Following the recent rally, most quality stocks have put on substantial gains, and even the relatively weaker firms saw their prices shoot up. This suggests that a correction might be in the offing.
One should bear in mind that the current rally in Chinese stocks was not driven by earnings growth, but instead the outcome of valuation re-rating.
China’s new leaders had adopted a relatively tight monetary policy after they took over the reins. The move was aimed at phasing out inefficient companies and those suffering from excessive industry capacity.
However, that led to an unwanted situation. State-owned enterprises fared much better thanks to their monopoly, while private companies were struggling. As a result, economic growth fell and pushed the nation to the edge of deflation.
Given this situation, Beijing has switched its monetary policy stance to an easing bias. And the Chinese central bank cut interest rates and reduced the reserve requirement ratio in order to lower the financing costs for businesses.
Meanwhile, the government has pushed forward the reform agenda, including SOE reform, innovation, and financial reform.
The reforms and monetary easing have helped fuel a stock market rally and led to a re-rating of listed firms.
As for the next 12 months, there are three key issues that will determine the market’s prospects. Will the interest rate and RRR cuts continue? Is the economy likely to return to inflation trajectory? And, will company earnings start to pick up given various reform measures?
If the answer to all three questions is “yes”, then we can expect quality stocks to gain further in the next couple of years.
Mainland banks, which had lagged behind for a long time, posted sharp gains last week. But financial intermediaries, internet technology and power sector players — which had led the market’s rally during the recent run-up — saw sharp correction, with some counters even sliding 20 or 30 percent over the week.
Could it be telling us something about market consolidation?
Value investment may not offer the highest return but it offers the lowest risk. The approach would offer the highest risk-adjusted return.
That being said, companies that will benefit from China’s capital account de-regulation and environmental protection already have margin of safety.
And investors could gain another layer of margin of safety if these stocks are available at a discount after a correction. It’s very difficult to predict short-term volatility, but profitability would remain attractive if there is sufficient margin of safety.
This article appeared in the Hong Kong Economic Journal on June 17.
Translation by Julie Zhu
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