Newsletter commentary Feb 2024

In February, the market initially experienced a sharp decline, particularly affecting among small and mid-cap stocks. However, with the notable influx of funds into certain index products, trading order gradually restored. Following the Chinese New Year holiday, the market clearly exhibited an oversold rebound.

Since the beginning of this year, the performance of various indices has ranged from positive to negative. The dividend index, SSE 50, CSI 300, CSI 500, CSI 1000, and CSI 2000, as well as the micro-cap stocks, have shown a range of returns. The percentage gains have generally decreased from over +10% to approximately -25%, with larger indices experiencing relatively smaller declines.

The plunge originated from the continuous decline in the market, which created pressure on certain snowball-structured products. This, in turn, caused significant fluctuations in the basis of stock index futures, impacting quantitative investments. The inflow of various ETFs also led to significant differences in the performance of broad-based indices.  Notably, the CSI 500 index stood out, and many quantitative products tracking the CSI 500 had significant risk exposure to small and mid-cap stocks.

The trading proportion of the entire market in small and mid-cap stocks significantly deviated from the weight of their market capitalization. It was several times higher than the natural weight. As funds were forced to flow back in the process of tracking indices, there was a significant disparity in the price movements of large and small-cap stocks. Plus, the liquidity of small and mid-cap stocks dried up until liquidity improved.

During the surge of blue-chip stocks from 2019 to early 2021, there was a wave of industrial upgrading and widespread adoption of wealth management, which made them highly attractive to institutional investors. Over the following three years, this bubble gradually dissipated. Currently, the CSI 300 index has a new generation of blue chips led by CATL and the old blue chips represented by Kweichow Moutai, and it has returned to a value range.

Indeed, it took nearly three years to gradually mitigate the risks associated with blue-chip stocks. On the other hand, the risk release for small and mid-cap stocks occurred within a few weeks. However, the subsequent rebound has raised doubts about the extent of risk release. From a valuation perspective, it appears that the process is not yet complete.

We believe that the risk mitigation process for small and mid-cap stocks may differ from the bubble created by fundamental investing. This is because sectors such as electric vehicles, solar power, healthcare, and consumer companies have different business cycles. As a result, the steps taken to adjust stock prices may vary. However, the dominant force behind small and mid-cap stocks could be more consistent algorithmic trading and strategies.

Looking forward, in an economic environment that is still somewhat uncertain, there are indications in the stock market that the investment value is increasing. This is primarily due to the implementation of measures that prioritize investors. After the impact of recent events, broader discussions are likely to bring about institutional changes. For example, there may be an emphasis on investor returns, strengthened regulations throughout the entire process from IPO to exit for listed companies, and greater protection of investor’s interests.

We express an optimistic outlook because we believe that the underlying logic behind the change in capital market positioning aligns with the needs of economic development. In the past, the focus on financing was a self-selected approach driven by ambitious catch-up economic goals. However, in the current context where internal circulation is becoming increasingly important, it is crucial to allow more people to benefit from economic development and promote a virtuous cycle of income and consumption. Ensuring stable returns for the ultimate participants of the stock market, which includes secondary market investors numbering nearly 200 million, has become more important than before. Other stakeholders, such as various levels of government finance and participants in other financial investments, are also gradually converging on this point of interest.

In addition, with no positive feedback in terms of good returns, it becomes challenging to continue expanding the user base of over 200 million. Therefore, it is more likely that behaviours aimed at retaining these existing users will occur naturally.

According to the data from the Spring Festival holiday period showed relatively positive signals compared to other holiday data in the past 23 years. Although there were some unfavourable indicators regarding average transaction value, the overall activity level has improved. In our view, there are expectations for further policy-driven positive recovery during the upcoming "Two Sessions" (the annual meetings of the National People's Congress on 4 & 5 March), which could provide a clearer outlook.

The market volatility at the beginning of this year serves as a reminder that there is still a lot of uncertainty in the market. The preference for high dividend stocks has long-term logic behind it, if they are not overvalued, they can continue to perform well. It is important to pay attention to the sustainability of high dividend stocks and identify companies that may transition from low dividend to high dividend payouts.

In terms of new industry breakthroughs, the semiconductor sector could be a potential area to watch. However, further observation is necessary to assess the developments and potential opportunities within this field.

Overall, the bubble in large-cap blue-chip stocks, which had a significant market capitalization, has been relatively well released. The risk associated with small and mid-cap stocks is starting to be released. If there is further clarity in economic recovery and combined with reforms in the securities market, the future market outlook may improve compared to the current cautious expectations in the market.