True to form, Chinese stocks are once again confounding the bullish expectations of Wall Street.

Having tantalised investors with a mini-rally at the start of the year, the Shanghai Composite has tumbled since May and is now just 1.4 per cent higher than it started the year.

This is not how things were supposed to go – at least according to sell-side equity analysts. The narrative had been that the new head of China’s securities regulator would provide a much-needed boost to the market through his ambitious reform programme.

But while Guo Shuqing, who became chairman of the China Securities Regulatory Commission in October, has taken steps to open up the country’s capital markets to a broader range of investors, including foreigners, the Shanghai Composite has continued to decline.

The poor performance of Chinese equities is all the more remarkable because, by many valuation measures, they are cheap. The Shanghai Composite is valued at 12 times last year’s earnings, within a whisker of its record low and half its long term average.

Using forecast earnings for the current year, the index is also near all-time lows with a price to earnings ratio of 9.7.

So what’s going on? One problem is that Chinese corporate profits are falling. State-owned enterprises reported a 10 per cent decline in profits in the first five months, according to Andy Xie, an independent economist.

But perhaps the bigger problem is that retail investors appear to have lost almost all faith in domestic Chinese stocks, known as A shares. Ever since a huge stock bubble burst in 2007, Chinese investors have shunned equities and instead flocked to the perceived safety of property, gold and fixed income products.

“The investors themselves, the retail investors, nowadays feel that the A share market is not where they can really make money,” says Jiong Shao, analyst at Macquarie. “Participation is very low right now.”

In a sign of flagging demand, investors opened only about 100,000 stock trading accounts each week in May, compared with an average of 260,000 over the past three years.

Both inside and outside China, investors have recognised that the stock market is an ineffective way to access the economy’s growth. While China’s gross domestic product has quintupled since 2000, the Shanghai Composite rose just 50 per cent, barely keeping pace with inflation.

Rather than holding stocks as long-term investments, most investors use the market like a casino for short-term speculation. Chinese retail investors trade so frequently that average annual portfolio turnover is more than 700 per cent, says Jerry Lou, chief strategy officer at Morgan Stanley Huaxin Securities in Shanghai.

Portfolio turnover among Chinese mutual funds is also extremely high – more than 300 per cent compared with less than 100 per cent in developed markets. As these funds are judged on the basis of their weekly performance, they must chase short-term profits or face heavy redemptions.

Analysts say reviving confidence in the A-share market requires a range of reforms from improving corporate governance standards and reducing the role of the state, to giving greater access to long-term investors such as pension and insurance funds.

“The investor pool is too shallow,” says Mr Lou. He adds that deepening the pool will take time given the legal, regulatory, and institutional obstacles that must be overcome.

Under Mr Guo’s leadership, the CSRC has lifted the cap on foreign ownership of Chinese stocks and bonds from $30bn to $80bn and last month substantially expanded the range of foreign institutions that are eligible to apply for investment quotas.

But analysts note that even if the $80bn quota is fully subscribed, foreign investors will still account for only about 1 per cent of total free-float market capitalisation in China.

The languid performance of the Shanghai Composite suggests investors see little chance that Chinese pension and insurance funds – a vast pool of capital – will be allowed to pour money into stocks any time soon.

“Guo is a visionary guy, he’s inviting this money into the market but he’s not the one calling the shots,” says Mr Lou.

“For example, allowing more insurance money into the equity market needs the blessing of the CIRC [China Insurance Regulatory Commission]. To get the annuity money into the market he needs to work with the NSSF [National Social Security Fund].”

Others add that there are deeper problems in the Chinese equity market that need to be addressed, particularly to do with state interference in the operations of listed companies at the expense of minority shareholders.

“The reason why the market subscribes lower valuations to Chinese companies is that the companies are doing national service,” says Sean Darby, global equity strategist at Jefferies.

“The government has got to allow more flexible pricing and it’s got to have a lot less of a visible hand in the way that the economy is run, because otherwise investors are never going to go into this equity market at all,” he adds.