Verdict Time for Chinese Stocks After Week Whipsaws Investors

(Bloomberg) -- A rally in China’s small cap stocks is unraveling as quickly as it began amid signs that officials are attempting to prevent a bubble from forming.

The ChiNext gauge of mostly technology companies slumped 2.6 percent in Shenzhen on Thursday, taking its two-day loss to 7 percent, the steepest since June. Friday’s trading will dictate whether the gauge can eke out a sixth straight week of gains, or whether it halts its best winning streak since 2015. The ChiNext started this week with a 7.2 percent rally.

The securities regulator has instructed brokerages to minimize risks from margin lending and warned analysts to avoid inflammatory language, the 21st Century Business Herald reported Thursday. Data showing China’s worst start to a year since 2009 in terms of industrial output added to the gloomy tone, along with a growing number of executives and large shareholders cashing out of their companies’ stocks.

Verdict Time for Chinese Stocks After Week Whipsaws Investors

The ChiNext had surged 44 percent in just four weeks, fueling demand for leverage and drawing parallels with the mania in 2015 that ended in a $5 trillion rout.

"The crackdown on margin trading at this early stage of the bull market is a lesson learned from 2015," said Daniel So, Hong Kong-based strategist at CMB International Securities Ltd. "Obviously Beijing wants a slow bull market, but the question is whether they can manage to have one."

The broader Shanghai Composite Index closed below the key 3,000-point level that’s either been a floor or ceiling for the gauge for most of the past three years. Stocks also tumbled on Friday after China’s largest state-owned brokerage issued a rare sell rating on one of the best performing stocks this year, warning the shares could fall more than 50 percent.

Though China’s equity market has been rallying all year, the gains accelerated following the Lunar New Year break as Beijing started removing many of the curbs that were designed to keep out speculators. With every major benchmark entering a bull market, traders started borrowing more money to chase returns. Leverage in the stock market has climbed for five straight weeks, while daily turnover now regularly exceeds 1 trillion yuan ($149 billion).

Gains had turned so extreme that insiders started to cash in while Chinese stocks are still hot. They announced plans to sell about 16 billion yuan worth of their companies’ shares last week alone, signaling that at least one group of investors is calling the market’s top.

"Stocks lack support now with shareholders and executives dumping shares," said Dai Ming, a Shanghai-based fund manager with Hengsheng Asset Management Co.

Bulls say pullbacks will be temporary, with valuations remaining low after last year’s rout. Even before this week’s sell-off, the ChiNext traded at about 25 times projected earnings versus a multiple of more than 70 in 2015. Morgan Stanley strategists say sentiment is still far off the exuberance seen at the height of the bubble that year, predicting the rally in China will continue through December.

Whichever way China’s stocks go, this week shows that the ride is likely to remain bumpy. Investors are grappling with the widest intraday swings in more than three years for the ChiNext, where daily moves exceeding 4 percent are becoming a common occurrence.

What Beijing wants to avoid is a repeat of 2015, when leveraged traders rushed for the exit and declines were so severe they almost paralyzed the equity market. The challenge is how to manage a bull run that’s sustainable -- with as little volatility as possible.

©2019 Bloomberg L.P.