China’s Stock Market Is Bouncing Back. Check This Before You Buy.

That idea has almost certainly crossed the minds of many investors. The MSCI China ETF has gained 7.3% in October, nearly three percentage points more than the

S&P 500.
China’s beaten-down tech stocks have rallied even more, with

Alibaba Group Holding

(BABA) surging 22% amid reports that it would build its own chips and that founder Jack Ma had emerged from hibernation to travel to Europe, and

Baidu

(BIDU) is up 18%.

Those moves are too large to chase. While the declines in Chinese stocks reflect a lot of pessimism, analysts remain far too optimistic, according to Cirrus Research’s Georgiana Fung. Despite the market tumble and China’s slowing economy, earnings revisions have been strong, while the certainty of those estimates—measured by the relative lack of dispersion among them—all point to a level of overconfidence heading into earnings season. “Currently, the rise in earnings expectations appear to be too buoyant,” Fung writes. “These cautionary readings signal lower expected returns to come.”

The bigger issue, however, may be policy makers’ lack of action to boost the economy, something that may be necessary for China’s stock market to sustain a rally. According to Gavekal Dragonomics’ Thomas Gatley, it rallies when private credit growth is accelerating but underperforms when credit growth is slowing.

It’s not difficult to see why. When credit growth is accelerating, it means that demand is increasing, something which should lead to higher profits for Chinese companies. And just as with the Federal Reserve, when the People’s Bank of China eases, the cash often makes its way into stocks….