Fired up by the red bulls

China’s most successful investors often refer to themselves as a “God of Stocks”. One of the best known is Lin Yuan, who has written a book about how he turned Rmb8,000 into a stock portfolio worth Rmb2 billion ($325 million) over 18 years. When CCTV interviewed Lin in 2006 Chinese stocks were on a bull run. At one point he pulled out a monthly statement for one of his trading accounts, showing that his balance had doubled to Rmb90 million in less than two months. “This is my speed of making money. They don’t call me the God of Stocks for no reason,” he explained, rather immodestly.

The same reporter visited Lin again in early 2012. This time the market had gone through a rough year. With a stony face, Lin confessed to heavy losses, admitting he was waiting for a rebound in the market. “Stock investment is a trade where you make money 5% of the time. You sleep through the rest of the time,” the chastened Stock God told the broadcaster.

As an assessment of the sometimes frenzied nature of China’s A-share market, Lin’s view is hard to fault. For three years in a row China has been the black sheep of the global equity markets. Its benchmark Shanghai Composite Index fell 6.7% last year, compared with a 30% rise in the US and Japan’s 57% surge. But a sudden year-end spurt has made China the best performing major market in 2014. The share-buying splurge now has analysts readjusting their outlook for next year.

Time to get buying?

“Bull market” doesn’t describe the frenzied ascent of Chinese shares in the recent rally, The Economist has noted. Local media have started referring to it as a “super bull” rally instead.

In fact, the Shanghai Composite had put in yet another lacklustre performance in the first half of this year. But it perked up with a respectable 10% gain in the third quarter, starting October at around the 2,300-point level. Then in late November it went into hyperdrive, surging more than 20% over a dozen trading days. On Monday this week, the rally pushed the Shanghai Composite above 3,000 for the first time in three years. At that point, Chinese shares were 43% higher than at the beginning of 2014 and China displaced Japan as the world’s second largest equity market by value, with a total capitalisation of more than $4.5 trillion.

Trading volumes have been astonishing. The value of shares changing hands breached Rmb1 trillion for the first time last Friday. Two trading days later, transaction volumes hit another new record of Rmb1.24 trillion – almost five times the average of the past 12 months. Then came a stark sell-off on Tuesday as the Shanghai Composite sank more than 5% in its biggest one-day decline since 2009 (mind you, it bounced back 3% the following day). Despite Tuesday’s retreat, as of Thursday this week the benchmark index has still registered a 38% gain in the year.

Did anyone make the right call?

Not many analysts predicted this much upside when they dished out their forecasts for 2014.

According to news portal NetEase Finance, most domestic brokerages had expected the Shanghai Composite to be rangebound this year. Both Citic Securities, the largest listed brokerage, and CICC, the best-connected investment bank, thought that the index could reach 2,500 at best. Others even forecast it would dip as low as 1,800.

In fact, it was the Chinese Academy of Social Sciences (CASS), an important think tank under the State Council, that looks to have made the best call. In a report published in December last year, CASS eggheads said the policy environment in 2014 was likely to resemble that of 1999, and posited that the stock market might make dramatic gains akin to the so-called “May 19 rally” fourteen and a half years ago.

That date marked the beginning of the most famous bull-run in China’s stock market history. On May 18 the market was trading near a record low of around 1,000. Then the central government began to unveil a slew of measures to encourage savers to put more of their funds into the stock market. Interest rates were cut and a 20% tax was placed on interest paid on bank accounts.

Huge buy orders from institutional investors began to flood the market. Retail investors soon took heed and joined the binge. On June 15 of that year, the People’s Daily weighed in with an amazing front-page editorial equating investing in the stock market to “being patriotic”. By the end of June, or in a month and a half, the Shanghai Composite had surged 65%.

What provoked the spurt this time?

Last December’s CASS report had suggested that Beijing would initiate important financial reforms, linking them to a likely market rally. And similar to 1999, the People’s Bank of China has helped out too, with a looser monetary policy. The central bank has injected at least Rmb1 trillion into the economy, according to the China Securities Journal, while recently cutting interest rates for the first time since 2012.

Financial regulators have also made changes that could see more of the country’s massive savings pools switch back into equities. The crackdown on shadow banking activities has made higher-yielding wealth management and trust products less popular (returns on wealth management products issued by banks have fallen to 5.4% from their peak of around 6.2% in January, Bloomberg notes).

Likewise, CBN points out that the weakness in home prices has more Chinese thinking that the time may be ripe to put their money back into stocks rather than real estate.

