The Rally From Chinese Stocks Just Hit a Roadblock

Just for the record, everybody had been warned that Chinese stocks were rising at a dangerous pace for all the wrong reasons. It’s just that nobody chose to heed the warning.

Those people paid the price on Monday when China’s market doled out the biggest single-day loss it had suffered in more than six years. All told, the Shanghai Composite Index fell nearly 8% yesterday, while U.S. markets were closed in observance of Martin Luther King Jr. Day.

However, there’s little doubt that United States investors will feel some of that pain, sooner or later.

Putting the Brakes on Rampant Margin Trading

chinese stocksOn Monday, the China Securities Regulatory Commission pulled the rug out from underneath Chinese stocks by dropping a bomb on several of China’s biggest stock brokerage firms. Specifically, regulators banned Citic Securities, Haitong Securities and Guotai Junan Securities from opening new margin accounts for the next three months.

The prompt for the decision was habitual mishandling of margin accounts, like opening these riskier brokerage accounts for unqualified customers, and extending margin loans for a longer period than Chinese law allows.

Margin accounts are a way for investors to borrow money to invest in stocks, using their own cash as collateral. When times are good and the market is rallying, as Chinese stocks did in 2014, the upside is magnified by using margin. When stocks tank, though, the losses are equally magnified.

And make no mistake. The use of margin accounts in China has reached dangerous levels, as inexperienced investors — unaware of the nuances and risks of margin-trading — are attracted to the idea of what looks like big, easy trading gains.

Stock and futures trading margin-lending website, for instance, taunts traders with statements like “(China’s) A shares are heating up; if you don’t allocate capital now, then when?” and catchphrases like “High leverage, low thresholds!” Jinfuzi allows investors to borrow up to ten times the amount of cash they bring to the table … leverage that could intimidate even the most experienced of traders, but being granted to people who are anything but experienced.

Measurable Impact

For perspective on how quickly risky margin trading has grown for Chinese stocks, as of the end of 2014, 2.4% of the country’s entire A-share market was held as margin-based positions, matching the margin-driven portion of NYSE-listed holdings. China’s margin trading is, or was, expanding at breakneck speeds, though.

It took the New York Stock Exchange’s stocks 13 years to see its margin positions grow from 0.9% of total investor holdings to 2.4%. It only took Chinese stocks a year and a half to do so after margin loan rules were eased in 2013. In the past three months alone, margin loans on Chinese stocks grew 73%.

The impact of less-restrictive margin trading has been noticeable too, and unhealthy.

Despite lackluster corporate profits in China of late — in addition to concerning economic data — Chinese stocks gained 54% in calendar 2014; the Shanghai Composite Index reached five-year highs to close out last week’s trading. The recent and largely undeserved strength from Chinese equities has been almost entirely attributed to the rush of small investors buying into Chinese stocks using margin loans they don’t fully understand.

What Now for Chinese Stocks?

Although it would be easy to assume the potential crimp on demand for Chinese stocks was fully baked into prices after Monday’s sharp dive, that would be an unreasonably optimistic point of view.

While the ruling from the China Securities Regulatory Commission was superficially pointed at Citic Securities, Haitong Securities, Guotai Junan Securities and nine other brokerage firms because of their failure to abide by the nation’s margin trading rules, Chinese regulators rarely introduce “one-off” efforts to effect change.

Odds are good the punitive ruling is the beginning of what’s going to be a string of efforts intended to cool rampant margin-based trading of Chinese stocks.

The net result for Chinese investors as well as U.S. investors in Chinese stocks is obvious … red-hot Chinese stocks are about to cool off, and that cooling period is going to last more than just one day.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.

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