THE mainland's stock market has been in fluctuating mode over the past month. The benchmark Shanghai Composite Index lost 3.3 percent last week and posted a dip of 0.57 percent for April after a rebound of 0.8 percent in March.

So what is causing all the gyrations and where should investors put their money?

To try to shed some light on market movement, we sat down with Liu Jun, deputy index investment officer of Huatai-PineBridge, a joint-venture fund management company in Shanghai.

Due to industry policies, Liu is barred from discussing specific stocks.

The conversation focused only on market sectors.

Q: The Shanghai market has been volatile in the past two weeks. Why such sudden changes?

A: I think investors are now more worried about the possibility that China's economy has been hurt by all the existing tightening measures targeted to rein in inflation.

China's economy has already showed signs of slowing, with growth of 9.7 percent in the January-March quarter, following a gain of 11.9 percent a year earlier. Slower growth means shrinking demand in markets, which might lead to a decline in corporate profits.

More importantly, companies now have a high level of stockpiles because of anticipation that high inflation would endure for some time, and stockpiles tend to be of more expensive goods.

If demand declines, companies will find themselves stuck with bigger stockpiles than they had expected. They need to run down those stockpiles. That's what worries investors most.

Another thing we need to watch, especially for the B-share market, where serious declines have occurred in recent days, is the future direction of the US dollar.

The US Federal Reserve has signaled it would not raise interest rates any time soon and hasn't ruled out the possibility of a third round of quantitative easing, which means the US economy recovery is probably not as good as anticipated. A slower economy recovery in the West will continue to put pressure on China's exports.

But on the other side, liquidity is not likely to be tight in the market because of the unchanged loose monetary policy in the United States.



Q: So if the dollar continues to be cheaper, commodity prices probably are going to shoot higher. Will that lead to a greater imported inflation for China?

A: I don't think so. Yes, gold and crude oil have been rallying for some time, partly because of the cheaper greenback. But prices for basic metals such as copper haven't see such steep rises so far, which I think is because people realize that demand for those metals has not been as strong as previously expected. I'm not saying there won't be momentum there if the dollar falls further in face of a possible QE3, but prices won't be able to stay high for long without demand support.



Q: The price of gold has already risen beyond US$1,500 an ounce. Do you think gold producers are a good sector to invest in?

A: In the Chinese market, gold miners don't necessarily run with the price of the metal. That sector is more affected by changes in the broad stock market itself and also is sometimes affected by the performances of the non-ferrous sector.

In the short term, the rising price of gold isn't likely to lead to a sharp increase in production, which means profit forecasts are not likely to be much changed either.



Q: If interest rates in the US start to rise, how would that affect China and its stock market?

A: If the US finally starts raising interest rates, emerging markets, including China, are likely to see some hot money leaving their shores, but I personally don't think it will make that much difference. Take China for instance. If some portion of speculative money leaves for developed markets, there will still be more than enough money left in this country. A total of 870 billion yuan in central bank bills and repos matured in April, and another 549 billion yuan comes due this month. If the hot money leaves China, its impact will be more a psychological one with investors. Prices of commodities may see a short period of downward correction.



Q: You just mentioned the large amount of central bank bills and repos maturing, which is one of the reasons so many economists are predicting a new round tightening in China. How would that affect the market?

A: I think that would deepen investors' profit worries because borrowing costs will undoubtedly be higher for companies, especially small and medium-sized firms. Secondly, part of the money in the stock market may return to banks as they seek for safer profits, which would be discouraging news for shares.

In such a case, shares are not likely to be bullish but rather more volatile because people will be more cautious and inclined to go for quick profits rather than waiting patiently for their stocks to rise.

So I think the market is probably going to bounce between 2,900 and 3,000 points in the second quarter because as long as the index is above the 3,000 mark, jittery investors will begin selling to protect their gains.



Q: The Shanghai stock market saw momentum led by blue chips, such as lenders and developers, in March. Do you expect that to continue?

