Strong hands need to buy Chinese stocks

While America took the weekend off to celebrate its independence from Britain, the rest of the world went bonkers.

The Greeks voted overwhelmingly to reject the bailout offer from its creditors, throwing the entire Euro Zone into turmoil. Most markets around the world fell on the news, but China’s stocks rose. That’s because the Chinese were doing some creative financial engineering of their own.

In response to the Chinese stock markets falling 30% during the month of June, the Chinese government went into full-out panic mode. In an extraordinary weekend, the authorities told some people they need to buy stocks: Now! And it told others to stop selling stocks.

Under a heavy suggestion from the People’s Bank of China, on Saturday “China’s top brokerages pledged to collectively buy at least 120 billion yuan ($19.3 billion) of shares to help steady the market, and would not sell holdings as long as the Shanghai Composite Index remained below 4,500,” reported Reuters. “The China Mutual Fund Association said 25 fund companies also pledged on Saturday to buy shares. Another 69 fund firms said on Sunday they would do the same.” At the same time, “28 companies that had been approved to launch IPOs all announced they had suspended their plans.”

Chinese blue chip Shanghai Stock Exchange Composite Index rose 2.4% to 3,776 Monday, but let’s hope it holds.

China’s stock market is paying for ad hoc monetary policy and hesitation on structural reforms. Every day seems to uncover previously-overlooked pockets of leverage in the retail-driven A-shares market, and the slaughter of the innocents will continue until the last forced seller has been driven from the market.

All the measures to support the market may not be enough to persuade China’s disappointed retail investors that a turnaround is in the offing. China’s problem is structural: 85% of the volume is in the hands of retail investors whose access to leverage has been virtually unlimited. Let’s face it. Chinese stocks are in weak hands, and reforms are required to place them into strong hands, with greater participation of Chinese pension funds (which own very little equity) and global investors.

The PBOC’s improvisatory and opaque efforts to address excessive real interest rates and spot shortages of liquidity failed to persuade the market that the government knew what it was doing. The Ministry of Finance last week offered new guidelines that would allow pension funds to put 30% of their assets into equities. The right move now would be to have pension funds start buying at this week’s open.

While the A-shares remain a work in progress, we find the H-shares a compelling value proposition. Bank valuations remain low and the major bank H-shares are one of our conviction trades. The H-Shares now trade at just over 9 times earnings, while the average price-to-earnings ratio for Chinese stocks is 21.

But there is hope for the A-shares. When we dig a little deeper into the numbers, we find telecommunications and infrastructure held up very well. Even after the correction, United Network Communications remains up 70% year to date. Heavy industry did the worst, posting a loss for the year. Telecom and infrastructure are major components of the New Silk Road project, so we expect these to continue to do well.