China, the world’s most populous country, is widely expected to be the premier engine for global economic growth in the twenty-first century. The country earned that expectation, posting year after year of fast expansion: From 1989 to 2014, China’s annual GDP growth averaged 9.1% as China’s manufacturing sector took off like a rocket.
Last year, the Chinese economy even overtook the U.S. in one important economic indicator — real-purchasing power — relegating U.S. to the #2 spot for the first time since 1815.
And China’s stock market? It’s been similarly explosive, especially in the last year. Since June 2014 — just seven months ago — the Shanghai Composite Index has rallied a remarkable 67%. Last year, Alibaba Group Holding Ltd (NYSE:BABA) lit up Wall Street with a record public offering that raised $25 billion, shining a glowing light on China’s corporate golden boy.
E-commerce rival JD.Com Inc(ADR) (NASDAQ:JD) also went public in the U.S. last year, raising roughly $1.8 billion. And Baidu Inc (ADR) (NASDAQ:BIDU), the Chinese search engine often compared to Google Inc (NASDAQ:GOOG, NASDAQ:GOOGL) has rewarded investors to the tune of 370% in the last five years.
But all good things must come to an end, and for Chinese investors, it’s going to be a rather fiery one. Here are 3 reasons why China’s stock market will crash in 2015.
Reasons China’s Stock Market Will Crash in 2015: #1 — Bye-Bye Margin Trading
The Shanghai Composite Index cratered on Monday, losing nearly 8% of its total value in the steepest single-day selloff since the depths of the 2008-2009 global financial meltdown.
What triggered China’s sudden stock market slump? In short, Chinese regulators who were worried Chinese stocks were hitting new highs without merit. The China Securities Regulatory Commission, or CSRC, banned China’s three largest brokerages from allowing new margin trading accounts for the next three months.
Buying stocks on margin is the concept of borrowing money from a broker to finance additional stock purchases one could not otherwise afford. Margin trading has a very large opportunity for reward, but similarly the risk to the investor is immense, as one can lose more than they invested to begin with.
China’s current situation looks eerily similar to the U.S. in the 1920s. In the 1920s, the U.S. stock market was booming, but much of the run-up was fueled by rock-bottom interest rates and heavy speculation. Specifically, margin trading was out of control and the Federal Reserve banned margin trading in February 1929, just eight months before the notorious crash that would spiral the country into a devastating depression.
As for China, it lowered its interest rates in November. Nearly two-thirds of the market’s 56% jump since last June has come since that rate cut. Just how bad has buying stocks on margin gotten in China? Between June and January, outstanding margin loans have nearly tripled, soaring from $64 billion to $177 billion.
Reasons China’s Stock Market Will Crash in 2015: #2 — Housing Bubble Bursting
Over the last four months, 67 out of the 70 cities tracked by the Chinese government have seen home prices decline or remain stagnant in successive months. Real estate and other related activities are responsible for an estimated 33% of economic activity, the International Monetary Fund said in October.
But a stable housing market is doubly essential in China because the Chinese consumer needs to have confidence in rising home prices, as 9 in 10 Chinese families are homeowners.
And, according to a December article in the New York Times, developers are holding two to three times their normal apartment inventories in major Chinese markets. With Chinese buyers waiting on the sidelines, the central government took action in November, lowering interest rates. Those lower rates, in turn, helped fuel the speculative buying-stocks-on-margin bonanza that the government in turn had to snuff out.
Reasons China’s Stock Market Will Crash in 2015: #3 — Secular Growth Deceleration
The plainest reason that China’s stock market is set up for a crash is simply its broadly decelerating growth. The Chinese government was quick to spin the most recent GDP numbers, which show China grew at just 7.4% in 2014 — its lowest rate in 24 years — as “the new normal.”
But that phrasing, which China’s National Bureau of Statistics itself used, would have been heresy a few years ago, when GDP growth was flirting with 10% per annum. According to the Financial Times,
“As recently as 2011, the government regarded 8 per cent annual growth as a quasi-mystical threshold, below which Chinese society would descend into chaos and the Communist dynasty would implode.”
The fabric of Chinese society remains intact despite this previously unthinkable lapse in growth, but China’s growing embrace of the free market doesn’t work in favor of its stock market. Without swift growth to support the facade, the euphoric valuation of Chinese stocks begins to look like the house of cards that it really is.
Of the public Chinese stocks listed on the financial data website Finviz, the average forward P/E was just over 44. The S&P 500 currently trades at less than 17 times forward earnings, so that gives you an idea for the absurd premiums these stocks currently command.
Boom-and-bust, it’s a never-ending economic cycle. But it is a cycle, and the boom is definitively over.
Jon Divine is an Assistant Editor at InvestorPlace. As of this writing, he was long GOOG and GOOGL.