The Chinese market drop – what does it mean?

What with China, Greece, the Fed and the plug getting pulled at the NY Stock Exchange, the last couple weeks have been great for headline writers. All that uncertainty and confusion created from and by those headlines has been transmitted into some interesting trading days and made some folks uneasy.

With all the daily volatility, you might be surprised to learn the net changes to the three leading US stock market indices – Dow Jones Industrials, the S&P500 Index and the NASDAQ 100 – in those two weeks had the Dow and S&P each being lower by only about 1% and the NASDAQ off about 1.6%. Gold was down by about 1% in that time as well.

The only conclusion I can draw from that data snapshot is, as has been the case all year, we continue to have some sort of dynamic balance going on. There’s a lot of ongoing internal rotation going on, with positions that have worked in the old market environment being swapped out for those thought to benefit from what the market perceives is coming.

Speaking of what’s coming, the upcoming flood of earnings reports may help provide us with the catalyst for the next market moves.

How did the Chinese market get to this point?

Late last year, no one was saying “the Chinese wealth effect (from their stock market growth) is going to be a huge boost to the global economy”. But, as soon as the bubble burst, it’s a major global financial “crisis” and the only thing that seems to matter to anyone.

As you’re probably aware, China’s economy significantly ramped up its growth in recent years which has made it a place to be for global investors. Mutual fund families and ETFs have added portfolios for their clients so they can invest in the Chinese markets. China’s two major stock exchanges have seen their share indexes rise tremendously over the last year. Consider this:

After Chinese shares hit a seven-year high in June, new investors opened millions of accounts to be part of the rally. China now has 90 million investors…in a population of 1.4 billion. These investors include many middle class Chinese who had never been in any stocks before. Many of them then borrowed money to invest, using their shares a collateral; a process known as buying on margin. Some investors reportedly paid as much as 22% for that privilege. A quote I found is a classic. When a first-time investor was asked why she was getting into the market, she replied, “My hairdresser said it was still a bull market and I needed to get in.” Well, hello, bubble…

So, how did the Chinese stock market get so bubbled up in the first place?

China’s government wants to diversify away from Chinese banks as the primary source for Chinese companies to fund their expansion plans. Encouraging investment in the stock market seemed like a good way to do it. So, the state-run media started publishing articles regularly pointing out stocks’ benefits, talking them up left and right and encouraging the locals to pile in. They did and stocks took off. A textbook example of headline-driven investing.

Then, the Chinese government tried to pop the bubble. Now, they’re again doing everything they can to support the bubble, and it seems to be holding.

Last Wednesday, Bloomberg reported: “China’s securities regulator banned major shareholders, corporate executives and directors from selling stakes in listed companies for six months, its latest effort to stop the nation’s $3.5 trillion stock-market rout. Investors with stakes exceeding 5 percent must maintain their positions, the China Securities Regulatory Commission said in a statement. The rule is intended to guard capital-market stability amid an ‘unreasonable plunge’ in share prices, the CSRC said.” They went on to say they would “punch back” against illegal market activities by investigating “malicious short selling.” Dozens more companies have also requested their shares be halted from trading, adding to the list of more than 1,400 that have suspended their stock.

In June, when the Chinese peaked and wide scale selling began, the inexperienced investors panicked and started dumping their shares. Lower prices create margin calls. To cover your margin, you need to put up more money or sell. More selling leads to still lower prices, which creates still more margin calls helping to create the recent headlines about the drop. However…

Recent results need to be considered in context

The headlines proclaimed that the Chinese market dropped by almost a third in less than a month. Yes, it did and that’s definitely a bear market. Or was it?

There’s more – details that were somehow omitted from most stories.

Instead of starting the story only from when the market peaked, how about we go “all the way back” to late November last year. Had you started investing about Thanksgiving time last year, your return on the Shanghai-Shenzhen 300 index was a positive 107%. Even after factoring in the recent big drop, you’d still be up about 70% so far – IF you didn’t sell. Bigger picture, the market value of Chinese stocks today is almost $3 trillion more than it was a year ago. So now, it sure looks like a real bull market.

