Beware Of China’s A-Shares ETF Rally Craze

December 23, 2014

China’s A-shares market has been red hot lately, producing eye-popping performance on record-breaking trading volumes.

 

The Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (ASHR | D-50), the largest and most popular U.S.-listed China A-share ETF that tracks the CSI 300 Index, has surged more than 10 percent in November alone and has beaten every major index in the world. 

 

ASHR Vs. SPY

 

The A-shares market is showing no sign of cooling off despite Chinese regulators sounding a cautionary note about excessive leverage in the market and a series of disappointing economic data. So, what gives with this market, and the ETFs that track it?

 

It is hard to tell whether we are witnessing a case of irrational optimism, or whether the market has finally turned a corner. But I’d argue that either way, investors are getting ahead of themselves here.

 

Macroeconomic Discount

Many strategists have cited attractive valuation of the A-share market as the driving force behind the rally. Now, why these valuations couldn’t attract much interest just a few months ago beats me. Not a whole lot has changed economically, in my view.

 

China’s economy continues to show signs of softness. Its manufacturing PMI has been treading dangerously close to the contraction territory. In fact, according to the latest HSBC Dec. Flash Manufacturing PMI report, China’s manufacturing sector might have entered contraction already.

 

Burden Of Financing Costs

The first rate cut since 2008 by China’s central bank has done little to lower yields and financing costs for real investment. If you believe there is a bad debt crisis brewing in China, the spike in yields certainly doesn’t help in refinancing those bad debts.

 

Unless a rate cut or some other form of monetary easing translates into a decline in yields and financing costs, weakness in the property market will linger, and the debt problem will persist.

 

Strategists also point out that there is a widespread expectation of further easing by the central bank. The forward-looking market is pricing that in, but that sounds an awful lot like policy-based speculation.

 

Given an existing overcapacity issue in China, the marginal return on investment is likely to be much lower going forward. I am just not convinced that even further monetary easing and liquidity injection might lead to asset bubbles but not necessarily significant real economic growth.

 

Record Brokerage Activity

Perhaps an even more troubling sign that this rally is fueled by hot air is the fact that Chinese retail investors are opening brokerage accounts at a record pace. China Securities Depository and Clearing Co. data show that the pace of new account opening has dramatically accelerated in recent weeks, as the chart below reflects: 

 

Account Opening

 

When you see housewives, students, retirees and random persons opening brokerage accounts with chump change or with borrowed money, and trading the market with significant margin only on the expectation of price appreciation, you might be witnessing a classic case of irrational exuberance.

 

Cross-Border Disconnect

More sophisticated institutions in Hong Kong are simply not sharing the same excitement and optimism as retail investors in the mainland. To be sure, institutions aren’t always right, and they can certainly revise their market outlook and get back into the game. However, such level of institutional exodus and persistent discounts in the H-shares market don’t really incite confidence.

 

While mainland retail investors are trying to get a piece of the rally, institutions in Hong Kong are reducing their A-share exposure. Three Hong Kong-listed ETFs that track the FTSE A-50 Index, the largest 50 companies in the A-shares market, have seen massive outflows since November and December (more than $5 billion in aggregate) while the broader A-share market was producing jaw-dropping performance.

 

Final Caveats

Let me be perfectly clear: I am not calling a market top. I am also not calling an end to the China story. In fact, I think China will continue to grow, and probably outpace the U.S. growth rate in the foreseeable future.

 

But there are irrationalities in this stock market performance. If you want to jump into this rally, do so at your own will. But know that if you are looking for a seismic shift in the China story to be hiding behind this rally, you will come out empty-handed.

 

At the time this article was written, the author held no positions in the security mentioned. Contact Howard Lee at [email protected].

 

 

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