Volatility returns to China stocks: Time to worry again?

China market has found its footing: Huarong

A sudden late-day slump on Wednesday may have reminded investors that Chinese stocks remain a dangerous bet, but some analysts seem to think that the market is regaining its footing after a dramatic crash earlier this year.

Equity markets in China posted their biggest tumble in five weeks, with the benchmark Shanghai Composite and blue-chip CSI300 index slumping 3.5 and 2.9 percent respectively, in the previous trading session. The ChiNext - Shenzhen's Nasdaq-style start-up board - took a bigger bruising, losing 6.5 percent.

However, mainland shares, notably small-company names, managed a comeback on Thursday. The ChiNext board surged over 4 percent, outpacing the main Shanghai Composite and CSI300 which closed up 1.5 percent each.

"Beijing has heavily bought into financial stocks and the market slowly came back to almost touch the 3,500 level yesterday before we saw a huge pullback as stocks hit key short-term resistance. But if the [Shanghai Composite] holds around 3,200 then confidence will come back," Jackson Wong, associate director at Huarong International Securities, told CNBC Asia's "Squawk Box" on Thursday.

Wong believes that the Shanghai bourse could attempt a return to the key support level of 4,000 towards end-2015, on the back of supportive measures from the Chinese government. If the index manages to do so, "this stock crash will be over," he said.

The benchmark Shanghai Composite fell below 4,000 points in July during the thick of the multi-month market meltdown that not only sent domestic investors rushing for the exit, but sparked jitters in global markets.

"China's market will try to challenge 4,000 towards the end of the year after so many things that the government has been doing lately, such as [approving] infrastructure projects and moves by the central bank to add liquidity to the market. Economic data also show the economy improving so towards the end of the year, markets should do well," Wong added.

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Analysts at Citi Private Bank share Wong's optimism.

"We just need to see the economy stabilize. We've not seen real data do that just yet, but there's been a bounce back in credit growth, money supply growth, aggregate credit generation and construction activity so these are good early signs that growth will stabilize in the fourth quarter," Citi's Asia investment strategist Ken Peng said.

Meanwhile, Japan's biggest brokerage, Nomura, is expecting China's stock markets to enjoy better visibility in November and December, thanks to clarity over when the U.S. Federal Reserve will lift interest rates from near-zero and the state of the world's second-biggest economy.

"By [November/December], a delayed Fed rate hike could be more of a consensus and China is likely to have made another monetary policy easing move. After all, equity investors are more responsive to monetary easing than fiscal easing," analysts wrote in a report dated October 5. Nomura expects the People's Bank of China (PBOC) to lower the reserve requirement ratio (RRR) this month.

A board shows the stock movements inside the Shanghai Stock Exchange.
Johannes Eisele | AFP | Getty Images

Frail market sentiment is also another danger lurking in China's stock markets.

Mainland traders, nearly 80 percent being retail investors, often display a herd mentality and place little emphasis on fundamentals and valuations. Sudden swings in market sentiment could result in unexpected moves such as Wednesday, analysts told CNBC.

To be sure, there are analysts who remain skeptical of a sustainable turnaround in China's notoriously volatile markets.

IG's market strategist Bernard Aw, for one, thinks that the benchmark will have obstacles in reclaiming the 3,500 mark.

"Prior to the Black Monday on 24 August, 3,500 was deemed as the line in the sand for the Chinese government to support the domestic equities. As such, it is fair to say that many investors may have bought [Shanghai-listed] shares at that time, thinking that state buying will protect the downside. Clearly, they have gotten stuck when the index fell below the handle," Singapore-based Aw said.

This indicates "considerable selling pressure", with these "stuck long positions" likely to jump upon the chance to exit the market, should the Shanghai Composite breaches 3,500 points. "Until this formidable resistance is broken, we are unlikely to see further upsides in the Chinese markets," he added.