Are China Stocks Overbought? Charts Show Correction's Near

Shanghai stock exchange
Xu Changzheng | ChinaFotoPress | Getty Images
Shanghai stock exchange

After a stellar run-up in December, Chinese equities have entered deeper into "overbought" territory from a technical perspective, prompting strategists to turn cautious on the market in the near-term.

The Relative Strength Indicator - used to determine whether a market is overbought or oversold – for the Shanghai Composite is near 81, climbing from 80 during the third week of December, according to data from A reading above 70 indicates shares are overbought and a reading below 30 means they are oversold.

A-shares, or those listed in Shanghai, rallied 15 percent last month, and another 0.5 percent since the start of 2013 driven by growing confidence about China's economic recovery.

According to independent technical analyst Daryl Guppy, there is an increased probability the Shanghai market will retreat to its support level near 2,250 in the coming days, which is fall of 1.2 percent lower from current levels.

He, however, added that the pullback would be a "consolidation within the rising trend" rather than a correction or change of direction.

"The China market has developed a pattern of developing rallies very quickly followed by a consolidation pattern for a few days," Guppy told CNBC on Wednesday.

Shanghai Composite 3-Month Chart

Equity strategists also foresee a retreat in the market in the near-term, however, they too believe the downside will be limited.

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

"We think the rally will take a breather, but it will be a mild pull-back – as sentiment is still quite positive," said, Steven Sun, head of China equity strategy at HSBC, pointing to the robust inflows into the market in recent weeks.

In December, foreign mutual funds poured nearly $5 billion into MSCI China - an equity index made up largely of Chinese companies listed in Hong Kong - and the number of active A-share trading accounts rose to 10.5 million from a historical low of 5-6 million,according to data from HSBC.

While foreigner investors can't access the A-share market directly, they can participate in the market via the Qualified Foreign Institutional Investor (QFII) program, or through China Exchange-Traded Funds.

Dickie Wong, executive director, Kingston Securities, who estimates that the market could decline up to 5 percent over the next 1-2 weeks, said the correction is due to the lack of positive news in the last week – following the highly anticipated fiscal cliff deal and resilient purchasing managers index data at the end of December - and investor caution as stocks, including Chinese property plays, trade at their historical highs.

(Read More: China Fourth-Quarter GDP Growth Seen Rebounding to 7.8% )

However, he said that an improvement in Chinese economic data and domestic investor sentiment will help the upside in mainland stocks continue. Wong forecasts the Shanghai Composite will hit 2,600 by the year-end - or 14 percent higher from current levels.

Another catalyst for the market in the near-term will be monetary policy loosening, according to Wong.

Economists expect the People's Bank of China, or the country's central bank, to lower the reserve requirement ratio(RRR) for banks before the second quarter, helping to boost liquidity in the banking system. Liquidity is a key driver of the China market, say analysts.

Potential Risks

Sun of HSBC said while he is positive on the outlook for the market this year, there are some risks to watch out for including a disappointing earnings season and the possibility that China's Communist Party could launch an anti-corruption campaign in mid-January.

Chinese companies are due to report their full-year earnings in March, which he expects will show flat growth from 2011.

In addition, he said that the launch of an anti-corruption campaign would lead to a negative knee-jerk reaction for stocks in sectors including gaming, luxury brands and jewelry retailers. China's incoming leaders are expected to make the crackdown on corruption top priority.

"Sentiment wise, these sectors may get hurt. These stocks have rebounded quite sharply, so it (anti-corruption campaign) may also be used as an excuse to take profit," Sun said.

(Read More: China's Corruption Crackdown Takes Shine Off Luxury Boom)