China COSCO (1919 HK)

2018 年 04 月 04 日（水曜日）

China Market Strategy Hao Hong, CFA The Year of the Rooster: A Trend Breaker? [email protected]

Summary: The ChiNext has violated its secular rising trend. Investors should take note. Credit spread historically has been closely correlated with the relative performance of large versus small caps. The spread has widened, concurrent with the underperformance of small caps. The market has started to differentiate the quality of companies. The reprieve in the ChiNext will likely be technical in nature only, and the tides have turned. Tighter liquidity will make ChiNext’s rich valuation an even more acute issue. Price/EBITDA and market geometric return are peaking in the US, similar to Asian Finanical Crisis and Russian Default around 1998, the TMT bubble in 2000, the subprime crisis starting at the end of 2007, and just prior to the Great China Bubble bursting in mid 2015. It bodes ill for overseas markets.

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ChiNext’s rising trend has broken. Recently, the ChiNext has violated its long-term rising trend, with intraday plunges of over 6% (Focus Chart 1). But the trend in Shanghai Composite has withstood the test, and the tendency of doubling every decade, which has been consistent with China’s growth target embedded in the Five-Year-Plans, persists (please see our report “The Market Bottom: When and Where?” on June 6, 2016. Focus Chart 2). Now the important question is which trend to trust?

Focus Chart 1: ChiNext’s rising trend is breaking down.

Source: Bloomberg, Bank of Communications (Int’l) The market has started to differentiate the quality of companies. Pundits were quick to explain the ChiNext’s recent plunge. Some believed that the accelerated pace of IPO was to blame. But the amount raised by IPOs in 2016 was only ~RMB 150bn in a market valued at well above RMB 50tn and turning-over RMB 500bn daily, albeit the number of IPOs has grown. Further, this theory does not explain why the large caps have held steady, despite the volatility in ChiNext. Potentially, however, declining return from IPOs could induce liquidation in some positions held to be qualified for the IPO lottery, and thus represents an overhang on the market.

Some believed that the looming unlocking of private placements would strain market liquidity. True, private placements amounted to over 1700bn in 2016, and their unlocking would drain some liquidity. But the time of unlocking was scheduled well

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before hand, and thus could not explain the sudden plunge. And the diverting performance between large and small caps remains a puzzle.

Focus Chart 2: the Shanghai Composite on track to double every ten years.

Source: Bloomberg, Bank of Communications (Int’l) We note that credit spread between lower-grade bonds and treasury has surged. That is, the credit market is starting to demand a much higher premium on companies with lower credit ratings. The credit spread historically has been highly correlated with the relative performance of large versus small caps, both in China and in Hong Kong (Focus Chart 3). Intuitively, as the financing costs of lower-quality companies start to surge when treasury yields are rising and credit spread is widening, the return on their stocks will suffer. When the market is bullish and is flushed with money, this may not be a hindrance to small caps. But in a bear market as it is now, stock prices should start to reflect the quality difference between companies.

Focus Chart 3: The market is starting to price in difference in company quality.

Source: Bloomberg, Bank of Communications (Int’l) While the ChiNext seems to have double-bottomed at the level where it plunged to after the stock market bubble burst in 2015, the credit spread and treasury yield (risk-free rate) should continue to rise in the coming months. As such, any bounce in the ChiNext will likely remain technical in nature within a longer-term trend that has now reversed.

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Euphoric sentiment in overseas markets bodes ill near term. Two important measures of market sentiment in the US, namely, the market geometric return and the Price/EBITDA ratio of S&P 500 are peaking (Focus Chart 4). The market geometric return is an equal-weighted return index. It gives more weight to smaller caps when calculating the return. Its peaking suggests that small caps’ return relative to large caps has been significant, and suggests reckless risk-taking. The meaning of peaking Price/EBITDA for S&P 500, a type of quasi cash-flow valuation, is palpable. Similar phenomenon occurred in the Asian Finanical Crisis and Russian Default around 1998, the TMT bubble in 2000, the subprime crisis starting at the end of 2007, and just prior to the Great China Bubble bursting in mid 2015. Euphoric sentiment tends to augur ill for the market.

