Caution: China Stocks May See Double-Digit Correction
After a positive start to the year, Chinese equities have fast fallen out of favor with investors, down more than 6 percent in the past month on worries over a bubble building in the property market and on the overall growth outlook.
According to technical analyst Ray Barros of Ray Barros Trading Group, the worst is not over for the market, he expects a further correction of up to 15 percent for the benchmark Shanghai Composite in the next two months.
"We have had a strong move from the 1,950 level to a high of 2,443, and then it [Shanghai Composite] started a big down move. This is the start of a move all the way back down to the 1,900-1,950 level," he said.
Barros describes the recent rally in China stocks - which rose 25 percent in the three months from December to February on renewed confidence over the outlook for the world's second largest economy - as a merely "bear market rally" that is already in the process of unwinding.
The Shanghai Composite has been in a bear market - a period during which a market undergoes a series of "lower highs and lower lows" - since 2009, according to Barros.
If the market tests the 1,900-1,950 level, it could decline to the next resistance level at 1,600, Barros said, noting this could come as soon as September.
The speed of decline may depend on how the Cyprus bailout issue plays out, and whether it remains contained to the island nation, he added.
(Read More: Don't Count Cyprus Out of the Euro Just Yet: Traders)
Barros, however, said he doesn't expect the decline in Chinese stocks to be sharp, noting that it will be a "gentle move down."
Hard Landing Fears Return
Concerns over a hard landing in the mainland economy have resurfaced in recent weeks. A survey by Bank of America Merrill Lynch released on Tuesday showed that the number of investors who consider a hard landing in China the biggest tail risk, ticked up from 10 percent to 18 percent this month.
The Chinese economy grew at its slowest pace in 13 years at 7.8 percent in 2012.
(Read More: China Displaying Symptoms of Financial Crisis)
This week JPMorgan, the largest U.S. bank by assets, downgraded China to underweight, citing uncertainty over the policy environment in the country.
"Economic risk today is arguably higher than in mid-2012. Back then, the market could look forward to a stimulus," Adrian Mowat, chief Asian and emerging markets equity strategist at JPMorgan Securities, said, referring to the fixed asset investment of over $150 billion that was announced in the second half of 2012.
"Growth momentum is now slowing with policy response constrained; a nasty combination," he added.
With worries over inflation returning to the forefront, the People's Bank of China is constrained in its ability to provide further monetary stimulus, say analysts. The country's consumer price index (CPI) rose to a higher-than-expected 3.2 percent in February from a year earlier, compared with 2 percent in January.
(Read More: How Serious Is China's Inflation Comeback?)
Goldman Sachs' chief china equity strategist Helen Zhu also believes inflation and policy tightening concerns are the "biggest risk" for the market.
Last week, Zhu told CNBC while she sees no clear, positive catalyst for mainland equities in the near-term, the bank is sticking to their forecast of double-digit returns for the market in 2013.
She believes that as growth picks up in the economy, this will benefit corporate earnings and the broader equity market.
"We see more margin improvement coming through. We are forecasting 13 percent earnings growth, and a bit of valuation expansion, (this) would be enough to get us into our high teens returns for the rest of the year," she said.