Morgan Stanley doesn’t like Chinese stocks, but we still do

Okay, it looked pretty ugly on the Chinese stock market Friday.

The Shanghai Stock Exchange Composite Index plunged 7.4% to 4,192.87 points, it’s worst one-day loss since Jan 19.  This follows the 13% plunge last week. With a total 19% decline from its June 12 high, the benchmark for the Chinese mainland stock market is precariously close to the 20% mark used to denote a bear market. The Shenzhen Composite Index actually did enter bear territory with its 7.9% tumble.

Meanwhile, the CSI 300 Index, which tracks the 300 largest companies in China,  posted its biggest one-day loss in seven years, plummeting 7.9% to 4,336.19.

Almost 2,000 of the 2,800 stocks trading in Shanghai and Shenzhen fell 10%, hitting their daily limit.  Chinese stock-index futures also tumbled to their 10% limit

We know we sound Pollyannaish, but Asia Unhedged remains bullish on Chinese stocks.

Morgan Stanley, not so much.

There was no fundamental or economic reason for Friday’s dive. However, in a volatile market looking for direction, Morgan Stanley’s pre-market research note evaluating the A-Shares wasn’t going to be well received.

Don’t buy the dips, said analyst Jonathan Garner. He predicted a decline on the Shanghai Composite by as much as 30% by mid 2016. He said the June 12 index highs were the peak for the Shanghai and Shenzhen Composite Indices. The ChiNext Index has also topped out, said Garner. On Friday, it sank 8.9% for a 27% drop from its June 3 high.

Garner said he was concerned by four factors: a) increased equity supply, b) continued weak earnings growth in the context of economic deceleration, c) high valuations, and d) very high margin debt to free float market capitalization.

Yes, the market had gotten very heady. For the 12 months through June 12, the Shanghai Composite rocketed 152%, up 60% this year alone, to a seven-year high of 5166. And the Shenzhen had soared even higher.

Classic technical analysis will tell you that markets need to consolidate after such a rally. And some of the issues are real.

The slew of initial public offerings to hit the market has been huge and soaking up large amounts of the money. But that won’t be reflected in the indices.

And yes, the amount of margin in the market was approaching scary levels. Which is why the Chinese regulators started to clamp down on it two weeks ago, sparking last week’s dive. Obviously, a lot of this week’s decline is forced selling as investors need to respond to their margin calls.

But taking speculators out of the market, especially those buying on margin with small down payments, is typically good. Outstanding margin debt on the Shanghai Stock Exchange dropped for a fourth day on Thursday to 1.42 trillion yuan ($229 billion), reported Bloomberg.

“The correction is basically margin selling,” Francis Lun, the chief executive officer at Geo Securities in Hong Kong, told Bloomberg.

As we said earlier this week, we believe that the economy is rebounding and that liquidity will return next month. Typically when things we like have their prices slashed by 20% we go buying.