“The market is not very well prepared for tightening monetary policies,” said Min Liangchao, a strategist at HSBC Jintrust Fund Management in Shanghai. “It’s now pretty hard to make money simply through valuation expansion. Market pricing will be more driven by earnings and we should put more emphasis on it.”

The CSI 300 Index, which tracks the biggest companies in Shanghai and Shenzhen bourses, has risen 78 per cent from end-2018 to surpass the 2015 peak on January 5. The rally helped fuel China’s stock market capitalisation above the US$10 trillion mark in October.

There is a consensus that Chinese authorities will dial back their stimulus efforts this year and continue to tighten regulations in sectors such as real estate, according to BCA Research. “Investors may disagree on the pace and magnitude of policy tightening, but the policy direction has been explicit from recent government announcements.”

Investors in mainland stocks have other worries to contend with, including earnings momentum.

The current divergence between forward earnings and price-earnings expansions in Chinese stocks is reminiscent of the massive stock market boom-bust cycle in 2014/15, according to BCA Research. The disparity between the earnings outlook and valuations indicates Chinese stock prices are overstretched, it added.

Early results in January showed 75 per cent of 1,200-odd companies have reported higher earnings last year, according to Bloomberg. Firms in the communication services and health care sectors are set to report the biggest growth, followed by consumer staples and technology.

The risk, though, lies in how fast earnings can grow to catch up with excessive valuation, BCA Research said.

“Earnings from some of China’s high-flying sectors have been mediocre,” Sima said in the report. “The stretched valuation measures suggest that investors have priced in significant earnings growth, which may be more than these industries can deliver in 2021.”

Besides, the breadth of the recent stock surge – or the percentage of stocks for which prices are rising versus falling – has worsened, BCA said. A sharp narrowing in that indicator has led to price corrections and major setbacks in the past, it added.

Since October, gains in stock benchmarks have papered over some flaws. The number of stocks with ascending prices has fallen, with only a handful of large-cap stocks driving the broader market up.

Unlike the tech titans which represent more than 20 per cent of the S&P index, the overconcentration in the Chinese onshore market has been more on the sector leaders rather than on a particular sector,” Sima added in the report.

China’s own technology giants such as Alibaba, Tencent, and Meituan, represent 35 per cent of China’s offshore market, but most of the sector leaders in China’s onshore market account for only 2 to 3 per cent of the total equity market capitalisation, making it difficult for them to shore up the market when the rest of the pack slump.

01:26

China kicks off antitrust probes into Alibaba over alleged monopolistic practices

China kicks off antitrust probes into Alibaba over alleged monopolistic practices

To be sure, there are market positives to digest, such buying support from an influx of retail cash into the market.

Chinese households, limited by investment choices, have been increasingly investing in the domestic equity market. Onshore mutual funds have raised money at a record pace, bringing in over 2 trillion yuan in 2020, more than the sum of the previous four years combined, according to BCA.

The massive stimulus rolled out last year should continue to work its way through the economy and support the ongoing uptrend in the business cycle, it added. Beijing’s relative success in containing Covid-19 outbreaks has given consumers, businesses and investors a shot in the arm.

“Although the central bank has had a subtle change of attitude towards liquidity, investors should not be too alarmed,” said Tan Yunfei, a Shanghai-based fund manager at HFT Investment Management. “It simply wants to adjust the expectations about policies being too loose, and it will not deviate from the main theme of stabilising the economy to make sure that the real economy can have access to stable funding.”

Still, investors should be watchful of cyclical stocks, according to Sima. The performance in cyclical stocks in both the onshore and offshore equity markets has started to falter, after trouncing defensive types in 2020. Cyclical stocks tend to follow the heartbeat of the economy, and their stumble suggests prices may soon peak.

“For now, there is little near-term benefit for investors to chase the rally in Chinese stocks,” she said. “While we are not yet negative on Chinese stocks on a cyclical basis, the risks for a near-term price correction are significant.”