The Real (Simple) Reason Chinese Stocks Have Resumed Their Fall

How does the saying go? Expect it when you least expect it?

The Real (Simple) Reason Chinese Stocks Have Resumed Their Fall

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That was sage — and largely unheeded — advice for some investors who were sure Chinese stocks had hit a trade-worthy bottom on July 9. Although the Shanghai Composite ended a four-week, 32% rout that day with a sharp reversal that carried Chinese stocks modestly higher over the past two-and-a-half weeks, the nation’s stocks completely tanked again Monday, likely reigniting the selloff.

The prod for the pullback was reports that the nation’s government was backing off on its expensive efforts to prop up Chinese stocks while they stabilized. Even the mere mention of the removal of the crutch, however, put Chinese stocks — as well as U.S.-traded instruments like the iShares FTSE/Xinhua China 25 Index ETF (FXI) — back into a tailspin.

Stability remains elusive, to say the least.

Or, maybe the problem is the simpler fact that Chinese stocks are still overvalued even after June’s and early July’s big dip.

Shanghai Composite Gets Blindsided

While the saga superficially began on June 15 when the Shanghai Composite rolled over from a multiyear high of 5,178.19 to begin what would eventually become a 32% tumble, the basis of the lingering problem took shape well before that.

The story really starts in mid-2014 and then accelerates in late 2014, and in many ways it was a perfect storm of bullishness. A combination of low interest rates, the relatively recent availability of the Internet for the many of the nation’s citizens, and a supply of loans (margin or conventional) for the purpose of investing in stocks all took shape at the same time in the same way, with one extra ingredient to hold the other three together: certainty that China’s government would never let its equity market suffer.

It’s a recipe for greed, and greed is a recipe for bubbles since it crimps common sense. Just ask any U.S. investor who was caught off guard in early 2000 as dot-com mania came to an abrupt halt.

The Shanghai Composite bubble popped on June 15 largely because unbridled greed from inexperienced and unsuspecting investors finally had an “a-ha” moment after a 150% run over the past 12 months. The grand realization? Chinese stocks weren’t worth nearly as much as their prices suggested.

With the pendulum swinging the other way at full speed by late June, a desperate Chinese government pulled out all the stops and initiated a massive support effort for Chinese stocks. It stopped approving IPOs, for one, hoping investors would instead direct that money toward the purchase of existing equities. The government also loosened bank reserve requirements while lowering interest rates in hopes of spurring activity as well as encouraging wary investors. Regulators even allowed (for the first time ever) some pension funds to buy Chinese stocks.

Meanwhile, China’s brokerage firms also chipped in, committing nearly $20 billion of their own capital to send a bullish message to nervous investors by buying the stocks they were selling.

All the measures seemed to work too…. for a while. The Shanghai Composite rallied 24% of its early July lows. FXI gained more than 11%. But, it was a move that wasn’t built to last. The Shanghai Composite fell more than 8% today following reports that Beijing was backing off on its financial support of the country’s stock market.

Shanghai Composite chart

It wasn’t even an official policy statement. It was just a whiff of a rumor. And yet, it was enough to spark the biggest one-day loss the Shanghai Composite has seen in the past eight years.

What’s Really Wrong With Chinese Stocks?

The media’s response to the renewed weakness in Chinese stocks has included the requisite explanations. That is, a lack of state support for its stock market is worrying amateur and professional investors alike, and the 0.3% year-over-year drop in profits China’s industrial companies saw in June is a concern.

What too few journalists have been willing to directly acknowledge, however, is the reality that the biggest reasons Chinese stocks are tanking again today is the same reason they imploded in mid-June — they’re still overvalued, and the nation’s investors (many of them new) are still in the process of recognizing this reality.

Take the number with a grain of salt, but even with the recent selloff, the Shanghai Stock Exchange’s stocks boast an average price-to-earnings ratio of 18.3. That’s a frothy reading, and may actually still overstate the value of these names.

While it’s still an enviable figure, China’s second-quarter economic growth rate 7% is weaker than it has been in recent years, and some pros say it’s going to slow down even more in the near future. Analysts recently polled by Reuters say the country’s economic growth rate will likely fall to 6.7% next year. It’s still an impressive rate by U.S. standards, but many Chinese stocks were bought on the premise that the county’s economic growth rate would rise rather than subside. That’s just not happening.

In fact, it may not even be as good as the superficial numbers suggest. Taking out the effects of inflation and currency fluctuations, China’s GDP only grew between 5.5% and 6.0% as of its latest update.

Meanwhile, those 1,300 companies that halted trading on their stocks in an effort to circumvent the selloff may find that sellers have been waiting in the wings the whole time, and though margin debt on Chinese stocks is only two-thirds of what it was in mid-June when the pullback started, the $130 billion worth of margin loans currently on the books for Chinese stocks has the potential to drive another sizable wave of margin-call-driven selling.

In that light, the plunge from Chinese stocks today makes sense. There’s just no room for anything but a blatant, clear, well-voiced message from China’s government that everything’s going to be all right.

With the coffers running a little dry following an $800 billion effort to prop up its market, though, the Chinese government may be unable to make a promise they know they shouldn’t try to deliver on.

In other words, the free (read “free of government influence”) market has spoken about Chinese stocks, and it still doesn’t like their prices.

It would be wise to take today’s hint at face value: The bubble hasn’t yet fully deflated.

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

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