China Market Strategy - bocomgroup.comresearchreport.bocomgroup.com/Strategy-170714e.pdf · China Market Strategy 14 July 2017 Download our reports from Bloomberg: BOCM〈enter〉

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14 July 2017

China Market Strategy Hao Hong, CFA

[email protected]

Market Trilemma

Please go to the following webpage to participate in Asiamoney Brokers Poll 2017:

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Voting period: July 6, 2017- August 18, 2017

On August 10, 1992, not long after the Shenzhen Stock Exchange was set up, an IPO subscription fraud was uncovered, as the

stock market was roaring and an IPO ticket would mean staggering sums. The mob rioted on the streets, and the “8-10” incident

is since forever etched in the almanacs of the fledgling Chinese market. The incident also highlighted the urgency to set up a

market regulatory body.

Dr. Liu Hongru, China’s first CSRC chairman and a brilliant student of a former Soviet Union monetary master, gave a speech at

the first ever CSRC staff meeting. And he was frank: “We all need to be patient in this job. If stocks plunge, the crowd below us

would be upset for being stuck in a losing position; if stocks soar, the leaders above us would be upset for fear of damaging

social harmony; if stocks don’t move at all, someone would be upset and say it is not a free market. In the end, it would be hard

to satisfy everyone. Someone somewhere is bound to be upset sometimes.”

Dr. Liu’s opening speech from twenty years ago is prescient, and paints a good picture of the state of the Chinese market today:

the Shanghai Composite is stuck and going nowhere. A mysterious force from above has swayed the market. It can neither go up

nor down too quickly, or sideways - it is a trilemma.

Indeed, not only is the Chinese market in doldrums, the market leadership in overseas markets is narrowing, too. Fewer and

fewer stocks seem to be leading the market higher. This phenomenon is evidenced by the peaking stock median return. Surging

market volatility tended to ensue, if history is a guide. The Russian Default and the collapse of LTCM in 1998, the onset of global

financial crisis at the end of 2007 and the burst of the Chinese stock market bubble in mid-2015 and its global contagion all

followed the peaking of the market’s median return, for instance (Focus Chart 1).

Focus Chart 1: Median of stock return has reached historical peaks; more stocks will underperform the indices

Source: Bloomberg, Bank of Communications (Int’l)


China Market Strategy 14 July 2017


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In our report entitled “2H2017 Outlook: An Idiot’s Guide to China’s Nifty-Fifty Run” published on June 8, 2017, we wrote that

other market risk indicators, such as the VIX, junk bond spread, implied market risk premium and our proprietary market

sentiment indicator were all pointing to heightened market risks ahead. Although the market continues to break new ground,

we note that the volume of index put options is several times of that of call options, and buying of VIX calls is rising, too. When

market trends are approaching such extremes, it suggests that the market opinions are reaching consensus. As such, the

value-added investment suggestion now is not to forecast the next market correction, but rather, the market direction after the

correction, and how to cope.

Our focus chart above suggests elevated market risks, but also gives hints about the future market direction. The market

trajectories after these peaks in market median return and the subsequent market correction were different. In 1998 after the

LTCM collapse and Russian Default, the Fed immediately cut interest rate. Meanwhile, the US economy continued to grow. The

environment of lower interest rate and stable economic growth was conducive to the US stock market gains, till the NASDAQ

bubble burst in March 2000.

After the subprime crisis broke at the end of 2007, global economy sank into one of the worst post-war recessions. And after the

Chinese stock market burst in 2015, the global economy continued to grow, thanks to the collaboration between the global

central banks. And the US market continues to make new highs. Obviously, economic growth determines the market direction

after correction.

We believe that global economic growth will moderate in the second half, but a recession is unlikely. We note that tightened

regulatory oversight in the financial industry in China has taken its toll. Leading indicators such as credit expansion, M2 broad

money supply growth and the property inventory cycle have slowed rather rapidly. (Please refer to our report “A Definite Guide

to China’s Economic Cycle” on March 24, 2017).

