Goldman on China Stocks: Why We'll Be Right This Time

Goldman Sachs may have been significantly off the mark on its call for a bumper rally in Chinese equities in 2012, but this year, the U.S. investment bank is confident that its upbeat outlook for the market will materialize.

According to the bank's Chief China Equity Strategist, Helen Zhu, a pickup in earnings growth and the expectation of economic reforms by China's new government will lift the MSCI China Index 8 percent in 2013 from current levels. The index climbed 4 percent in the first week of the year.

Goldman forecasts earnings growth of 9 percent in 2013, driven by an acceleration in gross domestic product (GDP) growth to 8.1 percent from an expected 7.7 percent last year.

"Faster reform progress is the key upside risk," Zhu wrote in a note. "We see better returns heading into the second quarter on a pickup in exports and a kickoff of reforms."

(Read More: 2013:The 'Break-Out' Year for China Stocks? )

China's outgoing President Hu Jintao has signaled that financial reforms will be top the top priority for the new leadership, which officially takes over in March and will govern the country for the next decade.

There has already been some evidence of reform efforts, with the country's foreign exchange regulator raising the limit for foreign sovereign wealth funds and central banks buying Chinese assets through the Qualified Institutional Investor Programme (QFII), in mid-December.

(Read More: Can China's New Leaders 'Revolutionize' With Financial Reforms? )

Zhu said that with expectations among domestic investors running low, the market is ripe for upside surprises this year. Local investors play a critical role in determining the direction of the market as they account for around 80 percent of the turnover at China's two stock exchanges in Shanghai and Shenzhen.

"The cyclical recovery skepticism is gradually going away – it has been accepted by offshore investors for a couple of months – for onshore investors it's still starting to prove as more of an upside surprise, and that's part of the reason for the increased optimism in December," she told CNBC on Monday, referring to the 15 percent rise in the benchmark Shanghai Composite last month.

Off the Mark

At the start of 2012, Zhu had predicted Chinese stocks would have a bumper year, forecasting 30 percent upside for the China Securities Index (CSI) 300 – which tracks 300 stocks traded on the Shanghai and Shenzhen stock exchanges. The index, however, rose just 10 percent last year.

Zhu was not alone in her optimism over the outlook for Chinese shares last year, with many strategists predicting a major breakout for the market.

(Read More: China Equity Bulls Still Wait For Their Moment in the Sun)

From a global perspective, Chinese stocks were among the biggest laggards in 2012, as concerns over China's economic slowdown prompted investors to flee the stock market.

The Shanghai Composite ended last year just 3.2 percent higher. That compares with double-digit gains across most major Asian bourses and a rise of about 13 percent in the S&P 500 stock index.

Zhu said her failed prediction was a result of overly optimistic expectations for corporate earnings growth, which failed to materialize. At the start of 2012, the market consensus was for earnings growth in the low teens for Chinese firms, which in reality is likely to be flat, she said.

"Earnings deceleration was far more than the Street had anticipated… that stemmed from the fact that GDP decelerated from 9.3 percent the year before to probably just north of 7.5 percent last year," she said.

Now that investors have already considered "every possible negative piece of news", there is less room for downside going forward, she added.

"We see the fact that investor sentiment was so poor at the end of November as exactly the reason we would tell investors to get in, because there is no room for further downside surprises and indeed I think we've already started to see the beginning of that," she said.