The recent rally in Chinese stocks has many investors hoping it is the start of a bull market in the region's worst performing market, but the structure of fund flows suggests it is bargain hunting rather than a lasting vote of confidence. Money has flowed into mid-cap non-ferrous and defence stocks, which were previously among the most discounted, yet little has gone into banking and financial stocks, which are the ones that will bear the brunt of any economic slowdown if it comes.
"A lack of interest in banking and other economic-sensitive stocks is a clear sign that investor confidence in economic growth has yet to be restored," said Chen Huiqin, senior analyst at Huatai Securities in Nanjing.
"In such a mixed market environment, the proper strategy is defensive, not to be a stubborn long nor a stubborn short," she said.
While Beijing can only welcome investors shopping for value in mid-size stocks, as opposed to just speculating in them, for investors the implication is that this will not turn into a full-blown bull market and that if the rally continues, it will do so slowly.
The benchmark Shanghai Composite Index has gained 19 percent since its recent low in March and hit a near 18-month intraday high on Thursday. That is a sharp contrast to the bourse's 6.75-percent loss in 2013 when it was the region's worst performing stock market.
Daily turnover reached 197 billion yuan ($32 billion) on Thursday, its highest level since March 2011. The 30-day moving average of the index's trading volume hit its highest level since November 2010 last week and is lingering near that level.
Average daily cash flows in the Shanghai market have reached 130 billion yuan ($21 billion) now, more than doubling the 60 billion yuan of mid-June, traders estimate.
These movements have sparked a slew of bullish forecasts.
For instance, a research report by Guotai Junan Securities, one of China's top brokerages, stated last week that the index could rise as high as 5,000 points, nearly double about 2,317 on Friday. It cited China's economic and market reforms as the catalyst for its bullish forecast.
But traders said that investors were going into undervalued defensive stocks rather than stocks that typically perform badly when economic growth slows.
Notably investors are buying defensive mid-caps such as non-ferrous metals and defence stocks due to rising tensions in Sino-Japanese relations and in the East China Sea and not banks, financial and property companies.
By its recent peak hit on Thursday, Shanghai's commodity stock sub-index had jumped 25 percent since mid-June, while the index covering military stocks both in Shanghai and Shenzhen had surged 45 percent, far exceeding the main Shanghai Composite Index's 16-percent rise.
In comparison, Shanghai's financial sub-index has risen just 9 percent and the property sub-index 14 percent from mid-June to Thursday.
That means that despite the headline rally, Beijing has still not succeeded in its efforts to get the retail investors who dominate China's stock markets to buy blue chip stocks.
"Economic and market fundamentals don't support stocks to stage a full-fledged bull turn, which will wait at least until well into next year when the economy shows a clear bottom in its growth," said Zheng Weigang, a senior trader at Shanghai Securities.
It also means there is still limited positioning ahead of the launch of the Hong Kong-Shanghai stock connection scheme that will allow foreign investors to buy selected blue chip A-shares traded in Shanghai.