Meanwhile, the US return on capital investment, a consistent leading indicator, has resumed its secular down trend, hinting at

moderating growth ahead. In Yellen’s testimony yesterday, she suggested disinflation may not be due to some transitory factors,

and saw “roughly equal odds that the US economy’s performance will be somewhat stronger or somewhat less strong than we

currently project”.

Our historical back tests suggest that large caps tend to outperform smaller caps amid moderating growth, and as such should

lead the US and HK market indices dominated by large caps to their new highs. But the easiest money is behind us, and it will get

even harder to beat the market. This is probably the reason why so many top macro hedge funds have underperformed so far

this year.

Our Earnings Yield/Bond Yield (EY/BY) model helped us predict the inception and the end of China’s stock market bubble in 2015,

and negotiate the troubled waters after the bubble burst. In early December 2015, we used this quantitative model to forecast

the trading range for the Shanghai Composite in 2016 to be 2500-3300. And in 2016, the actual range was 2638-3301.

In early December 2016, the market consensus turned bullish. But our EY/BY model forecasted that the Shanghai Composite

would spend 2/3 of its time trading below 3300 in the twelve months after the forecast. It has now been seven and a half

months, and the peak in the Shanghai Composite so far since our forecast was 3295. Further, the model forecasted the

trading range for the Shanghai Composite to be 3300+/-500, and foretold that 2017 would be a better year than 2016. But

because the index level forecasts in the remaining time were rather dispersed, these model results from more than half a

year ago also presaged market risks ahead.

Below is a video excerpt from a TV program that I did in early December 2016 with Mr. Wu Xiaobo, one of the most famous

journalists in China who also runs one of the most-watched TV shows. During the program, I recommended large cap blue chips

and the Hang Seng, and suggested avoiding small caps and ChiNext.

To watch the video, please click this link: http://mp.weixin.qq.com/s/xpfwlmOrYkmNyQbJ2QugSQ

As my reasons, logic and results are coming together and becoming increasingly palpable, I am sticking to my calls. In our report

entitled “Outlook 2017: High-Wire Act” on December 5, 2016, we recommended buying financials, materials, energy, industrials,

http://researchreport.bocomgroup.com/Strategy-170609e.pdf



http://mp.weixin.qq.com/s/xpfwlmOrYkmNyQbJ2QugSQ




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technology/internet and consumer discretionary. In the second half, we continue to like financials, technology/internet,

consumer and healthcare. We believe these recommendations should help break the market trilemma in the second half.

Below are the summary charts of my reports and calls last year. I hope that I have been right more often than wrong. Please

vote for us in this year’s Asiamoney and II polls.

Thank you! And wish you a good summer.

Review of Last Year

Focus Chart 2: Review of China Market Calls

1700

2200

2700

3200

3700

4200

12/2015 01/2016 02/2016 03/2016 04/2016 06/2016 07/2016 08/2016 09/2016 11/2016 12/2016 01/2017 02/2017 03/2017 05/2017 06/2017

2015/12/9 Outlook 2016: The Chinese Curse Buy governemnt bonds, not stocks in 2016. SHCOMP

fair trading value 2,900+/-400. US dollar strengthening suggests looming market crisis.2016/1/21 Weak Hands: volatility continued; wait for a better entry point

2016/4/18 Sweet and Sour Hog Cycle Rally stretched. risks are escalating. bearish trading setup for commodities

2016/6/6: The Market Bottom: When and Where Shanghai's 2016 bottom at ~2500

2016/9/12 The Most Crowded Trade Bearish on bonds

2016/6/13 The Great China Bubble: Anniversary Lessons and Outlook

Looming global vol surge. Bullish trading setup for Commodities

2016/11/14 A Price Revolution – On Global Asset

Allocation Inflation returns, long yields likely found

historical lows, bonds underperform equities,

commodities continue to perform.

SHCOMP

2016/12/5 Outlook 2017: High-Wire Act Bonds to Underperform Equities; SH

COMP likely trading range 3300 +/- 500, 2/3 of time < ~3300.

