The annual return of the Shanghai Composite Index has turned negative again, with the market showing a broad-based decline today. Affected by factors such as volatility in external markets, the A-share market has experienced significant overall declines recently. The Shanghai Composite Index fell 2.1% today, causing its year-to-date return to turn negative again and marking the first time it has fallen below the annual moving average (250-day MA) since April 7th. The CSI 300 has retreated approximately 7% from its June high, while the ChiNext and STAR 50 indices have retreated around 15% and 10% from their peaks, respectively, indicating a widespread sell-off. Small and mid-cap stocks have seen even larger pullbacks, with the All Share Equal-Weighted Index and the CSI 2000 Index retreating 17% and 18%, respectively, since May 14th. At the sector level, the AI industrial chain performed strongly earlier, and a style rebalancing has occurred since July, yet a broad decline persists. Sectors like coal, banking, and agriculture have shown relative resilience, while building materials, electronics, and communications have seen significant declines.

The recent market correction has been substantial and widespread. The magnitude of the Shanghai Composite's pullback since mid-May is approaching the adjustment triggered by the US-Iran tensions in March, raising concerns among many investors about the medium-term outlook for A-shares. In contrast, we believe the current short-term market correction may already reflect excessively pessimistic expectations, and a rebound could arrive at any time in the coming 1-2 weeks. A quick analysis follows.

Recent Market Drivers

The recent market correction has been primarily triggered by external factors, with internal microstructure issues also playing a role. Specifically: 1) A predominance of negative narratives around AI overseas. Recent frequent negative narratives concerning the AI industrial chain have changed the previously optimistic market expectations for AI computing demand, intensifying concerns that high upstream prosperity might negatively impact downstream demand. Affected by this, the global upstream AI supply chain has seen significant corrections since late June, and the ChiNext Index, which has a relatively high exposure to overseas AI supply chains, has declined notably recently. The domestic semiconductor sector saw gains exceeding 30% in June but has recently undergone profit-taking adjustments influenced by the changing AI narrative. 2) Risk sentiment contagion from overseas market volatility. The South Korean stock market has recently become a global focus. Earlier significant gains in leading memory stocks were partly related to investors taking on substantial leverage. Since the beginning of the year, the Korea Exchange and other overseas markets have issued a large number of leveraged ETFs. According to our estimates, the global leveraged ETF scale related to the South Korean market once exceeded $50 billion, with their aggregate daily trading volume accounting for a relatively high proportion of South Korean stock market turnover. Recently, with the shift in the memory narrative, market declines in South Korea and leveraged trading stop-losses have formed a negative feedback loop. The KOSPI index has fallen 27.5% from its peak, with risk sentiment spreading to sectors like US and A-share technology hardware. 3) Recurring overseas geopolitical risks are also suppressing risk appetite. US-Iran tensions have recently escalated again, with the intensifying conflict leading to a rapid rebound in international oil prices and recurring expectations for overseas liquidity tightening, which are also constraining the performance of global risk assets. 4) Microstructure issues within the A-share market still need improvement. Earlier, A-shares saw overheated trading sentiment again in late June, with daily turnover of 3.8 trillion yuan corresponding to a turnover rate exceeding 6%. Structurally, the technology sector faces issues of excessive trading concentration. Last Thursday and Friday, the TMT sector's share of A-share trading volume rapidly rose to a historical high of 52%, and the semiconductor industry's trading volume share reached 20%, while non-AI sectors faced significant pressure from capital outflows and obvious corrections.

