Jargon Busters - Equity
Lessons from the Chinese equity bubble

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The Chinese stock market bubble and crash offer a couple of important lessons in equity investing that advisors must reiterate to their clients. (1) Indian investors can be reassured that our markets are significantly more transparent, robust and efficient, which makes it a much safer market to invest in, from a structural point of view, and (2) the recent Chinese market bubble and crash underline the important role that you as an advisor are playing in helping your clients follow a disciplined investment strategy that keeps them away from the pain that Chinese investors are now experiencing.

Today the Chinese stock markets are in the news for all the wrong reasons. The chief being the huge slide in the markets and the fact that the stock markets are poorly regulated, leading to shares of companies with opaque financials being traded on the bourses.

It is important to remember that the Shanghai, Shenzhen and Hong Kong exchanges with a total market capitalization of over $9.5 trillion, is the world's second largest stock market after America.To understand the recent volatility in the Chinese markets, we must first understand the nature of the Chinese system. The first thing isthat China, despite it genuflections to the market economy, is still ruled by the Communist Party, which is ruthless in maintaining its power. 'Markets' work at the government's will and pleasure, except of course, for Hong Kong.

Jump in retail investors

The problem really began in the last year, when the government began encouraging the public to invest in stocks. The aim was to strengthen the financial position of many companies which were burdened by debt. The idea was to reduce the leverage of companies that were struggling to maintain profitability.Government propaganda assured prospective investors that investment in the stock exchanges was both safe and profitable. A series of big IPOs were planned to soak in retail savings. Meanwhile, persisting weakness in the property markets meant that Chinese investors - who made huge gains in property investing over the last decade - were eagerly looking for alternatives to make money.

This started a boom in the number of retail investors. In just one week in March, 2015,Nearly 1.7 million new stock accounts were created which represented a 58% increase from the week before. In March alone, 4 million new stock accounts were opened. This hectic pace of growth has been going for the last year or more.

"A lot of speculative money has come into the market," Michael Wang, a strategist at hedge fund Amiya Capital LLP says. The rally "is not fundamentally driven. It's much more of a flow-driven phenomenon," according to Bloomberg (April, 1 2015).

Creating a Bubble

A whole lot of people, retirees in particular, put in not only their own retirement funds but also borrowed money, to invest in shares.The matter was further complicated by frenetic buying and selling by retail investors, most of whom have not even finished school, and knew little about the functioning of stock markets .This lack of experience could be seen from the high volume of trades in previously unknown scrips, with dubious financials. Traditional Chinese love for gambling seems to have done the rest.

The frenzied investing created a bubble that saw the Shanghai stock market leap 135 percent in the nine months to June. At its recent peak, the price-to-earnings ratio was over 37, according to Standard & Poor's Capital IQ, compared with a historical average of just over 10. The Shenzhen market valuation was even more elevated, with a price-earnings ratio in June of nearly 80.(NYT July 9 2015).

The Consequences

"I have been trading in the past few years, but this market plunge is unprecedented," said one retiree, referring to the nearly 30-percent drop since the markets peaked on June 12. By early July, $2.8 trillion in value had been wiped out, roughly equivalent to ten times the size of the Greek economy.

Many of the retail investors who were upbeat in April are now feeling the pinch, with many facing direct losses. Certainly a few read the signals right and exited the market at the right time, but the majority are now facing the double trouble of coping with actual financial losses as well as the necessity to repay loans with which those investments were made.

Further, foreign fund managers too seem to be intent on exiting the market while they still can, pulling the market down further.

Government measures

Even extraordinary emergency measures unveiled in early July, such as a $19-billion rescue fund organized by the country's regulators and funded by China's top brokerage firms, failed to stem the fear among retail investors who perform 85 percent of the market's transactions.

The China Securities Regulatory Commissionsaid that controlling shareholders and managers holding more than 5% of a company's shares could not reduce their holdings for six months.To further counter the panic effects of sales on such a huge scale, the Chinese government has imposed controls on over 700 stocks, prohibiting any sales in those counters. "Then there is China, where the authorities have suspended the sale of72 percent of the A share stocks. Investors with stakes exceeding 5 percent must maintain their positions," the China Securities Regulatory Commission said, writes Barry Ritholz in the Bloomberg (July, 9, 2015).If one cannot buy or sell, where then is the 'market'? Ritholz asks.

The challenges ahead

"China's stock market is like a big casino and the Chinese love gambling," says Hu Xingdou, professor of economics at the Beijing Institute of Technology. "The stock market valuation is out of line with the economic fundamentals, and this is due to speculation and government policy interventions. The market could bounce back, but over the long term, I am not optimistic because China's economic situation isn't good, and the more the government intervenes, the bigger the market bubble becomes," he added. (NBCN)

Stating that USD 19 billion was insufficient to stem the slide in the markets, he said, Japanis thought to have spent about 0.8 percent of its market's value in the 1990s, a much larger relative amount that was nevertheless insufficient.

Yet the other side of the story is that even after the dramatic fall,the Chinese markets are still 78% up from the year ago values.Given the opaque nature of the Chinese economic statistics and the still strong command and control features of the economy, China may pull itself out of trouble. Indeed this is the aim of the much vaunted Silk Road projects and the One Belt One Road initiatives that the government has taken in recent months.

It is only when these projects actually get off the ground can we really say if Chinese tactics have worked or if as, Mr. Saito,founder of the Observatory Group, an economic advisory service says,"Ultimately, not even China can defy the laws of economic gravity,".(NYT July 9 2015).

Lessons from the Chinese stock market bubble

In many ways, we must be thankful that our market structures seem far more robust, transparent and independent than the Chinese market. Our market is clearly more efficient, which means our investors have lot less to fear from a market structure perspective.

However, the broader point of herd mentality and its consequences is worth noting and remembering. We have seen our share of scams and our share of bubbles. Stories like what is happening in China and its impact on Chinese investors, should underline the need for quality, impartial advice from experienced advisors. It is worth letting your clients know that the value of your disciplined investing is to help your clients avoid exactly the pitfalls that Chinese investors today find themselves in.

Share your thoughts and perspectives

Do you have any observations or insights or perspectives to share on this issue? Did this help you understand the topic better? Do you disagree with some of the observations? Please post your comments in the box below ..... it's YOUR forum !



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