2017/1/24 The Year of the Rooster: A Trend Breaker? small

caps will underperform large caps

2017/3/7 The Reflation Trade Is Over; Get Set for Defensive Rotation China’s cyclical

relative strength has faded,the momentum in the current cyclical upswing will wane soon

2017/3/24 A Definitive Guide to China’s Economic Cycle. China’s

cyclical upswing is peaking, and its longer-term trend is declining

2017/6/9 2H17 Outlook: An Idiot’s Guide to China’s Nifty-Fifty Run Big caps will continue to

outperform. small caps bear market,commodity’s bear market rally will continue




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Focus Chart 3: Review of Hong Kong Market Calls

18000

20000

22000

24000

26000

28000

12/2015 01/2016 02/2016 04/2016 05/2016 06/2016 08/2016 09/2016 10/2016 12/2016 01/2017 03/2017 04/2017 05/2017 07/2017

2016/4/18 Sweet and Sour Hog Cycle Rally is

now stretched, and risks are escalating.

Commodity will correct in the short term.

2016/6/13 The Great China Bubble:

Anniversary Lessons and Outlook

Looming global vol event.Turn bullish

on Commodities and HK in 2H2016.

2016/6/27 Post Brexit: How to Trade China the RMB depreciation

pressure remains; USD will likely strengthen; market will

technical rebound, but hard to trade.

2016/9/12 The Most Crowded Trade

Market sentiment reaches its historical

extreme in HK; market correction

looming

HSI

2016/1/21 Weak Hands

vol continues; wait for a

better entry point

2016/1/25 Stabilizing an

Unstable Market Bearish

trend will persist; HSI is

likely to make a second low

2017/5/24 Re-pricing Risks under

New Regulations Despite

euphoric sentiment,Hong Kong

still has allocation value

2017/6/9 2H17 Outlook: An Idiot’s Guide to China’s

Nifty-Fifty Run With big caps outperforming

Market will see new highs, but risk is rising.

2016/12/6 Outlook 2017: High-

Wire Act Southbound flows

should offset outflows from

HK,HK has allocation value

2015/12/9 Outlook 2016: The Chinese Curse

Looming market crisis.




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Recent Reports

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20141111 Remaining Questions for SH-HK Connect 20141117 SH-HK Connect: Breaking New Ground 20141119 SH-HK Connect: D.O.A.? 20141124 A Rate Cut! And A New Trading Paradigm 20141117 SH-HK Connect: Breaking New Ground 20141119 SH-HK Connect: D.O.A.? 20141124 A Rate Cut! And A New Trading Paradigm 20141205 Shanghai Rising: Raising Our Market View 20141217 Outlook 2015: Repricing Risks 20141224 China: 5 Surprises in 2015 20150118 Margin Destruction. But is 4200 Possible? 20150218 Margin of Danger 20150204 RRR Cut, RMB and the Imbalance of Payment 20150208 Option D-Day and the Story of Red Temple 20150302 Rate Cut and the New Extremes 20150320 Price-to-Whatever Ratio: A Bubble Scenario 20150330 One-Belt-One-Road and A New World Order 20150413 Hang Seng = 32,000; Don’t fight China’s Big Mama 20150416 A50/500 Index Futures: Pricking the ChiNext Bubble 20150420 CSRC, PBOC and the Greed of Man 20150506 Taming the People’s Daily Bull 20150511 Rate Cut As Expected 20150528 “5-30” Once More

20150616 The Great China Bubble: Lessons from 800 Years of History 20150624 Remembering “2013-6-25

20150629 The PBOC cuts. Now what? 20150702 The CSRC steps in. Now what? 20150706 Shock and Awe

20151026 The PBoC cuts. It’s time for a resolution 20151109 Re-opening IPO: Devils in Details 20151116 A winter of violence

20151130 Three Market Extremes 20151209 Outlook 2016: The Chinese Curse 20151217 The Fed Hikes: Moment of Truth

20160104 China’s Circuit Breaker: The First Cut is the Deepest 20160108 Circuit Breaker Suspended. Now What? 20160115 An Oversold Reprieve

20160203 One Last Ditch to Salvage the Property Bubble 20160217 Historic Lending! But Three Important Limits 20160301 No Growth, No Gain

