Chinese stocks could be headed for a 'megarally' with gains of up to 100%, veteran analyst says

By Joseph Adinolfi

A report from Gavekal Dragonomics recounts China's history of stock-market booms and busts - and concludes that another cycle could be just beginning

Investors around the world are wondering how much longer the latest face-ripping rally in Chinese stocks can last. One longtime China analyst might have some answers.

Assuming all goes according to plan, Chinese stocks' blistering advance over the past week could be just the beginning of a "megarally" that would deliver gains of up to 100%, according to Thomas Gatley, a China-based analyst at Gavekal Dragonomics. Gatley shared his analysis, which is based on how Chinese stocks have performed over the past 20 years, in a report provided to MarketWatch on Monday.

However, whether the rally can continue will likely depend on whether or not policymakers in Beijing can deliver the combination of monetary and fiscal stimulus that international investors have come to expect.

If they do, more gains are pretty much guaranteed, Gatley said.

"This combination of monetary, fiscal and direct market support, assuming it is actually delivered, pretty much guarantees that the rise in equities will continue," he said.

To be sure, the rally has already made its mark on history. The CSI 300 index XX:000300 rose roughly 25% in the five trading sessions through Monday, its fastest pace of appreciation since at least 2002, according to Bespoke Investment Group. The market will now be closed for the remainder of the week as China's "Golden Week" holiday begins, although U.S.-based ADRs of Chinese companies will continue to trade.

See: Chinese stocks see massive surge in past five days - but remain 'in the hole'

But it would risk becoming a mere footnote if policymakers don't give investors enough to cling to as they set about trying to revive a Chinese economy mired in deflation.

'Feast or famine'

China's famously "feast or famine" equity market has seen a number of booms and busts since the CSI 300 was launched in 2005, Gatley said.

By his count, there have been five "megarallies" since then.

The first such rally saw the biggest gains, but it was followed by the most painful crash: It lasted from 2006 and peaked just before the start of 2008, as the chart below shows. The CSI 300 had risen nearly 500% at its height.

The other four were over within eight to 13 months. Given this history, it's understandable that investors have been wary about committing capital to Chinese stocks for the long term, given that they have been prone to exuberant booms followed by painful busts. In fact, Chinese equities have really only risen during five of the past 20 years.

See: Morgan Stanley forecast another 10% rise for Chinese stocks - which nearly happened in just one day

Of these five previous notable rallies, only two - the ones that began in 2006 and 2017 - were driven by strong organic economic growth and rising corporate profits. The three others were fueled by stimulus, Gatley noted.

These stimulus-driven rallies saw trough-to-peak gains of about 50% to 100%. So if another such rally is indeed just getting started, there should be plenty of upside left.

Of course, this all depends on whether policymakers follow up on monetary stimulus measures announced by the central bank last week - and follow through with fiscal stimulus measures teased by the Western press after the country's senior leaders dedicated last week's Politburo meeting to the economy, an unexpected development.

More monetary easing may be needed; after all, the measures announced by the People's Bank of China last week were more modest than previous easing efforts, Gatley said. And although the $300 billion in fiscal stimulus reportedly under consideration should help deliver a modest pickup in growth, more dramatic action may ultimately be required to achieve a lasting turnaround.

That being said, the PBOC's efforts to boost the country's stock market by encouraging Chinese firms to buy back their shares should help revive the central bank "put" that has helped keep a floor under the Chinese market since 2015. Stock buybacks have not previously been a major driver of equity-market returns in China, Gatley noted.

Investors interested in playing the rally should keep the following in mind, he added.

During past megarallies, stocks trading onshore have tended to outperform rivals trading in Hong Kong. So far, stocks trading in both markets have seen robust gains.

If China's market continues to climb, it could entice Chinese consumers to shift some of the savings they have kept in cash back into the stock market, which could fuel further appreciation.

Chinese exporters might even be tempted to repatriate some of their foreign profits, which many have been keeping outside of the country as China's currency has weakened against the dollar. This could also help to further bolster sentiment.

But investors have been disappointed by false starts in the Chinese market before. One only needs to look at a chart of how Chinese stocks have performed over the past three years to understand why.

"Investors have experienced encouraging talk and underwhelming reality enough in recent years to run for the exits if disappointment strikes again," Gatley said.

But the government's latest stimulus efforts have already helped to restore investor confidence, at least for now. Barring any surprises, there is likely more money to be made.

As of Monday's close, China's Hang Seng Index HK:HSI was up nearly 24% year-to-date at 21,133.68. That's a bigger gain than seen from the S&P 500 SPX, which has risen by just shy of 21%, FactSet data show.

-Joseph Adinolfi

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10-01-24 0600ET

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