CICC: Who is the "smart money"?

CICC has released a research report stating that, currently, Hong Kong stocks are more suitable for focusing on swing markets and structural opportunities. The bank maintains its baseline forecast for the Hang Seng Index at 26,000-27,000 points. In terms of operation, 1) if Hong Kong stocks rise close to that range, combined with accelerated inflows of active external capital and a slowdown in southbound funding, profits can be taken; 2) if there is a subsequent adjustment and southbound capital flow accelerates again compared to previous trends, then allocation can be increased. In terms of direction, technology looks at industries, cycles look at the Federal Reserve, and consumption looks at policies. In the short term, if technological progress is limited, dividends can be used to moderately hedge against portfolio volatility. CICC's main viewpoints are as follows: Since 2026, Hong Kong stocks have consistently diverged from neighboring markets, including A-shares, exhibiting a typical "seesaw" effect. In the first half of this year, while the tech sectors in Korea and A-shares strengthened, Hong Kong stocks lagged and suffered capital outflows; after a correction in tech stocks in late June, Hong Kong stocks rebounded and attracted capital inflows. This phenomenon is not unique to this year; it was also true in 2025 and even earlier: Internally, during the first half of 2025, Hong Kong stocks gained momentum with sustained southbound inflows, while those inflows slowed after A-shares strengthened in the second half; externally, overseas capital will adjust its allocation to Hong Kong stocks based on the attractiveness of stock markets in Japan, India, and South Korea. The underlying reason for this phenomenon lies in the fact that the Hong Kong stock market is an "offshore market," lacking domestic capital, which requires it to "compete" for the attention of different investors from other markets. As various funds reallocate among these markets, a "seesaw" effect emerges. Additionally, the relatively low trading activity in Hong Kong stocks magnifies the impact of capital changes, further highlighting the importance of different capital behaviors. Reviewing the relationship between southbound and overseas capital trends and market performance since 2016, the bank has drawn the following conclusions: 1) The inflow and outflow of southbound capital are highly correlated with market performance, but they also exhibit certain "smart money" characteristics, such as a slowdown in inflows after significant increases in Hong Kong stocks and a speeding up of purchases after declines or underperformance relative to A-shares. Compared to insurance funds, active public offerings and ETFs display more pronounced market-following characteristics; 2) Active foreign capital usually accelerates its inflow only after improvements in performance and earnings expectations, serving as a lagging indicator; passive foreign capital, being small in scale and more affected by non-China market redemptions, has limited reference value; 3) The reference value of capital becomes more significant during fluctuations in China's credit cycle or tightening of overseas liquidity: at such times, accelerated southbound inflows often indicate an impending market rebound; conversely, accelerated inflows of active foreign capital correlate with weakened future returns. The reverse is also true: a marked slowdown or net outflow of southbound capital suggests a potential market peak, while accelerated outflows of active foreign capital often reflect prior market weakness. Characteristics of capital behaviors in Hong Kong stocks: southbound capital has "smart money" traits, active foreign capital acts as a lagging indicator, and passive foreign capital has limited reference value. Over the past decade, although there has been a structural long-term influx of both southbound and overseas passive capital, the bank finds that short-term capital movements are more crucial for market pricing. Therefore, the bank observes capital signals from two dimensions: "changes in capital flow speed" and "changes in relative returns." "Flow speed change" is defined as the difference between the average net inflow over the past month and the average net inflow over the past three months; "return change" is measured by the performance of the Hang Seng Index relative to other market indices over the past month. Firstly, on an overall trend basis, southbound capital is highly correlated with market performance. Secondly, on the margin, southbound capital tends to slow its inflow after significant increases, accelerating purchases instead after declines or underperformance relative to A-shares, exhibiting certain "smart money" characteristics. Furthermore, when the speed of southbound inflow is in the top 20% historically, the Hang Seng Index averages a 1.7% increase over the next 20 trading days; when southbound inflows shift from acceleration to slowdown, the index typically weakens within 3-5 trading days, subsequently averaging a decline of 1.6%. This suggests a capacity for buying at low points and taking profits at high points, thereby demonstrating "smart money" traits. Looking at different types of investors: insurance capital is the main long-term buying