BofA’s Cui Sounds Warning on Chinese Stocks as Leverage Surges

(Bloomberg) -- Bank of America Corp. has taken a close look at Chinese stocks and it doesn’t like what it sees.

Many of the "disturbing" trends that affected mainland equities just before they crashed in mid-2015 are still present and some have even gotten worse, said David Cui, a Singapore-based strategist at Bank of America. Leverage is higher now, individual investors still dominate trading, major shareholders are cutting their stakes, while hedge funds have emerged as the largest institutional investor, he said.

Cui, who correctly predicted MSCI Inc. wouldn’t include China A shares in its benchmark indexes this year, recommends investors avoid the nation’s stocks in general and expensive small-cap shares in particular.

"Still rapidly escalating leverage means that the financial system is even more vulnerable to large losses if the market heads south again," the analyst wrote in a note dated Tuesday. Cui has long held a bearish view on Chinese assets.

Calm had prevailed in the world’s second-largest stock market for much of this year, after shares plunged in January, with the benchmark Shanghai Composite Index climbing to an 11-month high in recent weeks. Such equanimity was broken on Monday when the Shanghai gauge tumbled the most in six months as investors fretted about higher money market rates, regulatory moves to curb leveraged equity purchases and U.S. President-elect Donald Trump’s questioning of the One China policy.

Among Bank of America’s key concerns, A-share market positions funded by leverage plus shares pledged for loans have risen to 22 percent as of September, compared with 14 percent in June 2015, Cui wrote. The Shanghai Composite peaked last year on June 12.

Retail Investors

Individual investors held 41.3 percent of A shares in the third quarter, compared with 43.4 percent in June 2015, according to the report. By contrast, parent companies and other corporate investors have cut their holdings as a percentage of total market cap by four basis points to 39.3 percent, Cui wrote.

During the same period, hedge funds raised their stake to 4.5 percent from 1.9 percent, while the government’s holdings has increased to 1.9 percent from nothing, according to Bank of America.

"Given the high fees that hedge funds can earn and their ability to leverage, we are concerned about moral hazards in this part of the market," Cui said.