The current valuation of A-shares is determined by 3 driving forces: ....
1). short-term economic stabilization, improved earnings of enterprises 2). marginal tightening of liquidity though overall volume is relatively loose 3). progress in domestic supply side reforms and state-owned enterprise reforms reinstate risk appetite to a certain extent. The Shanghai Composite Index has recovered 20% from its lowest point of 2638 in the beginning of the year and has entered the technical bull market. Considering the weak Chinese economic demand, the investment focus is to deemphasize index and to select specific industry leaders.
From the perspective of improved earnings, with the government s latest measures, such as PPP (i.e. public-private partnerships), to stabilize the economy and the impact of Chinese industry replenishment the Chinese economy is likely to continue to bottom moderately. Under such context, there is still room for improvement on the micro-earnings of listed Ashare corporates. In addition, there is still rising momentum for cyclical industries that have been affected by supply side reforms to reduce capacity in the past year. Going into 2017, pharmaceutical industry presents good prospect after continuous improvement on fundamentals and a significant change in the competitive landscape resulting from regulatory policies.
In terms of liquidity easing, it is likely that asset shortage will be the defining event for core strategy of the 2017 Chinese capital market asset allocation with low risk capital favoring securities with low valuation and high dividend. Since 2016, asset allocation capital has been continuously channeling in the bond market driving down the yield curve while credit spreads and rating spreads reached historic low. Currently, the size of the Chinese asset management market reached RMB 95 trillion with the growing need to identify high security margin assets. As the dividend yield of China Securities Bank Index has reached 4.8%, it has apparent allocation advantage compared with China’s 10-year treasury bond yield.
The characteristic of the A-share market has been the differentiation between main board and SME (i.e. small- and medium-sized enterprises). Since this year, the valuation of SME securities continues to decline indicating bubble squeeze during market adjustment. Currently PE (TTM) of the GEM (i.e. growth enterprise market) has returned to 45 times which is in line with the 1H2014 level showing better price/performance ratio. However, the PE (TTM) of the GEM Composite Index is still as high as 66 times signifying apparent differentiation. Under the increasingly strict supervision and the combat of cross-industry M&As, the performance of SME and GEM market is weak for the first three quarters of this year.
Despite this, the growth of overall earnings of the SME and GEM for the first three quarters of this year is prominent with increasing price/performance ratio compared with the main board. With the launch of the Shenzhen Hong Kong Stock Connect, it is expected that the allocation value of the GEM market will be further recognized by the market.
Looking at the current Chinese stock market, the biggest investment risks focus on the following areas: 1). uncertainty in the overseas markets especially the direction of the RMB exchange rate after the US presidential election. It may further constraint the space for further easing of Chinese monetary policy 2). the actual result of the supply side reform to reduce production capacity 3). the strictest real estate regulatory measures on purchase limit and credit limit may bring along turmoil over short-term economic stabilization.