Focus Chart 4: Geometric return and valuation are peaking in the US, suggesting euphoric sentiment and auguring ill.

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

A review of our calls in 2016: We estimated that the trading range for the Shanghai Composite in 2016 was between 2500 and 3300 (“Outlook 2016: the Chinese Curse” December 9, 2015). In January 2016, the Composite plunged to ~2600 after the circuit breaker triggered sell-off induced by the second round of RMB devaluation. It then peaked at 3301 intraday on November 29, 2016. Our hits and misses in 2016 are summarized in Focus Chart 5 and 6, with report titles and dates in bold. Red color denotes more cautious views at the time of reports. We are glad that we have more hits than misses, and we wish you and your family a great Year of the Rooster.

Focus Chart 5: The Shanghai Comp has traded between 2600-3300 in 2016, within our estimated range of 2500-3300.

3900 2015/12/9 Outlook 2016: The Chinese Curse Buy governemnt bonds, not stocks in 2016. SHCOMP's fair trading value ~2,900+/-400. US dollar strengthening suggests looming market crisis. 2016/4/18 Sweet and Sour Hog Cycle Rally stretched, and 3700 2016/1/21 Weak risks are escalating. bearish trading setup for commodities Hands: volatility continued; wait for 2016/6/6: The Market Bottom: When and Where Market 3500 a better entry bottom should be defined relative to a long-term point economic growth rate; Shanghai's 2016 bottom at around 2500

3300 2016/6/13 The Great China Bubble: Anniversary Lessons and Outlook Looming global volatility. Bullish trading setup for Commodities 3100

2016/9/12 The Most Crowded Trade Looming HSI correction. 2700 Bearish on bonds 2016/11/7 Global Hedge Fund West Lake Summit Inflation returns; the end of the 2500 secular bond bubble. 2016/12/5 Outlook 2017: High-Wire Act Bonds to Underperform Equities; Volatility to Rise. strengthening Dollar, rising inflation and long bond yield, weakening CNY. Shanghai Comp likely trading range 3300 +/- 500. But with wider return dispersion. Further, 2/3 of the estimates are lower than ~3300. SHCOMP 2300 12/2015 01/2016 02/2016 03/2016 04/2016 06/2016 07/2016 08/2016 09/2016 11/2016 12/2016

Source: Bloomberg, Bank of Communications (Int’l) Note: Red denotes cautious view at the time of reports. Report titles and dates in bold.

Download our reports from Bloomberg: BOCM〈enter〉 4 China Market Strategy 2018 年 4 月 4 日星期三 Focus Chart 6: A review of our calls on HK in 2016.

25000 2016/6/13 The Great 2016/9/12 The Most HSI China Bubble: Crowded Trade Looming HK Anniversary Lessons market correction. Bond and Outlook market crash is coming. Looming global 24000 volatility.Turn bullish on Commodities and 2016/1/21 Weak Hands Market HK stocks in the volatility continued; wait for a second half of 2016. better entry point 23000

2016/1/25 Stabilizing an Unstable Market Bearish trend will persist; 22000 HSI is likely to make a second low

20000 2016/6/27 Post Brexit: How to Trade China Longer term, EU and China have peaked; the RMB depreciation pressure remains; USD will likely strengthen; market is going into a technical rebound, but hard to trade. 19000 2016/4/18 Sweet and Sour Hog Cycle Rally is now stretched, and risks are escalating. Commodity will correct in the short term. 18000 12/2015 01/2016 02/2016 04/2016 05/2016 06/2016 08/2016 09/2016 10/2016 12/2016

Source: Bloomberg, ECRI, Bank of Communications (Int’l) Note: Red denotes cautious view at the time of reports. Report titles and dates in bold.

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