force for southbound funds, often increasing allocations when Hong Kong stocks decline significantly and reducing holdings after considerable increases, with dividends likely being the primary allocation focus. Active public offerings and ETFs are more prone to follow the market, accelerating inflows during rises and turning to outflows during falls. Active foreign capital serves as a lagging indicator of market and earnings, lagging by one to two quarters. Passive foreign capital has limited signaling significance due to its smaller scale and the fact that it may not specifically target China. Since mid-2020, passive foreign capital has continued to flow into Hong Kong stocks, accumulating around $120 billion, yet it did not change the prolonged three-year downward trend in Hong Kong stocks from 2021 to 2024. The reason is that changes in passive funds are primarily influenced by the global scale of passive investment, with capital not exclusively directed to Hong Kong stocks, often first flowing into emerging market index products and then naturally allocating to Hong Kong stocks according to index weights. Thus, passive foreign capital's indicative value for short-term market trends is relatively limited. How to utilize capital signals? Value is greater during fluctuations in the Chinese credit cycle and tightening overseas liquidity. Then, combined with the behavioral characteristics of different types of capital, how can we better utilize capital signals to judge market trends? Although the Hong Kong stock market is more sensitive to capital changes as an offshore market, capital is just one dimension influencing market trends, particularly as other factors can also affect capital direction. Therefore, the bank finds that when the fundamental trend is unclear and external liquidity is not favorable (which is the current situation), the impact of capital is greater; conversely, capital might not play a leading role. Specifically, Firstly, when the Chinese credit cycle is clearly expanding or contracting, the direction of the fundamentals becomes clear, and the reference value of capital change decreases. The speed of southbound inflow during stages of credit expansion and contraction shows a correlation coefficient approaching zero with the Hang Seng Indexs returns over the next three months. Similarly, the scale of active foreign capital inflow during these stages has a correlation coefficient also near zero with future returns on the Hang Seng Index. Historically, in the second half of 2020, when Chinas credit cycle continued to expand, southbound inflows slowed at different stages, but Hong Kong stocks continued to rise; in 2021, when the credit cycle shifted to contraction, even with overseas liquidity easing and a brief acceleration in southbound inflows, the Hang Seng Index still faced pressure; following the "924" credit impulse rebound in 2024, capital and market experienced prolonged inflows and gains, indicating that when the credit cycle direction is clear, the reference value of capital is limited. During phases of a fluctuating credit cycle, capital signals are more meaningful: accelerated southbound inflows suggest the market may be bottoming, while accelerated inflows of active foreign capital may indicate that Hong Kong stocks could underperform. Fluctuations in the general fiscal deficit impulse and private financing impulse direction signify a lack of clear fundamental direction, with indices experiencing volatility. The bank calculates: 1) The correlation coefficient of changes in southbound capital flow speed with previous returns on the Hang Seng Index is about -0.1, while its correlation with future returns is 0.2, indicating that southbound tends to accelerate inflows at low market points, suggesting potential recovery in subsequent markets; conversely, the opposite is true. 2) The scale of active foreign capital inflows shows a high correlation of 0.4-0.6 with the Hang Seng Indexs past 1-3 month returns, while its correlation with future returns turns to about -0.3, illustrating the clear lagging feature of active foreign capital, revealing that market performance was previously strong to prompt improved inflow speeds, but the trend may have already been in operation for a while, with subsequent returns weakening, and vice versa. For instance, in 4Q22, during a fluctuating credit cycle, southbound capital accelerated inflows before the Hong Kong stocks reached a temporary bottom, while active foreign capital continued to sell off based on prior weakness, leading to a rebound in Hong Kong stocks. Secondly, during periods of tightening overseas liquidity, capital signals have greater reference value. For example, during the Federal Reserve's interest rate hike phase, accelerated inflows of active foreign capital may weaken Hong Kong stocks, while accelerated southbound purchases may indicate market bottoms. Conversely, after a shift to looser liquidity, both phenomena become less pronounced. 