A new trading link between the Hong Kong and Shanghai exchanges may have partly fuelled the latest rally too. The Stock Connect scheme allows foreign investors to access the A-share market in Shanghai (see WiC261) and it is widely hoped this will bring in more long-term investment funds from overseas, which could underpin further growth in the Chinese securities market.

What’s more, many Chinese shares look historically cheap, at least on paper. The banking sector carries the heaviest weighting in the Shanghai market. But until a few weeks ago, most of the state banks were trading at single-digit price-to-earnings ratios. Some of them still look reasonably priced. As of Thursday, ICBC (the biggest bank by market value) had climbed 18% over the course of the year. But it is still trading at just 5.5 times its 2013 net profit.

Momentum is back…

WiC has written before about pyschology in the Chinese stock market, especially how investors have often been responsive to policy signals (see WiC17 and WiC60). And true to form, the real reason for the rally over the past few weeks isn’t an influx of foreign funds or the returning mojo of China’s ‘Gods of Stocks’. Instead it is the enthusiasm of ordinary investors, as they stampede back into the market.

“There is no question who is behind the boom: retail investors,” The Economist surmises. “The recent rally has brought them back in a big way, pushing the market to new heights”, adding that “mom-and-pop” individuals account for about 80% of China’s equity trading volumes, compared to about 20% in other large markets.

The sudden enthusiasm has been infectious, with the Hong Kong Economic Journal noting that the number of active stock market accounts reached 2.4 million last month, compared to 1.3 million in January. More than 370,000 new accounts were opened last week alone. “The high level of retail participation explains the rollercoaster ride of late,” the newspaper suggests. “There is some way to go for China to increase the level of stable institutional holdings in the market.”

How about the fundamentals?

Bigger-picture, the sudden surge in the market seems harder to explain. “The parabolic rise is even more remarkable because it is built on scant fundamental support,” Barron’s has warned. China’s economic growth in the third quarter slumped to 7.3%, the lowest since 2009’s first quarter, with the US magazine noting that “almost every major economic indicator is pointing toward a continued deceleration in the fourth quarter”.

Many economists expect an official target of 7% for GDP growth next year, down from this year’s 7.5% (which is likely to be missed), while talk about a “new normal” of lower growth is a key theme this week at the Central Economic Work Conference, an annual summit for policymakers.

So is the current market surge based on little more than speculation? And if so, what are the dangers if investors succumb to the herd instinct? The Financial Times has noted that the balance of outstanding margin loans from brokers (margin trading was only allowed in 2012) had reached Rmb575 billion last week, up more than 70% from the beginning of September. This is the most worrying aspect, it says, prompting some to conclude that stocks are moving into “bubble territory”. Regulators have tried to advise caution. But, paradoxically, state media has preferred to stress the political dimension of the rally, i.e. that it is a reflection of national confidence in Chinese President Xi Jinping’s administration and the prospects for further reform.

“The distinctive characteristic of this bull market is not that of a speculative market but rather a confidence market,” said the China Securities Journal, which is run by Xinhua. “Deepening of reforms and expansion of opening-up have released an enormous dividend that is sufficient to support a long-term, steadily rising bull market.”

What’s the outlook for 2015?

According to Jonathan Anderson of Emerging Advisors Group, investing in Chinese shares is still a game in which market timing is crucial.

“If you believe that China is currently easing credit policy, effectively continuing to ‘kick the can down the road’, then there is no immediate looming earnings or sentiment shake-out and you should feel free to follow the rally,” he advised in a recent report.

“If, on the other hand, you believe that the authorities are already in more sustained tightening mode, then market upside could dissipate rather quickly indeed and you need to be much more careful, even on a near-term basis.”

So what does the think tank CASS, last year’s best predictor, have to say in its latest outlook? It expects the central bank to continue to cut its key interest rates next year. It also suggests that corporate earnings will improve because of the fall in commodity prices, especially oil. State firms are geared up for structural reforms too, it says. “With market liquidity at all-time highs, investors will be expected to move more of their funds to the equity market,” it predicts, forecasting that the Shanghai Composite could surge to 4,000 points in 2015 and even hit 5,000. That implies nearly 80% upside from today.

And as for Lin Yuan, the self-proclaimed market mastermind, it is another moment to bet big. He told domestic media last week that the Shanghai Composite could even breach 6,000 next year. (The all-time high was 6,124 in October 2007). We’ll revisit his prediction next year, to see if the God of Stocks has performed as divinely as he hopes…

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