A: I think banking shares will be a much safer choice than real estate companies in the second quarter because it's obvious that China will step up measures to curb housing prices this year. But for banks, so far, the latest tightening has been modest.

Because China is in a cycle of interest rate hikes, profits for banks are pretty assured despite the fact that overall loan supply is tightly controlled.

However, for developers it's a totally different story. We have already seen a decline in property transaction volumes in many cities due to government policies, which means profits for developers will soon begin to fall. That's why I find them less appealing than lenders.



Q: Of the 16 lenders listed in Shanghai, is it better to put your money with the big banks or the smaller ones?

A: In terms of a valuation correction, small banks are likely to bounce more than big lenders.

If banking shares continue to rise, that's something people need to watch carefully. If the price-earnings ratio for big banks jumps to up to 12 or 15 times that of small banks, then investors should probably start to think about slowly reducing their exposure to the sector.



Q: What about other blue chips, such as coal miners and steelmakers?

A: I think cyclical shares like steel, coal, cement and non-ferrous metals could be risky investments in the second quarter.

The market itself hasn't got much room to rise because we are now in a tightening cycle, so that means investors should look for opportunities among sector rotations. Last year, it was small and medium-sized firms that outperformed the market. This year it's the big caps that may take the lead.

For specific shares, if they have already seen some hefty gains, they are likely to fall, while those that have been languishing price-wise for some time are likely to undergo a valuation correction. This is, I think, how the market pattern is working right now.

Shares such as steel, cement and other construction material producers gained a lot in the first quarter. They are not likely to extend their rally in the second quarter. What's more, if the economy slows, demand for construction materials will decline. Besides, profits can not be assured for those companies because they have to worry about their stockpiles first.



Q: So cyclical shares could be risky in the second quarter. Is there anything worth buying, in your opinion?

A: I think banks are the first sector investors should think about. They are cheap and profits are assured. This is the kind of certainty people need to look for in an uncertain market like the one we're having now. Apart from that, I think food, beverages and apparel makers could also be good choices. Demands for food and clothes will not shrink in China. Those shares have been tumbled for some time. Their first-quarter earnings are at least as good as expected.



Q: Could you go more specific? What in the consumer sector do you find most attractive?

A: Wine and spirits makers, for one, because their profits are stunning and stable. Intimate and brand apparel makers could be ideal because they have solid market demand that can underpin profits.



Q: You forecast that big caps will take the lead in the market. So what are the prospects for small cap stocks?

A: I'm afraid there won't be a lot of opportunities for shares on the Small and Medium Enterprise (SME) board or the ChiNext start-up board because high valuations are a big problem for shares listed there.

Another factor to be considered is the unlocking of a large amount of non-tradable shares on these two boards. Last year, the ChiNext board unlocked 1.64 billion of untradeable shares worth more than 50 billion yuan, and this year the figure will be 2.43 billion shares, which may well exceed a market value of 100 billion yuan.

For the SME board, a total of 629 billion yuan worth of locked shares will become tradable this year.

Most of the stocks on these two boards have high price-earning values, so their prices are likely to tumble when we talk about such huge amounts of untradeable shares being unlocked.

Moreover, it's obvious that China has sped up the IPO process for new listings this year, and most of those will be on the SME and ChiNext boards. That means more supply of stocks in those markets. If investors have more choices, expensive stocks are expected to fall because few people will be willing to buy them at elevated P/E values when there are cheaper investments available.

But in a long run, for example after 2012, small caps may come into their own again.



Q: What do you expect to happen when the new OTC board opens?

A: I don't think a price correction will happen. When the ChiNext board was launched in 2009, many people worried whether the new board would lure investors out of the SME board and cause a wide sell-off there. That didn't happen. On the contrary, we saw a rally among shares on both boards.

I think that may be the case again when the OTC board opens because there won't be a lot of stocks available on the new board at first. Speculative money will have to seek opportunities in similar channels, such as small, high-growth firms on SME and ChiNext.