Story Wealth Management | Understanding the Chinese Stock Market
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Understanding the Chinese Stock Market

Understanding the Chinese Stock Market

The media has been awash with the news that the Chinese stock market, on Monday, had its largest one day fall since 2007. At 8.5% the fall is indeed substantial. Furthermore the most recent volatility comes in the face of unprecedented Chinese Government support following the falls experienced in June.

You may recall a number of measures were undertaken by the Chinese authorities to stem the steep declines. These included the indirect buying of company shares by Government controlled entities and more direct purchases by the China Securities Finance Corporation – a hitherto opaque state owned company. Rumours the latter had ceased providing support contributed to the falls on Monday. Other support measures included suspending large numbers of companies from trading and forbidding certain institutions from selling shares for 6 months.

It should not be a surprise that the first hint of withdrawal saw renewed selling pressure. The Chinese authorities have unwittingly succeeded in creating an ‘overhang’ of selling pressure. By now everybody knows there is a holder of securities (effectively the Chinese Government) who has not bought with the typical investment criteria in mind. That is to say, at some point in the future, and we do not know when, there will be a significant seller in the market. We have often observed the same phenomenon in markets with daily limits imposed. Certain futures markets have maximums at which trading ceases i.e. a 10% fall from the opening price. These arrangements often see selling pressure build and successions of ‘limit down’ days until prices reflect equilibrium of buyers and sellers. Furthermore, selling is often higher than would have otherwise been the case as the price of liquidity becomes a larger factor.

The following is an illustration of the Shanghai Stock Exchange Composite Index performance over the past year:
The dramatic fall in prices, is more than matched by the dramatic increase in prices over the past year. Even with the recent falls the market remains some 80% higher than it was one year ago. The dramatic rise over the past year has been generated by a mix of factors. Prior to this ‘bull market’ the market had spent over 5 years ranging between 2,000 and 3,000. There was an argument to suggest the Chinese market was lagging global markets and could be expected to rise as constituent companies matured and profits began to rise. However, the Chinese market is not like other markets and the drivers are as much political as economic.

The rise in the market has been aided and abetted by Chinese authorities as they have sought to encourage public participation in share investing. As property prices cooled this encouragement was taken as a “sure thing” by local Chinese. What has not been considered by Chinese authorities is the relative unsophistication of the new breed of Chinese ‘investors’. I use the term investors very loosely as what the policies have created is a swathe of neophyte share traders. Even the term ‘trader’ is flattering.

Earlier this year we started to read stories of Chinese citizens pulling up stumps in their local village to go to Hong Kong* to trade the market. By early April it was reported that new brokerage accounts were being opened at the rate of 1.7 million per week. A substantial part of this renewed trading stock has been funded by margin loans. On June 8th Bloomberg reported that the Chinese were deferring purchases of motor vehicles to buy stocks instead**.

An article in the Economist magazine^ May 30th encapsulates both the statistical and anecdotal evidence that has made this one of the most widely predicted market busts of recent times. Those who have lived through market manias and panics over the years recognise the conditions making the rally unsustainable. It is with some bemusement we have watched the Chinese repeat mistakes that have very recent examples from which to draw i.e. the Tech Bubble, U.S. property etc.

Given the experience of investors outside of China, it is not surprising that the hurt from the downturn is very much concentrated on local Chinese punters (sorry, investors). This does not mean there cannot be wider implications – millions of Chinese people have lost money and it will affect how they perceive both their wealth and the ability of the Government to again bail them out. As indicated above, the overhang created by Government intervention may mean this downturn has some way to run. You may recall during the GFC, when liquidity dried up in particular assets, investors resorted to selling good assets as it was the only liquidity they could access. Rational investment decisions tend to be subordinated to the financial survival instinct in times like these. Nevertheless I do not believe it is likely that global markets will be permanently affected by the ructions of the Chinese markets over the longer term. In the short term the defensive instincts of investors may result in marginal impacts on global equity markets.

For us it is an opportunity to reaffirm a few key lessons:

• Investing and speculating are different beasts. Investing is hard and requires discipline. There are no short cuts to wealth outside of luck or fraud. Incidentally, I do not believe in luck. It is a term people use to explain something they otherwise cannot.
• Efficient markets rely on rational participants – broadly, this precludes average human beings.
• In the words of Herbert Stein, ‘if something cannot go on forever, it will stop’.
• Diversification is always and everywhere a first principle of investing.
• Valuations matter – this applies to all investment assets. The more you pay for an asset, the lower the future returns.
• Good advice matters. Millions of Chinese investors had few options and even less experience.
• Education matters (tell your kids). According to Bloomberg ‘more than 2/3 of new equity investors did not finish high school’.^^

*Source: Bloomberg
** Source: Bloomberg
^ Source: The Economist
^^ Source: Bloomberg

We hope this information is valuable in helping you to understand what is going on in the world. We invite you to contact us if you require further clarification in this regard or have any other financial planning concerns.

David Graham, MApp Fin CFP® SSA™