20160307 Two-Sessions in a Cyclical Spring 20160321 Unprecedented Divergences 20160418 Sweet and Sour Hog Cycle

20160503 Ant Financial: A Unicorn’s Defining Moment 20160606 The Market Bottom: When and Where 20160613 The Great China Bubble: Anniversary Lessons and Outlook

20160627 Post Brexit: How to Trade China. 20160817 Shenzhen-Hong Kong Connect: A New Era for China’s Capital Market and Capital Account

20160822 Consolidation 20160912 The Most Crowded Trade 20161114 A Price Revolution – On Global Asset Allocation

20161206 Outlook 2017: High-Wire Act 20170124 The year of the Rooster: A Trend Breaker 20170307 The Reflation Trade Is Over; Get Set for Defensive Rotation.

20170324 A Definitive Guide to China’s Economic Cycle. 20170413 Price Inefficiency

20170524 Re-pricing Risks under New Regulations 20170609 2H17 Outlook: An Idiot’s Guide to China’s Nifty-Fifty Run 20170621 China’s MSCI Inclusion: Thoughts after a Milestone

China Market Strategy

14 July 2017


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BOCOM International

Unit 1701, 17/F, Low Block, Grand Millennium Plaza, 181 Queen’s Road Central, Hong Kong

Main: + 852 2297 9888 Fax: + 852 2766 3183 www.bocomgroup.com

Rating System

Company Rating Sector Rating

Buy: Expect more than 20% upside in 12 months Outperform (“OP”): Expect more than 10% upside in 12 months

LT Buy: Expect more than 20% upside but longer than 12 months Market perform (“MP”): Expect low volatility

Neutral: Expect low volatility Underperform (“UP”): Expect more than 10% downside in 12 months

Sell: Expect more than 20% downside in 12 months

Research Team

Head of Research @bocomgroup.com Deputy Head of Research @bocomgroup.com

Hao HONG, CFA (852) 3766 1802 hao.hong Geoffrey CHENG, CFA (852) 3766 1809 geoffrey.cheng

Macro-Strategy Internet

Hao HONG, CFA (852) 3766 1802 hao.hong Yuan MA, PhD (86) 10 8800 9788 - 8039 yuan.ma

Karen TAN (852) 3766 1825 karen.tan Connie GU, CPA (86) 10 8800 9788 - 8045 conniegu

Grace HUA, CFA (852) 3766 1837 Grace.hua Mengqi SUN (86) 10 8800 9788 - 8048 mengqi.sun

Zhe ZHOU (86) 10 8800 9788 - 8041 zhe.zhou

Shan Ying (86) 10 8800 9788 - 8044 ying.shan

Banks/ Non-Bank Financials Property

Shanshan LI, CFA (86) 10 8800 9788 - 8058 lishanshan Alfred LAU, CFA, FRM (852) 3766 1807 alfred.lau

Li WAN, CFA, FRM (86) 10 8800 9788 - 8051 wanli Philip TSE, CFA, FRM (852) 3766 1815 philip.tse

Hannah HAN (852) 3766 1858 hannah.han Carmen WONG (852) 3766 1830 carmen.wong

Jennifer ZHANG (852) 3766 1850 yufan.zhang

Consumer Renewable Energy

Summer WANG, CFA (852) 3766 1808 summer.wang Louis SUN (86) 21 6065 3606 louis.sun

Environmental Services Technology

Wallace CHENG (852) 3766 1810 wallace.cheng Chris YIM (852) 3766 1803 christopher.yim

Gaming & Leisure Transportation & Industrials

Alfred LAU, CFA, FRM (852) 3766 1807 alfred.lau Geoffrey CHENG, CFA (852) 3766 1809 geoffrey.cheng

Fay ZHOU (852) 3766 1816 fay.zhou

Healthcare Automobile & Defense

David LI (852) 3766 1811 david.li Angus CHAN (852) 3766 1805 angus.chan

http://www.bocomgroup.com/



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Documents

China Market Strategy - bocomgroup.comresearchreport.bocomgroup.com/Strategy-170714e.pdf · China Market Strategy 14 July 2017 Download our reports from Bloomberg: BOCM〈enter〉