Here's how investors can predict the next big correction in Hang Seng Index

It's been everybody's concern now.

After five years of grinding indecision, it has been noted that Hong Kong’s Hang Seng Index has finally broken-out and is advancing on the record high from 2007.

According to a research note from CCB International, one of the questions that has been raised in light of this development is how can long can the rally last.

The question every investor and risk manager is asking themselves is how long the present rally in Hong Kong and China will last and when people should expect the next big correction, said the note.

Unfortunately, it is impossible to forecast when a market will correct; however, it is possible to predict, albeit with limited accuracy, how long a rally might persist.

Here's more from CCB International:

In order to assess the likely duration of a rally, one needs a measure of value and a measure of business cycle location.

All things being equal, the cheaper a market is and the earlier we are in the expansion phase of the global business cycle, the longer an equity rally may be expected to last.

It doesn’t really matter which measure of value one uses because most will give similar readings. For example, the chart below plots our measure of deviation from the long-term trend against a measure of the equity risk premium.

These measures are very different in construction but generally paint a similar picture. We like using the deviation from the long term trend because speculative bubbles are extremely easy to spot with his approach.

To assess the business cycle position, we use the same measure of the business cycle that we employ in our market cipher methodology for sector allocation. By combining a valuation measure with the measure of business cycle position, we are able to generate an equation which models the coming year’s change in the Hang Seng Index.

Since 1978, the index has suffered seven serious year-over-year declines. Five of these declines followed speculative bubbles, in 1979-80, 1986-87, 1991-93, 1998-99 and 2005-07. The equation anticipated six of the seven bear markets. It missed the bear market in 2011 because the market was cheap at the time.

Notice that this framework cannot anticipate when equity bubbles will arise. However, what we can say is that the current reading in our equation is forecasting the strongest market environment since 1999. On the basis of the experience of the past 37 years, it is unlikely that the Hang Seng Index will be lower in 12 months’ time than it is now.

The current market deviation from the long-term trend is presently -23%. The left chart below shows the subsequent 12-month return whenever the deviation has been lower than -20%.

As can be seen, instances of a year-over-year market decline with such a negative deviation have been rare. In the 95 months where the deviation was less than -20%, the market was lower a year later on only eight occasions. In every single instance, the losses were subsequently erased by a powerful rally.