China – the dragon ready to roar in 2013?

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The Chinese equity market continued to give ground as we race towards the end of another year, with the benchmark Shanghai Composit Index closing below 2,000 on Monday for the first time since 2009 at 1991.17 – the lowest level in 4 years.

Investors are voting with their feet,” Zhang Ling, general manager at Shanghai River Fund Management Co., said by phone. “Regulators need to roll out policies such as encouraging more investments in the biggest stocks to restore investors’ confidence.

The Shanghai Composite has now fallen 9.5 percent this year and is heading for a third straight annual loss. Investor interest in mainland China-traded shares has waned even as recent data has displayed signs of a growth recovery in the world’s second-largest economy. Industrial companies’ profit accelerated 20.5 percent in October, the statistics bureau said today, while factory output and exports both rose last month by the most since May.

The Shanghai gauge has in fact now dropped 42 percent since Aug. 4, 2009, when the gauge reached its highest level since the global financial crisis. In contrast, the MSCI All-Country World Index has rallied 21 percent in the same time.

Yuan-denominated A shares trade at their biggest discount to their Hong Kong-listed peers since June 2011, according to an index compiled by Hang Seng Bank Ltd. Mainland Chinese are barred from directly trading overseas shares, including those on the Hang Seng China Enterprises Index.

Compelling valuation

The Shanghai measure trades at 9.5 times estimated profit for 2012, compared with the 17.7 average multiple since 2006 and at approximately a 30% discount to the MSCI World index

Policy makers have taken steps to revive confidence in the $2.6 trillion stock market and boost economic growth. China Securities Regulatory Commission Chairman Guo Shuqing has reduced transaction fees on equity trades, urged listed companies to pay more cash dividends and changed how initial public offerings are priced. The government also more than doubled allotments under the expanded the qualified foreign institutional investor program in April to $80 billion.

These steps aren’t enough to lure investors back to equities however, according to Jingxi Investment Management Co.’s Wang Zheng.

Confidence waning – a contrarian sign?

Investors have no confidence in long-term growth prospects and the government isn’t doing much to reverse the situation,” said Wang, Shanghai-based chief investment officer at Jingxi Investment, which manages $120 million. “Trading values may fall even further.

The Shanghai Composite dropped below 2,000 during intraday trading twice last week and rallied to close above that level amid speculation of government support. The index first broke above 2,000 in July 2000 and tripled to 6,092.06 on Oct. 16, 2007, and so by any measure the two thirds fall is one of the largest bear markets experienced by global markets over such a period and is comparable to the shakedown seen in the Nasdaq in the early part of the millenium. The fear is that China follows the path of Japan and enters a long secular bear market. We don’t believe this is the case given the already attractive valuations and signs of returning regional and global growth.

China’s stocks will “regain stability” by the first quarter of 2013 because of growth-inducing policies by the new leadership, improvements in macro conditions and recovery in the U.S. Chongkyu Juhn, a strategist at Samsung Securities Co., wrote in a note to clients. The Shanghai Composite will trade in the 2,000-2,400 range, he wrote. We wouldn’t be suprised to see the index trading closer to 3000 this time year given how oversold the index is

Earnings rebound evidence

Considering all the negativity, one could be forgiven for thinking that Chinese equities were actually experiencing falling earnings. Not so. Bank of America wrote today that the market is in fact experiencing an earnings rebound that is being driven by (1) a lower comparable base, (2) falling prices of raw materials and  (3) exports, and inventory cycle that re turning up.

In China producer prices have been falling since late 2011, but earlier this year manufacturers were still using materials purchased last year when prices surged, so net profits at same sales levels would thus suffer. Now that manufacturers are using more materials purchased at lower prices and profitability is surging. 

BAC sees industrial profits as a leading indicator for earnings of listed non-financial companies. Earnings for these companies were down 15.7 percent in the third quarter, and 16.8 percent in the second quarter. Here’s a chart that shows the turn around in industrial profits and its connection with earnings of listed non-financial companies. If the typical cyclical trajectory is followed then next year could be a bumper  year for Chinese equities as valuations expand and follow earnings.

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