1) Active foreign capital: during the Federal Reserve rate hike phase, the scale of active foreign capital inflows shows a correlation coefficient of -0.3 with future Hang Seng Index returns, indicating that accelerated inflows lead to weakened returns; during the rate cut phase, this correlation narrows to near zero. 2) Southbound capital: influenced by the peg system and high holdings by overseas investors, during the Federal Reserve's rate hike phase, the discount of Hong Kong stocks relative to A-shares is more prone to expansion, with southbound capital displaying clearer characteristics of accelerating buying at low points and selling at high points; the correlation coefficient of southbound capital flow speed with past 1-3 month returns on the Hang Seng Index is about -0.5, while relative returns over the next three months are about 0.3, suggesting that southbound capital tends to accelerate inflows after market weakness, making subsequent improvements in Hong Kong stocks more likely, and vice versa, with this relationship similarly weakening during rate cut phases. Implications for allocation: current capital signals are more important, slower southbound inflows and accelerated active foreign capital inflows indicate structural opportunities. Currently, the Chinese credit cycle is fluctuating weakly, and constraints on overseas liquidity are rising, making capital signals very worthy of attention. The Chinese credit cycle remains in a phase of overall fluctuations and structural differentiation, with a slight repair in the general fiscal deficit pulse expected in the third quarter. In July, the pulse of private financing showed a slight increase, with some narrowing in the differentiation of credit pulses for enterprises and residents, but the general fiscal deficit pulse weakened further. Looking ahead, the bank estimates that there may be an upward repair in the general fiscal deficit pulse in the third quarter, mainly due to a slower fiscal financing pace from January to July, which is down 1.1 trillion yuan year-on-year, leaving room for subsequent efforts. However, the overall incremental scale of fiscal resources for the year is limited, and investment directions still, which may bring about a phase of repair, but it is difficult to induce comprehensive expansion of the credit cycle. Overseas liquidity remains constrained, with interest rate hike expectations rising after the Jackson Hole meeting. Waller emphasized that the current economy and employment remain resilient, making financial conditions difficult to classify as tight; only confirming that inflation is clearly and quickly returning to the 2% target will mean no further action is needed, suggesting that the Federal Reserve is unlikely to clarify a shift towards easing in the short term. CME futures currently imply a 60.2% probability of a September rate increase by the Federal Reserve; therefore, in the short term, relying solely on improvements in overseas liquidity will likely have limited space for expanding valuations in Hong Kong stocks. In this environment, the importance of capital movements becomes even more prominent. In the past month, the slowdown in southbound capital inflows and the acceleration of active foreign capital inflows indicate that the likelihood of a major opportunity in the market in the short term is limited and may even weaken, aligning with recent market performance. Therefore, Hong Kong stocks are currently more suitable for focusing on swing markets and structural opportunities, and the bank maintains the baseline judgment for the Hang Seng Index at 26,000-27,000 points. This year's trajectory also roughly aligns with this judgment; for example, at the end of last year, the market was generally seeing the 30,000-point level or even higher, while the bank alerted that Hong Kong stocks were showing bottom characteristics in early July and indicated insufficient momentum in early August. In summary, the short term still revolves around "odds" thinking. For a sustained market to emerge in the medium to long term, we still need to see a rebound in the resident credit cycle or breakthroughs in key industries like NETDRAGON, which will require moments like "924" or "DeepSeek." In terms of operations, 1) if Hong Kong stocks rise close to that range, combined with an acceleration of active foreign capital inflows and a slowdown of southbound capital flows, profits can be appropriately taken; 2) if subsequent adjustments occur and southbound capital once again accelerates its inflows compared to previous trends, then allocation can be increased. In terms of direction, technology looks at industries, cycles look at the Federal Reserve, and consumption looks at policies. In the short term, if technological advancements are limited, dividends can be used to moderately hedge against portfolio volatility. The bank's proprietary AI stress index has significantly fallen from previous extreme levels, indicating that the most stressful phase is gradually passing, with fundamental stress in industries further easing; however, further upward movement still requires new catalysts to unlock the current demand "ceiling." Technology can still be the main focus for allocation, while beyond technology, adjustments can be made toward cyclicals based on position concentration, whereas consumption may need to wait for developments in fiscal policy in the fourth quarter. The bank's proprietary cross-market and cross-industry odds framework shows that for the week of September 4, the odds scores for insurance, transportation, materials, energy, and semiconductors are relatively high.