Today’s Headlines: Chinese Stock Markets Plunge

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Today’s Headlines:  Chinese Stock Markets Plunge
July 14, 2015

China's Bull Run Ends

China's primary stock markets, the Shanghai and Shenzen exchanges, have been on a remarkable 12-month bull run — or frankly, more of a stampede. To illustrate, at the beginning of June 2014, the Shanghai Composite Index was slightly above 2000, opening at 2039. One year later, the index had more than doubled, sitting at 4633 on its way to a peak of 5178 a few weeks later—a rise of almost 150% within a year.

The party was officially over on June 14th as the Chinese stock markets began a steep decline. Over a three-week period, the Shanghai value sank to close at 3,507 before rallying to close out the week near 3,878. The Shenzen market was even worse off, nearing a 40% loss. According to Bloomberg, $3.6 trillion in wealth was erased in Chinese listed stocks between June 14th and July 9th, eclipsing the GDP of developed countries such as France and the UK.

It's not often you can say that a market has lost nearly one-third of its current value but is still up 80% from a year ago. This begs the question: Is there further room to fall, or has a rebound indeed taken hold?

A Government Bear Trap

To answer that question, let’s first examine why stocks had risen so fast during a sinking economy, in defiance of market fundamentals. Part of the fault lies with the Chinese government’s unusual promotion of the stock market — promising steadily rising returns to unsophisticated investors. The Economist reported that some called the surge "Uncle Xi's bull market" after President Xi Jinping.

Millions of retail investors poured more money into the Chinese market and were rewarded in the short term with strong returns. Unfortunately, a large amount of this money was borrowed in an attempt to maximize invested capital. Margin buying has been estimated at $550 billion—nearing 15% of the collective value of the Shanghai and Shenzen exchanges.

Too many investors chose to sell their stocks as the market began to fall, and others were forced to sell in order to cover margin calls and other debts. The market quickly flipped from encouraged buyers to a massive surplus of sellers, producing a bear market. To paraphrase The Economist, "Uncle Xi's bull market" quickly transformed into "Uncle Xi's bear trap."

Fundamentals? What Fundamentals?

Another contributing factor is that Chinese markets are composed much more of psychology than fundamentals. Chinese stock markets are still relatively closed and the government stays directly active in the workings of the stock market (unlike most developed markets). Imagine the hair trigger of the US markets with less transparency.

Plenty of traditional warning signs of a classic stock market bubble were present, but with such a mix of free and controlled market forces, it's easy for people to assume the warning signs do not apply in China — if investors even are aware of those signs and how to interpret them.

A telling graph from Financial Review shows the rapid increase of the 12-month forward P/E ratio for the Shanghai Composite. The index shot from near 7 a year ago to a high mark of over 18. P/E estimates from other sources listed peak P/E values in the 20s and 30s, and the P/E ratio of the Shenzen market topped out at nearly 80. For reference, in that same period, the forward P/E for the S&P 500 mostly hovered in a range between 14 and 16.

Such a rapid change in P/E ratio typically spells trouble as cheap stocks become very expensive very quickly without underlying earnings growth. It was a classic bubble that was destined to burst, as it finally did in June.

Stopping the Bleeding

Traditional measures such as an interest rate cut in late June failed to have an effect on the markets, and since then, the government has thrown the kitchen sink at the market to reverse its slide:

  • Regulations were eased, allowing insurance companies to buy more stocks.
  • Companies were ordered not to reduce holdings of their own stock but to buy instead (waiving insider trading restrictions), and the government established a 120 billion renminbi fund (approximately $19.4 billion) for brokerage firms to use to buy stocks and prop up prices.
  • New IPOs were suspended, short selling was capped, and trading fees were cut. Patrick Ho, market analyst for UBS in Hong Kong, referred to the government's action as a "trial and error" approach.

Meanwhile, over 1,400 companies halted trading in their stocks at some point during the fall. This led to large discrepancies in some stocks trading on multiple exchanges, furthering mistrust in the Chinese stock market from a global investing perspective.

As of this writing, it's too early to tell if the rebound is sustainable, but the government clearly intends to do everything in its power to stop the continued fall — and it still has plenty of power.

The Takeaway

The Chinese government has plenty of room left to prop up the stock market, and will almost certainly do what it must to restore confidence to the average Chinese investor. While the slide may not have hit bottom yet, it should flatten out with governmental actions — including outright purchases as a possible last resort. However, as of this writing, many stocks have still not resumed trading, and there will likely be some residual sell-off once those stocks return.

If you are investing directly in the Chinese market through ETFs or other vehicles, you should have already had them correctly assessed as a higher-risk, higher-return component and dealt with them accordingly — and if you didn't, you probably will from now on.

The real question is whether the stock drop has shaken China's population and investor base enough that it takes a larger toll on the overall economy. If there are signs that China's slumping economy takes a further nosedive, the effect will be greater on companies who do more business with China or have factories or raw materials there. (For example, China has been a solid growth market recently for automakers.) Review the underlying companies in your holdings for exposure to China and adjust for any excessive risk.

Enjoy the sideshow of the Chinese Stock Market, but focus on the feature presentation of the Chinese economy and its growth rate.

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