices by 2009.

The US sub-prime falloutÆs impact û which is foremost on the minds of many investors û
is less pronounced on Hong Kong companies than on the rest of Asia, because of the strong corporate balance sheets of companies in the territory, Merrill Lynch says. ôOur economic team believes that neither ChinaÆs macro adjustments nor potential slowing global economic growth will have a significant impact on the territoryÆs real GDP growth.ö

Hong Kong has cut interest rates by 75 basis points to 7% in the past three months. This could fall lower should the US cut its Fed funds rate. Merrill Lynch US economist David Rosenberg forecasts that the Fed funds rate will fall to 2.5% by 2008 and 2% by 2009.

Against this backdrop, Merrill Lynch is bullish on Li & Fung, Bank of China (Hong Kong), Hutchison Whampoa, Sun Hung Kai Properties, Yue Yuen Cheung Kong, MTRC and Henderson Land. It is bearish on Kerry Properties, Johnson Electric, HSBC, Techtronic and Cathay Pacific.