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3 Reasons Why Chinese Stocks Won’t Stop Sliding

A series of fundamental and technical factors will pressure Chinese stocks throughout 2016

If the Chinese Zodiac was to be an advisor, 2016 should be an auspicious time — the year of the monkey.

3 Reasons Why Chinese Stocks Won’t Stop Sliding

But because the traditional Asian calendar celebrates the new year on Feb. 8, we are still technically in the year of the sheep.

Sadly, it’s an appropriate title as the equity markets — most notably Chinese stocks — are getting slaughtered. Any hint of an immediate recovery is not yet evident, and even if the broad markets gain back their losses, three critical factors will likely frustrate the bulls.

Panic in the Markets

The most obvious negative contributor is technical pressure — a fancy way of saying that investors are panicked out of their minds. After a mercurial collapse in Chinese stocks last year that evaporated $5 trillion of market capitalization, securities officials were anxious to propose a viable solution.

Their plan? Put in circuit breakers that would activate anytime Chinese stocks lost 5% of value for the day.

The road to hell may not be the only thing that good intentions pave. After the circuit breakers were taken to task twice in less than a week, waves of international criticism quickly put an end to the protective strategy. The artificial fumbling of Chinese stocks, however, has already inflicted severe reputational damage.

In a time when positive returns from global markets are hard to come by, why add one more highly questionable variable to the mix?

Ironically, the meddling by authorities only drew more attention to the poor technical state of Chinese stocks. The popular exchange-traded fund iShares FTSE/Xinhua China 25 Index (ETF) (FXI) is having its worst start to the year so far. Between Jan. 4 and Jan. 7, the FXI ETF is down 6.4%. The previous worst four-day start occurred in 2007, when the FXI lost 5.2%.

Even more significant is that post-2007, the FXI typically has a muted series of trades to ring in the new year. The average performance for four-day starts between years 2008 and 2016 is -0.23%, with no more than a 3% swing in magnitude in either direction. The fact that the FXI is currently flashing more than twice this figure represents a major sentiment shift that should not be ignored.

The Slowdown for Chinese Stocks

Source: Source: JYE Financial, unless otherwise indicated

Nor should the recent debacle be dismissed as merely a one-off event. A clear, fundamental truth cannot be avoided — Chinese stocks have gotten well ahead of a decelerating economy. According to data provided by The World Bank, China’s annual gross domestic product growth rate has steadily declined since 2010, with average losses nearing 9%.

Between 2012 and 2015, the average GDP growth rate was 7.4%, whereas in years 2009 through 2011, the rate averaged 9.8%.

Another way of describing economic deceleration is market saturation. While it is true that China owns the world’s second-biggest economy, not everyone there is rich, or even moderately stable. The country’s gross national income per capita is a paltry $7,400, comparing extremely unfavorably to U.S. GNI of over $55,000. This means that Chinese stocks specializing in retail markets are in for a tough ride.

Just ask investors of China Mobile Ltd. (ADR) (CHL). After gaining chunks of market share in China’s lucrative telecommunications sector, CHL has seen a conspicuous descent from prior years’ enthusiasm. According to CHL’s public financial records, the month-over-month growth rate in 2015 for total customers is 0.2%. This is exactly half the rate it was in 2014, and in 2013, monthly subscriber growth averaged 0.65%. Essentially, CHL sold their services to whomever they could. Although China doesn’t lack for people, a great many of them simply don’t have the resources to be corporate consumers.

Trouble Keeping People Invested

Those who do have the money to spend are quickly losing confidence in the economy, and — based on the Keystone Cops act courtesy of Chinese securities officials — are rightfully concerned about their government’s ability to properly deal with the core issues. It was fairly recently, in October, that the Westpac MNI China Consumer Sentiment Indicator dropped to its “lowest reading since the survey began in 2007,” according to CNBC. Surely, when the latest report is released towards the end of this month, the news will not be encouraging.

That’s a major red flag for Baidu Inc. (ADR) (BIDU), one of the most popular investments among Chinese stocks. Although BIDU has ambitious plans for this year — including seeking $500 million to support its online food ordering business — broadly weaker consumer demand could potentially derail such strategies.

Already, we are seeing the effects of Chinese consumers in crisis. BIDU recovered amazingly from last year’s correction in global markets, catapulting over 64% from Sept. 24 through Nov. 30. Since the first of December, however, BIDU has followed most other Chinese stocks into financial purgatory, dropping 19%.

Thursday’s decline of 6% was particularly damning as it occurred under heavier-than-normal volume.

Bottom Line for Chinese Stocks

The long-term faithful in Chinese stocks will be tempted to brush aside the recent volatility as an anomaly.

However, the record-setting technical decline in benchmark ETFs like the FXI, or well-known individual names like CHL and BIDU, reflect fundamental weaknesses that don’t have immediate solutions.

Until the markets fully price in this new reality, expect further nasty surprises in 2016.

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

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