China stocks look primed for a recovery, argues Z-Ben

Chinese equities have this week fallen into a bear market, with the Shanghai Composite Index losing 20% since hitting a peak in November (it fell to 2,648 on Tuesday).

The news around the European package for Greece provided hardly any respite. That's because the market is reacting to domestic impulses, with the global crisis having little to no affect, says a report from Shanghai-based funds consultancy Z-Ben Advisors.

The group says instead conditions today are similar to those of early 2007, in which regulatory changes and a clampdown on property prices initially muted sentiment but ultimately pushed investors into stocks.

The subsequent rally, which continued through much of 2008, particularly benefited local fund houses such as China Asset Management and E-Funds, which enjoyed a huge rise in their assets under management.

Z-Ben's analysts say the same could happen again in the coming weeks.

Unlike other markets, government attempts to take the steam out of rising property prices actually benefit the Chinese stock market. This is because investors have no other channels. The local bond market is not yet developed for retail investors, and money market funds can't beat inflation. Offshore investing remains niche and alternative investments difficult to access.

The situation is different for institutional investors. Domestic insurance companies, for example, are sitting on around Rmb1 trillion worth of cash and equivalents, and have access to long-duration bonds with yield, to private equity, and to overseas investments. But the local stock market remains driven primarily by retail sentiment.

Regulators, meanwhile, realize that, absent of a comprehensive system of social security, most investors therefore have only domestic stocks and property as a means of supporting themselves over the long run. Therefore when the government moves against excesses in the property market (or in the stock market), it allows liquidity to flow to the other.

Z-Ben reckons that, so long as the Greek drama doesn't turn into another Lehman Brothers-level collapse, then the local stock market should revert to form.

Fewer than 10% of assets in China's Rmb2.4 trillion mutual funds market is invested overseas via qualified domestic institutional investments (QDII). Nor is the local market dependent in any way upon global investors, and it is therefore inured to any bout of risk aversion. Although major events in the United States or Europe can impact Chinese sentiment in the short run, domestic moods tend to overwhelm these over weeks or months.