Chinese stocks fell Monday after the manufacturing sector said growth stalled in July. However, despite the recent news, Asia Unhedged sees a lot more upside than downside in the stock market.

The government on Monday said its official Purchasing Managers’ Index (PMI) stood at 50.0 in July, down from the previous month’s 50.2. The 50-point mark separates growth from contraction on a monthly basis. Analysts polled by Reuters had predicted 50.2, which mean the economy is growing, but at a sluggish pace. The survey said both export and domestic orders shrank.

This sent the Shanghai Stock Exchange Composite Index down 1.1% to 3,623. The Shenzhen Stock Exchange Composite Index fell 2.7% to 2,053. The small-cap ChiNext Price Index tumbled 5.5% to 2,399 and Hong Kong’s Hang Seng Index slid 0.9% to 24,411.

Asia Unhedged believes that the Shanghai Composite offers an attractive risk-reward ratio with a near-term upside of 550 points against 100 points of downside risk. These levels represent the index’s 100-day and 200-day moving averages, respectively, which have closely defined the trading range of benchmark since early July.

After the equity market’s severe drop last Monday, and the subsequent aggressive stock purchases by government funds, we firmly believe that Chinese authorities see the 200-day technical line as a must-defend threshold.

Obviously, many investors see 4200, where the 100-day moving average sits, as an exit point, either to take profits or liquidate levered positions. However, Asia Unhedged believes the market will soon stabilize at 4200, and when it does, we expect it to climb up to 4500.

The optimal trading strategy under the current market environment is to buy sectors diverging from the pack or those that have fallen the most. For the former, banks and military stocks have been out of tune with other industries since the Shanghai peaked on June 12. Military stocks had lost over half of their value by July 8, but have since climbed by about 25%. The banking sector is by far the most resilient and one with minimal price volatility, which should not come as a surprise given the enormous state fund support behind them. This is perfect for contrarian value investors.

We continue to like financials, and see exceptional value in healthcare and electronics. We expect the Peoples’ Bank of China to bring down interest rates soon, removing the biggest depressant on economic activity.

As for the PMI, new export orders fell to 47.9%, the lowest since June 2013, reflecting the difficult times that Chinese exporters are currently facing. Meanwhile, large manufacturers, the key driver of the index, also lost momentum into July at 50.6%, sliding 0.2% from June.

The bright spot is that managers are still expanding their raw materials purchases due to falling key raw material prices and as they become increasingly optimistic about their business expectations. The rise in optimism is likely because of the “Opinions from the General Office of the State Council on promoting stable growth of foreign trade” document released on July 24.

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