Chinese Stocks Continue Their Slide
Despite the efforts of the Chinese government to halt the slide of the Shanghai and Shenzen stock markets, the severe bear market that began on June 12th continues. Last Monday the Shanghai composite index fell 8.5%, representing the largest single-day drop since the 2007 slide. The Shenzen composite fared little better, with a 7% drop.
By the end of the week, which is also the end of the month's trading, both exchanges had registered the biggest one-month fall in six years. The damage appears to be bleeding into other exchanges, with the Hang Seng Index in Hong Kong finishing down by over 6% in July — its biggest monthly decline since September 2014.
Government officials remain committed to stopping the slide, but their efforts to date have produced mixed results. Thus, after Monday's drop, China's securities regulator stepped up buying further, and announced that they had no intention of exiting the markets anytime soon.
Government intervention has been helpful, according to most experts, but hasn't yet stabilized the Chinese market. This begs the question: Is the end of the sharp bear market near? An even better question might be: Why is anyone surprised the Chinese market is behaving this way?
Same As It Ever Was
Let’s hazard some answers…The Chinese stock market plunge shouldn’t surprise anyone who has followed it in recent years. Volatility has been a hallmark of the Shanghai Composite ever since it re-opened 25 years ago — soaring 1200% initially, then suffering two 50% losses within the first two years.
Since then, the market has risen by over 100% eight times, including the recent bull run of 164% from December 2012 until June. It's also fallen by two-thirds of its value twice, once in 1993-1994 and again in 2007-2008. The main reason, according to the Wall Street Journal, is that "They vacillate between government-driven rallies and equally dramatic selloffs." The Chinese government can control many elements of the economy, but what they can't control is investor confidence.
While the Chinese financial system is still isolated to a great degree, the effects on the global economy are increasing. In November 2014, the Chinese government embarked on the Shanghai-Hong Kong Stock Connect Program, creating a conduit to open up "A-shares," or shares only available within the Chinese market, to outside capital.
Even without direct access to the Chinese market, the indirect access of Chinese-based stocks with US market listings has taken a real toll within the US. As of Wednesday, June 29th, the drop in these stocks since June 12th wiped out over $56 billion in market value from the accounts of US investors. That's the equivalent of taking out the market value of General Motors with a couple of small caps thrown in for good measure. Alibaba alone has lost $11.7 billion to drop to a market value of $204.5 billion.
Parallels to the NASDAQ?
Several leading publications, including the Financial Times and USA Today, have noted an unusually strong correlation between the current Chinese bear market and the NASDAQ tech bubble from 2000. The observation has been made at different times through the cycle, and has so far held up in a remarkably constant way. If the correlation holds, the market is in for a short run of relative stability (the Shanghai Composite sits at 3,623 as of this writing on 8/03/15) followed by another precipitous drop to around 2000 — the index’s value at the beginning of its most recent bull run, in late 2014.
Why should this correlation hold? There's really no reason aside from the broad-brush commonality of an irrational overvaluation followed by an inevitable correction. Certainly the Chinese response of direct intervention doesn’t match the US government's more hands-off approach (in relative terms).
In both cases, the eventual bottom occurs when investors feel confident the market has bottomed out and will begin its eventual recovery. In the US, that is driven more by a return to fundamentals. Companies that survive the downturn will find a reasonable price equilibrium relative to their earnings potential, and the emotional aspect of trading settles down.
In China, because of the enormous influence of the government, investors have to worry about Beijing's actions as much as they weigh collective market confidence. Traders have two potential concerns: will the government continue to take strong actions to stop the slide, and is it possible that government actions alone simply can’t stop the slide but merely postpones it for the average investor?
Even in a market with heavy government influence, prices must eventually return to a reasonable value with respect to earnings. By attempting to manipulate the market and provide stable growth, the Chinese government ironically increases its volatility, usually to the detriment of the average investor.
It's important for investors in the Chinese market to understand this dynamic. The temptation of growth during the bull run is great, but the historical patterns are clear. There are no sources of feedback to bleed off excessive optimism for the less sophisticated investor in China, thus the buildups and teardowns are often greater than in the US. (Perhaps all of the screaming financial voices on TV do provide a valuable service after all.)
Do you really know how much exposure you have to Chinese markets? The average investor probably doesn’t. If you hold emerging market exchange-traded funds or certain mutual funds it's possible that your exposure to the Chinese market was increased during the bull run. Thus, knowing what specific equities your fund managers are buying can help you decide when it might be prudent to scale back those holdings.
Few funds have perfect timing, but you want to look for signs that your funds treat Chinese stocks like the more risky growth vehicles that they are. Chinese stocks will be back eventually, and you want to make sure you are aligned with funds that understand the volatile nature of these stocks and manage the risk/reward accordingly.
If you choose to do your own Chinese stock picking instead of letting a fund do it for you, make sure you can correctly assess the valuation (not easy to do with Chinese stocks) and that you keep up with proposed changes in Chinese governmental policy. Keep a graph of the historical performance of the Shanghai composite around as a reminder.
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