Investors should continue to steer clear of Chinese stocks, analysts warn. Here is what needs to change before they become a 'buy.'

By Joseph Adinolfi

Valuations in the Chinese stock market are collapsing in the new year, heaping more pressure on shares of some of the most respectable companies trading in the world's second-largest economy.

These steep January declines followed multiple years of losses for the Hong Kong-based Hang Seng Index, along with other indexes that track the performance of shares trading in the mainland, according to FactSet data.

So far, the worsening selloff is spurring a debate on Wall Street about whether Chinese shares are bombed-out enough to justify scooping them up on the cheap.

Take Alibaba Group Holding (BABA) for example. The company is presently trading at a forward price-to-earnings ratio of around eight, the lowest level since its 2014 IPO, according to FactSet data. It's currently trading at around $73 a share on Tuesday, having risen 6.9%, leaving it on track for its best daily session since July.

While investors are typically wary of trying to "catch a falling knife", to use markets jargon for timing the bottom, at least one veteran analyst has shared a few ideas about what it might take for Chinese stocks to experience a lasting rebound.

"Bottom line, Chinese stocks have been hit by a series of (mostly) self-inflicted wounds from a policy standpoint and until there's evidence that authorities are committed to stimulating growth or reducing regulatory interference, we should expect continued pressure on Chinese stocks," said Tom Essaye, founder of Sevens Report Research, in a Tuesday note.

As Essaye explained, Chinese stocks have struggled for years now, with the Shanghai-traded CSI300 index XX:000300 falling to a five-year low on Monday. Meanwhile, the Hong Kong-based Hang Seng Index HK:HSI, home to many large companies based in the mainland, touched a 14-month low, according to FactSet data.

What would it take for Chinese stocks to see a lasting rebound? According to Essaye, while the selloff in Chinese stocks is starting to look overdone, he is not yet convinced that companies like Alibaba represent an obvious "buy" at current valuations.

Changing his mind, Essaye said, would require two key policy changes at the highest levels of the Chinese government.

First, international investors would need to see evidence of real meaningful stimulus from the People's Bank of China. Hopes for interest rate cuts from the central bank were dashed on Monday, heaping more pressure on Chinese shares.

But even more important than dialing up stimulus at the central bank, Chinese authorities need to prove once again that they can be more business-friendly, following the crackdowns on the country's largest technology companies.

"So far, there is little evidence of either," Essaye said.

Chinese stocks have fallen for three consecutive years through the end of 2023, FactSet data show. Still, the iShares China Large-Cap ETF FXI is stocked with profitable, established technology giants like Alibaba Group Holding Ltd. (BABA), JD.com (JD), Tencent Holdings (HK:700) and others.

As a result, Chinese stocks presently rank among the most beaten-down and disliked shares anywhere in the world, Essaye said. This alone might boost their appeal to some investors with a contrarian streak who have the wherewithal to wait out any further declines.

Chinese stocks were seeing a solid rebound early Tuesday, following a report that Beijing was considering a $278 billion package to support the country's stock market. The news sent shares of Chinese companies broadly higher, with gains concentrated among large-cap Chinese technology names like the members of the KraneShares CSI China Internet ETF KWEB.

See: Hang Seng jumps off lows on report of Beijing's $278 billion support package

But few on Wall Street expect Tuesday's rebound will mark a turning point for Chinese shares.

Matthew Tuttle, of Tuttle Capital Management, told MarketWatch via email that "short answer is we probably have to see some more pain" in Chinese stocks before a compelling bullish thesis emerges.

-Joseph Adinolfi

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01-23-24 2233ET

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