Before anyone gets too excited about the potentially negative global impact of the bursting of that bubble, please understand that, from strictly an asset price standpoint, the Chinese stock markets are pretty much a local affair. The effect on global stock prices and sentiment should be minimal.

What happens in Chinese markets mostly stays in China

Whether deciding to invest or evaluating the stories from the, you should be aware of their structure. Mainland Chinese markets have two major stock classifications: A-shares (Chinese mainland stocks traded on the local exchanges) and H-shares (Chinese mainland stocks traded on Hong Kong exchanges). Practically speaking, H-shares are the ones primarily used by non-Chinese investors. A-shares are available mostly only to Chinese investors.

The wild ride the media has been all over lately has been largely about the moves occurring in the heavily local A-shares. H-shares have moved, but not nearly as much – up or down. This is a long-running trend. Since MSCI launched its A-share and H-share indices in late 2004, A-shares have been far more volatile.

The numbers since A-shares’ mania began are impressive. From 30 Apr 2014 through their 12 June peak this year, A-shares rose 163.2%.[i] Since then, they’ve fallen -30.2%.[ii] By contrast, H-shares rose 52%, then fell -14.9%.[iii] Big moves when considered in a vacuum, but far less volatile than A-shares.

Most important, these A-shares have next to no relationship with global stocks.

While stocks in the different developed-world markets can be a good leading economic indicator, A-shares really aren’t. The current drop in this share class is the third greater than -20% since 2009 and it had little effect on Chinese growth. during the period.

Valuation

Make no mistake; the A-shares still appear to be overvalued.

As of 10 July, stocks on the Shanghai-Shenzhen Stock Exchange traded at an average of 45 times their earnings. While that price/earnings (PE) ratio is down from its high of 108 at the peak in June, it’s still more than double the average P/E of 18.5 for stocks worldwide, according to the investment firm MSCI. By comparison, the S&P500 has a P/E of about 20 right now.

What to do?

Dr. Scott Grannis noted that, “instead of worrying that the collapse of stock prices is going to trigger a collapse of the Chinese economy, be thinking that what was a crazy-overvalued, bubble market just a few months ago is now coming back down to earth. China is not collapsing; it’s simply learning how to deal with prosperity.” Spot on, Doc.

What we’re seeing is an immature market environment with almost exclusively inexperienced investors piling in as stocks rise to record heights and then panic selling as prices started to return to more reasonable levels. And, of course, it hasn’t helped that the government has been actively meddling. I think they’ve realized that free markets can’t really be controlled…

One of the concerns about the Chinese market is that their growth is slowing. Well, the modest slowdown since 2012 is a largely government-engineered phenomenon. The economy is still growing, just not at the 10%+ growth rates it has had in recent years. The IMF expects the Chinese economy to grow 6.8% this year, unchanged from the forecast it made in April, before the market meltdown. It’s still a very big, fast-growing economy.

The status quo, politically and economically, seems fine for global investors. Even at its (relatively) slower growth rate, China contributes heavily to global trade, demand and growth. The A-shares’ wild ride shouldn’t change that today – the current drop is the third greater than 20% since 2009 and the previous two didn’t derail long-term growth.

Summary

I believe it’s an important global market that you want to have some exposure to for the long term. If you’re looking at funds, I think your investment should be through portfolios using the Hong Kong-listed H-shares. As the record shows, even though the H-shares got caught up in the “sell everything” mindset, these are the (relatively) more stable investments due to a longer track record and the exchange’s stricter accounting standards.

In my opinion, the recent headlines about the Chinese market appear to be a lot about not much. The bottom line regarding the recent correction is essentially a story of too much euphoria and now a natural correction.

Cheers!

Mike

[i] FactSet, as of 7/8/2015. MSCI China A Index returns with net dividends, 4/30/2015 – 6/12/2015.
[ii] Ibid. MSCI China A Index returns with net dividends, 6/12/2015 – 7/7/2015.
[iii] Ibid. MSCI China H Index returns with net dividends, 4/30/2015 – 6/12/2015 and 6/12/2015 – 7/7/2015.

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