Chinese Stock Indicator With 100% Success Rate Is Flashing Buy

The risk premium of Chinese stocks has reached a level that historically leads to spectacular returns.

A pedestrian in Pudong's Lujiazui Financial District in Shanghai, China, on Monday, Oct. 9, 2023. Chinese stocks edged lower as traders returned from the Golden Week holidays, with tourism data trailing some expectations and global uncertainties denting sentiment. Photographer: Qilai Shen/Bloomberg

With sentiment toward China’s economy and markets as depressed as they are now, perhaps it pays to be a contrarian. And at least according to one measure, there’s a reason for optimism: The risk premium of Chinese stocks has reached a level that historically leads to spectacular returns.

China’s stock market is sinking to the bottom of the global ranking in the first week of 2024 trading. From its peak in 2021, the CSI 300 Index has lost about 42%, comparable to the drawdown during the burst of the stock bubble in 2015.

In contrast, China’s bond market has extended its rally, sending the yield on 10-year notes to 2.5%, the lowest since April 2020. Both markets are telling the same story about the macro weakness in China.

Compared with bonds, Chinese stocks have rarely been so cheap. At about 8%, the earnings yields of the CSI benchmark is 5.7 percentage points above the 10-year yield. Since 2005, the gap has rarely been this big. Similarly, the dividend yield of the stock benchmark has risen above the long-term bond yields for the first time since at least 2005.

Of course, it’s just another way of saying that Chinese stocks are dirt cheap — and there’s no shortage of other measures to show that. What’s interesting about this Chinese version of the Fed model is that, historically, it provides a very reliable signal for forward stock returns.

There’s been five previous periods in almost two decades that the stock-bond yield gap has reached 5.5 points or more, including during the 2008 financial crisis and the pandemic in 2020. Stocks rose in the following 12 months each time, with a whopping return of 57% on average.

Note that 2012 shows a huge surge in the yield gap, which may be the result of a bad data feed. Excluding that from analysis, the three-month and six-month forward return would have had a 100% hit ratio as well.

Of course, valuation alone isn’t enough to turn around the market, a painful lesson we learned last year. A positive performance needs earnings to improve, valuation multiples to expand, or ideally, both. For that to happen, the housing market needs to stabilize and deflation needs to give way to modest inflation. So far, neither look promising without more forceful policy support.

But for those who are willing to take the contrarian view, it’s at least comforting that they have history on their side.

Things to Know:

  • Chinese Premier Li Qiang visited Yangtze Memory Technologies Co., the country’s foremost developer of memory chips, in the latest show of government support for the US-sanctioned business as the two powers clash over technology.
  • China supports initial public offering of data providers and encourages investment in data industry, according to the 2024-2026 digital development action plan published on National Data Administration’s WeChat account.
  • China’s government spending will rise this year, the nation’s Minister of Finance said, as authorities look for ways to bolster domestic demand and help the world’s second-largest economy regain momentum.
  • US companies ramped up hiring in December and wage gains continued to cool, consistent with an outlook for sustained economic growth and diminishing inflation.
  • Amer Sports, the maker of Wilson tennis rackets and Salomon ski boots, has filed for a US initial public offering.

Things to Read:

Xi’s Mixed Messages Leave Whiplashed Investors Wary of China 

Wall Street’s Ambitions in China Run Into a Rising Firewall

Bridgewater’s Flagship Macro Fund Lost 7.6% Last Year 

China’s Defense Purge Strikes at Heart of Xi’s Military Reforms

Story Link: Indicator With 100% Hit Rate Flashes Buy Signal: China Today

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