China will lift a freeze on initial public offerings by the end of the year.China Stringer Network/Reuters
Hao Hong has seen this movie before, and it didn't end well for China's stock-market bulls.
Five months after an equity boom built on weak corporate profit turned into a $5-trillion (U.S.) crash, a similar scenario is playing out in China today. The benchmark Shanghai Composite Index has surged more than 20 per cent from its Aug. 26 low, despite third-quarter profits that trailed analyst estimates at 68 per cent of companies in the index, the eighth straight quarter of disappointing results.
The absence of a rebound in earnings is one reason why Hong, the chief China strategist at Bocom International Holdings Co., says the latest surge in stocks is a "bear market rally." Foreign investors seem to agree: They've been selling mainland equities through the Shanghai-Hong Kong exchange link for four straight weeks, cutting holdings by the most in two months on Thursday.
"It's very difficult to see this rally sustaining without an earnings recovery," said Tony Chu, a Hong Kong-based money manager at RS Investment Management Co., which oversees about $18-billion. Foreign investors "don't have a very strong medium-to-longer-term view."
The rally in China follows an unprecedented government campaign to prop up share prices, along with increased monetary stimulus to combat the deepest economic slowdown in 25 years. The official support has helped revive confidence among local investors, spurring a pick-up in trading activity and sending the Shanghai composite to an 11-week high last week. China announced Friday it will lift a freeze on initial public offerings by the end of the year, removing one of its key measures of support for the stock market.
The $1.6-trillion recovery in Chinese share prices is also boosting valuations as earnings shrink. Trailing 12-month profits at Shanghai Composite companies have dropped 10 per cent so far this year, leaving the index with a price-to-earnings ratio of 18.8. While that's still well below the multiple reached at the height of the boom in June, it's about 38 per cent more expensive than the five-year average.
The last time lower-than-estimated earnings from Shanghai Composite companies were this widespread, in the first three months of 2012, the benchmark gauge fell for the following two quarters.
"China's bull market can't go long without earnings improvement, and so far there has been no improvement," Chen Li, a China equity strategist at Credit Suisse Group AG, said in an interview in Shanghai. "It's still a bubble. It's liquidity and not earnings driven. There has been no change in fundamentals."
Of course, Chinese stocks have rallied before in the face of disappointing earnings. The Shanghai composite's record rally earlier this year came after 2014 profits missed estimates by the most in six years.
In a market in which individual investors account for more than 80 per cent of trading, speculation often trumps fundamental analysis. Yao Lina, a 35-year-old accountant at a food company in Shanghai, says she's bullish on stocks amid expectations that China's new five-year plan for the economy will revive investor confidence.
"Almost no one is looking at earnings," Yao said. "Everyone is speculating."
For Sam Le Cornu, who oversees about $3-billion in Asian equities at Macquarie Investment Management in Hong Kong, liquidity is now a more important driver of the China's stock market than profits.
The People's Bank of China cut its benchmark one-year interest rate for the sixth time in a year on Oct. 24. The reduction was combined with a relaxation of lenders' reserve requirements – a move Bloomberg analysts estimate released around 650 billion yuan ($102-billion) into the banking system – and the scrapping of a ceiling on deposit rates.
"Corporate earnings are not the focus at the moment," Le Cornu said. "It has all to do with the PBOC and its monetary policy."
The central bank may be close to the end of its easing cycle. A Bloomberg survey of economists shows the monetary authority will probably leave its one-year lending and savings rates at current levels through 2016.
The rate cuts have so far failed to revive growth, with China's expansion slowing to 6.9 per cent in the third quarter, the weakest pace since 2009. Factory gauges signal the nation's manufacturing still hasn't bottomed out amid faltering global demand, while fixed-asset investment is growing at its weakest pace since 2000.
China's stock-market rebound "leaves me reaching for new synonyms for 'dead cat bounce,'" said Michael Every, head of financial markets research at Rabobank Group in Hong Kong. "Earnings will continue to disappoint. How can they do otherwise as growth slows?"