There's scary message for China bulls in financial firms' issues

Declines may signal a 'temporary peak of the broad market' for stocks

Chinese mainland stock bulls may want to take note of the sell-off in financial shares.

If recent history is a guide, the losses in the CSI 300 Financials Index - which total 8.1 percent since the start of the year compared with a 1.7 percent gain in the CSI 300 Index - are signaling that the world-beating rally in Chinese equities could be about to come to an abrupt, and painful, end. The last time the industry lagged behind the broader market by this much in November 2007 and August 2009, the CSI 300 Index lost an average 42 percent over the following 12 months.

Financial companies are often a leading indicator for China's $5.5 trillion stock market because of their sensitivity to capital flows in the world's second-largest economy, according to Shenwan Hongyuan Group Co, the nation's second-biggest listed brokerage by value. While China's central bank has cut interest rates twice since November to prop up the expansion, economic data last month showed deepening producer-price deflation, weak retail sales growth and a plunge in imports.

Declines by financial stocks may signal a "temporary peak of the broad market", David Cui, a China strategist at Bank of America Corp, who's ranked No 1 by Institutional Investor magazine, said by e-mail last week. "Our biggest concerns are deflation, yuan devaluation and an outbreak of bad debt in China. In this context, financials are unlikely to perform well."

Historical losses

When the financial index lagged behind the CSI 300 by more than 8 percentage points over the same time frame in November 2007, the broader gauge fell 60 percent in the following 12 months, with losses exacerbated by the global financial crisis. An underperformance of similar magnitude in August 2009 preceded a 24 percent slump by the CSI 300.

The CSI 300 index and the financial gauge both rose 2.43 percent on Monday.

The financial measure accounts for 41 percent of the CSI 300's total weighting, more than twice the size of the second-largest industry group. While the measure of banks, brokerages and property developers jumped 37 percent in the two weeks after the central bank first cut borrowing costs on Nov 21, the index is unchanged since the second reduction in rates on Feb 28 and money-market rates have increased.

Economic tracker

Gemdale Corp, a Shenzhen-based property developer, has tumbled 18 percent this year, while CITIC Securities Co, the nation's biggest brokerage by market value, has plunged 17 percent. Agricultural Bank of China Ltd has lost 11 percent. The CSI 300 index jumped 52 percent last year and is valued at 12.5 times estimated earnings for the next 12 months, a 15 percent premium to the five-year average.

"Financial stocks lead the broader market," said Hao Hong, the chief China strategist at BOCOM International Holdings Co in Hong Kong. "The market has been finding it difficult" to rally as the industry underperforms, he said.

Industrial output, investment and retail sales growth all missed analysts' estimates in January and February, while Bloomberg's gross domestic product tracker, which draws on that data as well as measures such as electricity production, shows economic growth slowed to 6.28 percent in the period, the weakest pace since the start of 2009.

Credit growth

While financial companies are likely to continue underperforming, investor interest in so-called new economy stocks in industries such as tourism, healthcare and technology will shore up the stock market, said David Gaud, a Hong Kong-based senior portfolio manager and global investment specialist at Edmond de Rothschild Group.

Indexes tracking technology, consumer discretionary and healthcare stocks have jumped between 9 percent and 32 percent this year.

Dai Ming, a money manager at Hengsheng Asset Management Co in Shanghai, said declines in financial companies are overdone and history is not an accurate guide this time round.

The index of banks and brokerages rallied 3.9 percent on Thursday as credit growth beat forecasts. Aggregate financing was 1.35 trillion yuan ($215.5 billion) in February, above the median estimate of 1 trillion yuan in a Bloomberg survey of economists. New yuan loans totaled 1.02 trillion yuan and M2 money supply rose 12.5 percent.

"Government measures to prevent further slowing growth have been very pre-emptive this time," Dai said by phone last week. "I am not too worried about the declines of financial stocks, which is a result of some profit taking after last year's decent performance."

Correction concern

The industry's retreat may foreshadow the start of a broader market decline as concern over bad loans increases, according to Gerry Alfonso, a director at the international business department at Shenwan Hongyuan.

Banks' bad-loan ratio rose the most in at least a decade last quarter as a property-market slump and slower economic growth hurt borrowers' ability to repay. Nonperforming loans accounted for 1.29 percent of commercial banks' total advances as of Dec 31, up from 1.16 percent three months earlier, the China Banking Regulatory Commission said in January.

"Most rallies and corrections in the banking sector are related to issues such as funding and quality of loans," Alfonso said last week. "A correction in banks could be a first step, if funding is the major driver, for a correction on corporates."