We maintain our long-standing very cautious stance on China, despite some signs of more positive earnings indicator readings caused by a handful of mega-cap Chinese stocks (that we call the “Magnificent 5”). Outside of those few stocks, our data shows that most Chinese stocks still have very negative earnings trends, and the economy remains weak. Though the Chinese stock market is cheaper now, valuation alone is unlikely to support a sustainable revival until fundamentals improve.

Client question: Chinese stocks have lagged severely and look cheap, and some earnings indicators look better, so is it time to jump in?

The short answer, in our view, is (still) no. While some of our measures of earnings estimate trends in China do look more positive, it is only the cap-weighted readings that are heavily influenced by a handful of mega-cap Chinese stocks, while most Chinese stocks still have negative earnings trends. We thus remain very cautious on China, as we have for a long time now, as underlying fundamentals are still weak.

While many investors in US markets have decried the high level of concentration in the S&P 500 (and other large-cap indices), and the outsized influence of a few Tech-related mega-caps (known as the “Magnificent 7”) on the indices, the situation is even more extreme in China.

You think the S&P 500 is “top heavy”? Check out China.

First, note that the MSCI China index ETF (ticker MCHI) has 596 holdings, not that different from the S&P 500 in terms of number of constituents. But as shown in the table below, the top 10 largest constituents of the China index (i.e., 1.6% of the constituents) make up 46% of the total index weight, compared to 35% for the top 10 S&P 500 stocks. And the two biggest stocks in the index make up almost 26% of the weight: Tencent, which by itself makes up 17.2% of the index, and Alibaba, which is 8.6%. By contrast, the three largest stocks in the S&P 500 (Apple, Microsoft, and NVIDIA) are of similar size and each 6-7% of the index, and thus about 19% for all three together (or 13% for the top two).  So the Chinese index is much more concentrated than the S&P 500.

Among those top 10 heavyweights in the MSCI China benchmark, a group we can call the “Magnificent 5” of Tencent, Alibaba, Meituan, Xiaomi, and JD.com are all large technology/consumer-related companies (not unlike the US Magnificent 7), highlighted by green arrows in the table. Those five companies currently have very strong earnings estimate trends based on our indicators that track revisions breadth, i.e., the proportion of analysts covering a stock that have raised earnings estimates most recently net of those who have lowered earnings forecasts (far right column in table). Revisions breadth readings can range from -100% (all analysts have reduced earnings estimates) to +100% (all analysts have raised estimates), with higher readings indicating more decisive estimate revisions among analysts.

Those five companies are driving the +28% average breadth for the top 10 shown in the table, which makes a capitalization-weighted average of the index’s estimate revisions breadth look strong right now (since those few stocks have very large weights in the index). The other column in the table, “MAER Rank”, is the percentile (0-100) rank of those stocks based on our multi-factor MAER stock ranking model that incorporates estimate revisions, price trends, and valuations (more info on MAER is here). So the high (90%+) rankings for the Magnificent 5 capture both the strong analyst estimate activity and the favorable price trends and relative valuations for those few stocks right now.

This is why some Mill Street clients (who can access and analyze such data regularly) and others have considered whether this is an indication of stronger fundamentals in China that would argue in favor of buying (or overweighting in a portfolio) Chinese stocks overall. And indeed, if looking for individual stocks to buy, those highly ranked stocks might be good candidates. But our view is that the strength in those few stocks is not sufficient at this point to argue for a positive view on Chinese equities overall, particularly when viewed alongside persistent signs of weakness at a macro level in China.

Outside of the few mega-caps, most Chinese stocks have weak earnings trends

Looking a bit further, we see that the average revisions breadth across all of the China index constituents is -22%, indicating that most Chinese stocks have significantly negative earnings estimate revisions. Indeed, when we look past the top 10 biggest names to even the just next 10 (stocks ranked 11th to 20th by size), we find an average revisions breadth of -12%. That suggests that many large Chinese companies outside the “Mag 5” have relatively weak earnings trends, not just the smaller companies.

Extending the view beyond the biggest stocks in the benchmark index to get a better view of the broader Chinese equity market (and economy), we can check the aggregated indicators for our own broad, equal-weighted universe of 800 Chinese and Hong Kong stock listings (all with market values of at least USD 500 million). The indicators are shown in the four-panel chart below.

The red line in the chart’s second section shows relative revisions breadth for Chinese stocks relative to the global average of our 6000-stock database (the blue bars show the monthly magnitude of average percentage changes in earnings estimates vs the global universe). We can see that it is still near its most negative readings in our 22 years of historical data, with no real signs of improvement. That is, analysts have been reducing earnings forecasts for Chinese stocks much more aggressively than they have for the average global stock for most of the time since COVID hit in 2020, and still are.

The black line in the top section of the chart shows the relative return of our equal-weighted China/HK stock universe versus the return of all global stocks. The dramatic downtrend in that chart since 2020 highlights the drastic underperformance of Chinese stocks versus the rest of the world. Thus the weak earnings trends have aligned with the sharp underperformance of Chinese stocks, i.e., there has been a fundamental reason for their underperformance.

That underperformance has made the Chinese market cheaper, as reflected in the rising relative earnings yield (purple line in the bottom section of the chart). But there is certainly a reasonable argument that valuations in China deserve to be lower (lower price/earnings ratio, equivalent to a higher earnings yield, or earnings/price ratio) given the structural headwinds and political risk facing the Chinese economy and companies. These include the slow-motion train wreck in the Chinese real estate market, poor domestic macro policy, trade disputes with the US and others, political interference in many industries, and unfavorable demographics.

Need to see broader fundamental improvement to support a bullish view on China given macro risks

If the average Chinese stock still has very negative trends in analyst earnings estimates even after several years of persistent “downside surprises”, and there are no real signs of improvement in the macro/policy outlook, then our view is that China still looks risky from a fundamental standpoint, even if a few mega-caps are seeing strong earnings trends recently. And even the apparent strength in earnings estimates for our so-called Magnificent 5 has not been enough to allow the cap-weighted index to outperform the rest of the world (especially the US) in recent months (since more US stocks have strong earnings trends). The narrow earnings strength in those few big stocks has been largely offset by lower valuations placed on Chinese stocks by investors looking at the overall trends and risks there.

So our view has been that while there will likely continue to be periodic rebounds and plateaus in the relative performance of the Chinese stock market (vs the rest of the world, and particularly the US), we would remain underweight in China (or avoid it) given the persistent weakness in earnings trends for most Chinese companies and the ongoing macro/political risk. Those who want or need exposure to China should certainly focus on the companies with the strongest earnings support, but seeming strength in a handful of big names is not convincing enough evidence in our work to argue for a big bullish bet on China right now.