China stock market's sharp rebound from a dramatic sell off in August has limited upside from current levels as a huge supply of IPO shares is set to counter investor optimism over an economic recovery.

Over 130 billion yuan in new share supply hit the market during July and August, another 50 billion yuan is set to flow into the market this month and a huge volume of shares are released from lock-up in October.

Investors are also absorbing news that authorities will set up an additional market this month and are working on plans for a board to list foreign shares, all adding to the supply threat.

A slew of IPOs will be among a huge number of new shares hitting the market shortly, tilting the balance to an oversupply against demand, said Wu Xiong, research manager at Orient Securities in Shanghai.

The index has limited room to rise, possibly for months. Investors should be defensive to avoid being caught in powerful market corrections similar to that seen in August.

The benchmark Shanghai Composite Index .SSEC crumpled a fifth in August -- its second-worst monthly performance in 15 years -- prompting a government pledge to support the market.

Subsequently, the index has jumped 16 percent from a three-month low on Sept. 1. But analysts say the rally has limited potential and investors should be prepared for a correction given the pipeline of supply.

Indeed, the index fell 1.1 percent on Wednesday after Vanke, China's second-biggest listed property developer, said its shareholders had approved a new share offer to raise up to 11.2 billion yuan ($1.6 billion) for expansion.

It was trading just above 3,000 on Thursday alongside firmer markets globally, but some analysts believe the upside is limited to 3,200 and it could track back to 2,600 later in the year.

Rising share supply is happening just as Chinese companies, especially state-owned enterprises, are pulling out the funds they had temporarily parked in stocks so that they can use the money for its original purpose - spending tied to China's economic stimulus plan. [ID:nSHA140084]

Analysts said that despite its pledge of support, the government had taken few concrete steps to boost demand. Officials had been talking up the market, they said.

He Zhicheng, senior economist at Agricultural Bank of China in Beijing, proposed investors retain a third of their positions, or even clear most of them if the index rises above 3,100 points.

HUGE SUPPLIES

The China Securities Regulatory Commission (CSRC) has approved dozens of IPOs, rights and other new share issues which have been seeping into the market over the past several months.

Firms raised a combined 133 billion yuan in July and August and analysts see 50 billion yuan in the pipeline in September.

Metallurgical Corp of China raised 19 billion yuan in Shanghai this month in the country's second-largest IPO this year and China International Travel Service Corp plans a Shanghai IPO this week worth about 1.7 billion yuan. [ID:nSHA191577]

China Merchants Bank Co plans to raise 22 billion yuan in a rights issue.

The commission has hinted it may launch a Nasdaq-style second board on the Shenzhen Stock Exchange in October, a month earlier than expected, as it has started to review 13 applications for IPOs from start-ups.

More share supply will also surface on other fronts.

In October, a record monthly 335 billion state and institutional shares in listed firms, worth around 2 trillion yuan, will be converted into freely floating shares following a lock-up period.

While most of the shares are expected to be retained in the hands of their long-term investors, analysts say even a small volume of the shares hitting the market would weigh on prices.

The Shanghai Stock Exchange is considering setting up an international board that sources said could see its first listings of foreign firms in the first half of next year.

Several overseas companies have expressed interest to list -- from British lender HSBC to Hong Kong-listed firms with operations in China, including Bank of East Asia, China Mobile and Lenovo.

Zheng Weigang, head of investment at Shanghai Securities, said a worrying sign of the sharp rebound in shares this month was that China's economic data in August showed the country still grappling with deflation and a recovery was not yet solid.

A full recovery is likely earliest in the first quarter of next year, Zheng said. The market is set to see see-saw trading for the rest of this year, during which the index has the potential of testing its recent low hit in early September.

The index could test 2,600 points later in the year, compared with a three-month low of 2,639 on Sept. 1, Zheng and six other stock traders and fund managers polled by Reuters said this week.

They see the index peaking around 3,200 during the rest of 2009, far from the year's high of 3,478 on Aug. 4.

($1=6.83 Yuan)

(Editing by Neil Fullick)

China