Market Outlook and Positioning

The current market level may already reflect overly pessimistic expectations, presenting a relatively good timing for positioning within the year. In the short term, awaiting improvements in external narratives and liquidity, a rebound could arrive at any time. The recent rapid market decline has been mainly influenced by overseas narratives and risk sentiment, implying concerns about the prospects of the AI technological revolution. From a valuation perspective, the equity risk premium of the CSI 300 has returned above its historical average, and the dividend yield has risen to 2.7%, also implying a relatively pessimistic outlook for the market. Regarding the AI revolution, Dr. Miao Yanliang of CICC proposed three criteria for judging an AI bubble in his report: whether it enhances productivity, leverage conditions, and secondary market valuations. Currently, the overall situation still appears relatively healthy and benign. Moreover, indicators like ARR for Anthropic and Open AI continue to grow, and the logic of AI forming a profitable business model closed-loop remains intact. With the release of overseas cloud provider earnings this month, related concerns may be further alleviated. There are also signs of accelerated clearing of leveraged ETFs in the South Korean stock market. A potential peak and subsequent decline in US inflation this month could also help alleviate liquidity concerns. In the short term, we believe negative factors have been largely priced in, and the room for market adjustment may be relatively sufficient. Currently, gradual positioning in directions with strong interim report performance is advisable, waiting for positive catalysts. As microstructure crowding issues are gradually digested, we are optimistic that the market may form another relative low point for the year within the next 1-2 weeks and gradually stabilize and recover. From a medium-term perspective, we firmly believe the A-share market will continue its volatile upward trend. The CICC Strategy Team pointed out in last year's report that the resonance between the restructuring of the international order and China's industrial innovation trend is the core driver for this market rally and the revaluation of Chinese assets. We believe these two conditions remain unchanged and will continue to support the performance of Chinese assets. The CICC Strategy Team also noted in its early-year report that with the shift in macro paradigms and the advancement of capital market system reforms, the underlying environment of A-shares has undergone qualitative change from quantitative accumulation. The restructuring of the international monetary order brings a "new order," with global capital reallocation injecting external momentum into A-shares. Economic transformation and the rise of new quality productive forces form a "new driving force," significantly enhancing profit stability and sustainability. Investment and financing reforms, market-stabilizing mechanisms, and the entry of medium- to long-term funds build a "new ecosystem," continuously improving market resilience and attractiveness, making conditions more favorable than ever for forming a "floor but no ceiling" slow bull market. The steady-advance market trend since 9/24 is expected to continue. A long-term, steady-advance market relies more on fundamental improvement to drive index progress rather than mere valuation expansion, which is also conducive to continuously attracting incremental funds, especially medium- to long-term funds, forming a virtuous cycle and contributing to the medium- to long-term healthy development of the A-share market.

Investment Strategy

In terms of allocation, pursuing innovation continues, but performance differentials may converge. In our November report, we suggested that while growth would still have an advantage in 2026, its relative performance compared to other sectors might converge. After three years of de-capacity cycles, coupled with policies like "anti-involution," an increasing number of pro-cyclical industries are expected to benefit from supply-demand rebalancing. In a volatile market environment, high-dividend, low-volatility stocks may show relative resilience. For the medium term, we suggest focusing on two main themes: 1) High-Growth Sectors: In an unfavorable external macro environment, industries with sufficiently high growth can achieve high numerator growth to offset drag from the denominator. As AI gradually realizes business model closed-loops and delivers earnings growth, AI infrastructure-related segments, such as optical communication and PCB, along with upstream related materials, are likely to maintain a state of high prosperity this year. Following last year's intensive BD transactions in innovative drugs, many companies are entering the clinical data validation stage this year, warranting bottom-up attention. While liquidity and valuation may cause short-term market disturbances, they are not decisive factors and do not directly impact the medium-term trend. The future focus for growth style remains tracking growth momentum. 2) Cyclical Recovery: Fundamentals in an increasing number of areas are recovering from cyclical bottoms. We recommend comprehensively considering geopolitical situations and capacity cycle positions to focus on sectors with improving supply-demand dynamics, such as power grid equipment, petrochemicals and chemicals, and construction machinery. Simultaneously, industries like oil shipping and minor metals may relatively benefit under geopolitical uncertainty. The pace of fundamental recovery in purely domestic demand-oriented industries remains relatively slow and requires further observation.

Risk Factors

Recurring geopolitical risks leading to tighter Federal Reserve monetary policy; slower-than-expected progress in global AI industry trends; greater-than-expected domestic economic downward pressure.