The bubble that turned into a bear is now in a bull: China's stock market is humming again

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Whether it’s because the wild intraday swings are shrinking or merely that they were closed at the beginning of the month, overseas investor attention on China’s stock market has diminished substantially in recent weeks.

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Almost by stealth, the bear market that saw mainland stocks lose around 50% in a little less than three months has been replaced by a staggering recovery, particularly for small cap, new-age tech stocks.

The ChiNext index in Shenzhen, affectionately nicknamed China’s “Nasdaq” for its similarities to the famed US index, has been in particularly good form, adding 36.13% from its September 2 nadir, making the 18.8% bounce in the benchmark Shanghai Composite index look like chump change.

Yes, the bubble that turned into a bear is now in a bull.

Chinese investors have been flocking back to the once high-flying ChiNext index in volumes never before seen.

According to analysis conducted by Bloomberg, over 5 billion shares were traded on the index on Friday last week, the largest daily turnover at any point this year – an amazing achievement given the index soared 176% from January 5.

In what will surprise few, particularly given the role of investor leverage in helping to create the wild swings in Chinese stocks this year, investors are yet again levering up big time in response. In the seven trading sessions up until and including October 16, traders borrowed extra debt every day to participate in the ever increasing rally.

Steve Wang, chief China economist at Reorient Financial Markets in Hong Kong, told Bloomberg that the rally, yet again, is being built on speculation of further support to China’s fledgling yet highly expensive tech sector.

“With macro indicators not looking great, investors are speculating that the government will roll out stimulus to help technology companies,” said Wang.

“They seem to believe it’s easier to flip small stocks for quick gains.”

Speculators flocking to the rally and Chinese fund managers too. As the chart from Deutsche Bank’s Yuliang Chang and Joseph Huo reveals below, A-share mutual funds now have overweight positions on ChiNext and small cap stocks, something that is in stark contrast to their underweight rating in large cap stocks.

“The relative allocation of ChiNext and SME stand at a daunting 16.3ppt and 10.7ppt overweight above benchmark respectively, at the expense of a remarkable 27ppt underweight in main board stocks,” Chang and Huo note.

With investors and mutual funds returning in droves to the sector, it is yet again seeing valuations become stretched. Bloomberg note that the ChiNext Composite trades at 90 times profit, more than five times the valuation multiple for the Shanghai Composite Index.

That’s 90 years for an investor to see their initial capital returned in full from current company earnings. 90 years! Investors are clearly expecting earnings growth to accelerate rapidly. Or they believe China’s average life expectancy – currently a smidge over 70 years – will lengthen substantially in the decades ahead.

As pointed out previously, fundamentals matter little for the average Chinese investor, particularly those with low levels of education or little market experience – it’s all about momentum.

According to Michael Every, head of financial markets research at Rabobank in Hong Kong, while fundamentals can be ignored for considerable periods of time, they always win out in the end.

“It’s greed and short-term memory loss,” Every told Bloomberg.

“The fundamentals stink, and they always win out in the end. Equities are still over-priced everywhere.”

Despite signs that stocks are beginning to bubble once again, with the ChiNext Index still down 40% from this year’s peak, it’s a safe bet that as long as it continues its recovery there’s likely to be more investors willing to take that risk.

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