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Bubbling Equity Markets In China?
Perspective | 22 May 2015
By: IG

This article is written by Bernard Aw, IG.

As we cross into the middle of 2015, Chinese equity markets continue to stay on a roaring path after several years of inactivity.

Sharp Surge

In the six-month period between November 2014 and April 2015, the Shanghai-Shenzhen CSI 300 Index (CSI300 Index) propelled over 90 percent, almost doubling its level, hurling towards 5,000 points. While the sharp movement lifted the index to a seven-year high, it is still considered relatively modest compared to the bull run in 2006 and 2007. This is not to say that a sharp market pullback is off the cards. Indeed, there are concerns of such a possibility, raised in some quarters.

In the 2006 to 2007 period, the CSI300 Index rocketed well over 500 percent, soaring from below 1,000 points to a record high of 5,891. However, the following year saw the index plunged over 70 percent, which ended the two-year bull run. The nosedive came even though China grew 9.1 percent in 2008 and the domestic capital markets are still relatively isolated from international markets.

In fact, the loss of 65 percent recorded on the benchmark Shanghai Composite Index (SHCOMP) in 2008 was the largest in Asia and second largest in the world (behind Russia). The onset of the global financial crisis (GFC) could partially explain the biting retreat but it is insufficient to pin the magnitude of the plummet on just that, as the burst of the speculative equity bubble contributed significantly to the plunge.

Pent-up demand for Chinese equities were unleashed after the government took concrete steps to improve the efficiency of the stock exchange after 15 years of inactivity and inefficiency. The quest for higher returns in an environment of low or negative interest rates drove investors to the stock market. Over Rmb70 billion (US$ 9.1 billion) was shifted out from savings accounts to stock trading accounts in Shanghai within four months in early 2007. In addition, tight monetary control left few options for local investors to diversify their investments.

Disconnect Between Growth And Stocks

We notice a disconnect between China’s growth and Chinese stocks – surging equities amid a slowing Chinese economy. There is no shortage of warnings. For instance, Chinese retail traders opened nearly 11 million trading accounts in April, almost tripling the 4.2 million new accounts in March. Second, outstanding margin loans for stock trading reached a record Rmb1.7 trillion (US$269 billion) as of 13 April, up 300 percent from a year ago. Finally, listed Chinese corporations posted unimpressive growth in earnings but stock indices remain in demand. Only 58 percent of companies on the CSI300 Index reported positive earnings growth.

Will we see the surge in Chinese share prices heightening the risk of a stock bubble burst? This is a key question many are asking but naturally, it is difficult to know. Nevertheless, we can look at various factors that are related to the probability of a market correction. To assess this, we need to look at upcoming event risks but of equal importance are the fundamentals, market internals and the technical set-up.

Stock Bubble?

From a fundamental perspective, the Chinese equities are trading at a discount to their 10-year averages. According to Bloomberg and as of 5 May, the SHCOMP trades on 17.1 times forward earnings consensus, which is a 10.7 percent discount to the 10-year average. Likewise, the CSI300 Index trades at a 9.6 percent discount (16.9 times) to its 10-year average. This coincides with a lower 13.9 times consensus forward earnings in the heavy-weight financial sector which comprises 38.4 percent of the CSI300 Index. In comparison, the SHCOMP and CSI300 Index traded around 38 times earnings in 2007. This does not mean that similar movements will be seen, but it does suggest that valuations are not excessive and are moving in line with expected earnings growth. This implies that there is room for more upside.

The upward trend in Chinese equities is also supported when we look at market internals. Corporate participation on the move higher has held steady with 99 percent of companies trading above their 50-day moving average on the SHCOMP since mid-March. This suggests the rally is broad-based. Compare this to the market correction in February where we saw just 41 percent of companies above the medium-term average. However, things look a tad shaky if we view the shorter-term 20-day average where corporate participation seems to have waned of late. The increase in trading volume has also slowed in late April although it still remains well above the one-year average. Market breadth helps to assess the quality of the rally and current circumstances point towards some decrease in breadth in the shorter term.

Technically, the SHCOMP appears to be taking a breather within a longer-term bull market with some signs of consolidation. A weekly close through 5,000 would open up the way for more bullish momentum towards the 6,000 level. The daily chart is also showing symptoms of fatigue with the Relative Strength Index (RSI) inching lower towards 70. A RSI value greater than 70 indicates an overbought condition. A sell signal is usually triggered when the indicator crosses 70 from above.

Policy-Fuelled Rally

Much like the stock market frenzy in 2007, policy actions are driving the current rally. The People’s Bank of China (PBoC) had lowered policy interest rates twice since November and cut the banks’ reserve requirement ratio. The establishment of the Shanghai-Hong Kong Stock Connect , a trading link which allows stock trading flows between Shanghai and Hong Kong equity markets, also helped to boost trading volume. Further expectations of stimulus measures from the Chinese authorities continue to fuel demand for China equities.

Should we be worried about the possibility of a massive correction? Maybe not quite yet. The Chinese government has been quite accommodative so far. Although they have imposed some tightening measures, particularly on margin lending, these moves are meant to manage the ascent rather than to reverse its direction. In addition, the technical picture is not giving clear sell signal right now.

A trinity of elevated fundamentals, weak technical and policy changes will be a strong red flag to the bears. As a whole, the trend remains fairly positive for the time being and retreats continue to present good buying opportunities if we view the market on a longer timeframe. However, this could still change and the second half of the year would prove very interesting.

Disclaimers:

This information/research prepared by IGA or IGA Group is intended for general circulation. It does not take into account the specific investment objectives, financial situation or particular needs of any particular person. You should seek advice from an independent financial adviser regarding the suitability of the investment, under a separate engagement, as you deem fit. No representation or warranty is given as to the accuracy or completeness of this information.. Any views and opinions expressed may be changed without an update. See important Research Disclaimer at IG.com.sg


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