Risk appetite is running high, and it’s the big caps that are outperforming, instead of the small caps. And cyclical assets such as commodities and US financials have corrected significantly. It is perplexing.
The new financial regulation in China alone cannot explain this global phenomenon. The market is increasingly challenging, as big caps are becoming crowded while smaller caps are fraught with risks.
Pundits have been attempting to find explanations for this phenomenon. Many compare Chinese big caps’ outperformance with the “Nifty-Fifty” era in the United States in the 1970s.
Ubiquitous expectation drove US funds into the Nifty-Fifty in the ’70s for growth, while it is now herding Chinese funds into A50 for risk sheltering.
Besides earnings stability, visibility and industry dominance in an increasingly unpredictable environment, the A50 is also seen as a convenient instrument for market stabilization ops. As such, owning these big-cap names indeed aligns one’s interest with higher market power.
Our research shows that big caps tend to outperform amid moderating growth, as it is now. Historically, big caps tended to outperform in an environment with moderating growth, which could be seen in a flattening yield curve. That is, big caps’ outperformance is portending moderating economic growth ahead, as it has been in the past.
But ubiquity also breeds extremism. Big caps’ relative return is approaching extreme, hinting at a technical rebound in small caps with lower highs – an opportunity to reduce positions. With growth in the US and China set to moderate in the coming months, big caps will continue to outperform, and commodities’ bear market rally will continue to test traders’ skills. When buying, size is key. Yield curve will continue to flatten, and credit spread will widen further.
Hong Kong can still push new highs, but the best gains are behind us. Shanghai is stuck. With big caps outperforming in a slowing environment, they should render some support to market indices such as the Hang Seng, the S&P 500, and to a certain extent the Shanghai Composite.
Our price target for the Shanghai Composite remains unchanged. Our Earnings Yield/Bond Yield model suggested that the index should stay below 3,300 for 2/3 of 2017, and that 3,300 is a strong resistance level for traders.
The current elated sentiment in Hong Kong augurs for new highs ahead, but our allocation model suggests that it is rapidly losing its appeal. While it is likely to push new highs, the easiest gains seem to be already in the bag. The final dash could be spectacular enough to make the early bears cry – till the winter sets in.
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