Chinese stocks cratered Tuesday after Beijing tightened collateral requirements on cash loans, underscoring both the high level of leverage employed by retail investors in that market as well as the Shanghai Composite’s own meteoric rise of late.
Chinese stocks were actually having a disappointing year up until late summer. Indeed, the largest China exchange-traded fund — the iShares China Large-Cap ETF (FXI) — still is. FXI was up less than 9% year-to-date before the Tuesday selloff, and with the exception of some short-lived strength in late summer, has lagged the S&P 500 for all of 2014.
The Shanghai Composite was also having a nothing year. That is, until summer, when what started as a slow boil turned into a full-on steam explosion. The Chinese equity benchmark is up nearly 50% in the last six months, while the U.S. benchmark gained less than 6% over the same period.
Chinese Stocks: Shanghai vs. Hong Kong
The proximate cause for Tuesday’s shellacking Chinese stocks was a regulatory change intended to squeeze a little risk out of the Chinese equity market. Authorities there have banned investors from using low-grade corporate debt as collateral to borrow cash.
That led to a stampede of selling as investors dumped stocks to raise cash to cover loans backed by the low-quality debt.
The move served as a stark reminder of at least a couple of things that are never good for investor confidence. For one thing, there’s a lot of leverage in the Chinese equity market, to say nothing of the wider economy. Just as worrisome, Chinese regulators have a habit of making abrupt changes and sending mixed signals.
That creates uncertainty, and the market hates nothing quite so much as uncertainty, especially when it comes to the opaque world of Chinese stocks.
That said, there’s a big difference between the Chinese mainland equity benchmark Shanghai Composite and the popular ETFs Western investors use to play China. And that happens to be a very good thing, as Tuesday’s action makes abundantly clear.
Regulators are slowly opening up markets, but foreigners are barred from owning most Chinese stocks on the Shanghai exchange. That’s why China ETFs track indexes based on Hong Kong’s Hang Seng. Although it can trade in sympathy with Shanghai, the Hang Seng it’s a very different animal.
Just have a look at the embedded chart showing the year-to-date performance for the Shanghai Composite, Hang Seng and the three largest China ETFs — the FXI, the iShares MSCI China Index Fund (MCHI) and the SPDR S&P China (ETF) (GXC).
The China ETFs and Hang Seng are all underperforming this year, which is a much more accurate reflection of what’s happening with the Chinese economy as struggles to manage a slower growth trajectory amid serious concerns about the property and financial markets.
The Shanghai Composite is more a reflection of the insanity of Chinese retail investors. Be glad you’re not part of that.
China ETFs have been disappointing underperformers for U.S. investors this year, but it’s not like they crashed. The Shanghai Composite, with that bubble-like chart, looks ready to do so at any time.
As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.