China: What Goes Up Must Come Down

It was a soft end to August overall. Despite a 6.7% fall in Chinese stocks on the last day of the month, global equity markets for the most part registered gains over August. For example the S&P 500 registered a healthy 3.4% increase in August compared to close to a 15% drop in Chinese (Shanghai B) equities. The phrase, “the higher it goes, the harder it falls” looks appropriate in the case of Chinese stocks; at the time of writing, year-to-date the S&P 500 is up around 13% compared to a 68% gain for the Chinese stocks.

Looked at from another angle the S&P 500 is up an impressive 51% from its low in March 2009, whilst the Shanghai index is up a whopping 113% from its low in October 2008. Much of the selling in Chinese stocks as usual appears to be rumour based with talk of more lending curbs in China and a report that China’s state owned enterprises may terminate commodity contracts with foreign banks spurring the initial selling. The law of gravity suggests that Chinese stock may have further to fall.

The fact that the sharp sell off in Chinese stocks is having only a limited impact on other markets is an interesting development in itself. It suggests that investors in other markets and products are not getting too carried away with China stock watching. In particular, currencies appear calm despite the volatility in Chinese stocks and generally correlations between equity markets and currencies remain low according to my calculations (happy to provide correlation coefficients to anyone who is interested).

Comments

[Dave Wrixon:]

I would think that perhaps one of the biggest factors weighing on Chinese Stock is the Exchange Rate. If the Yuan appreciates against the dollar then in international terms the Shanghai exchange will start to look more expensive, just as if the dollar collapses the S&P will start to look cheap. The problem is the rational for the currency peg is weakening. China is overpaying for commodities as quid pro quo for subsidising exporters. But exports are very subdued and would probably not be greatly further depressed if the Yuan did appreciate. It has always been a given that a strong dollar is good for America, then why is it always assumed that a weak Yuan is good for China?

Sep 01 07:07 AM

[CautiousInv...:]

From Bloomberg:

The Shanghai Composite Index, the world’s worst performer in August, may fall another 25 percent as China’s economic recovery isn’t “sustainable,” former Morgan Stanley Asian economist Andy Xie said.“The market is in deep bubble territory,” Xie, 49, who correctly predicted in April 2007 that China’s equities would tumble, said in an interview with Bloomberg Television.

Equities in China remain “a bright spot” among global stocks because of the nation’s strong growth potential, Goldman Sachs Group Inc. said yesterday. “We think the market concerns about a near-term ‘exit strategy’ appear premature as the government remains pro- growth,” Thomas Deng and Kinger Lau, analysts at Goldman Sachs, wrote in a research note.

Ignoring Goldman's perennially bullish stances on anything that trades and incorporates value, the debate is about how serious the credit bubble is in China and what measures will be taken to correct the imbalances after credit exploded 300% in H12009, producing various bubble, including equities, and leading to further excess capacity.

Some think there be a brief respite in bank lending while others including Xie believe the stimulus plan is inherently flawed and unsustainable.

Sep 01 08:18 AM

[Mark Bern:]

From CautiosInvestor comment: "Some think there be a brief respite in bank lending while others including Xie believe the stimulus plan is inherently flawed and unsustainable. "

Who ever heard of a "flawed stimulus plan" before. Certainly, the MSM in this country hasn't.

But let's just think for a moment about why Chinese equities are falling. China's GDP has been rising at a rate close to 7% even during the world recession so why shouldn't equities go up? Well, they should, but the rate of climb in equities is way out of whack relative to the potential rise in earnings produced by a 7% growth rate in GDP. Granted, if a company is run well it may be able to increase earnings faster that its top line. That also depends upon the industry, competition, labor/capital mix, etc. But there just is no way for all companies in a market to average a sustained 100%+ growth in earnings with GDP rising just 7%. Some companies will gain market share and other will lose, even as the market pie grows, so the average growth is tempered.

Anyway, China also has had a bubble going in real estate and who knows what else. So, in the end, they get to experience the capitalism roller coaster along with the rest of the world. How bad will it be? Who knows? It will be interesting to watch over the next couple of decades to see how central planning fairs in its quest to harness the "best of both" systems (that's China's idea, not mine).

On the other hand, it seems as though we here in the U.S. are moving in a direction that may allow us more of a first-hand view of how central planning works. I hope not.

Sep 01 08:44 AM

[buoy:]

yup, sustainability is the key word for China. Time will tell.


On Sep 01 08:18 AM CautiousInvestor wrote:

> From Bloomberg:
>
> The Shanghai Composite Index, the world’s worst performer in August,
> may fall another 25 percent as China’s economic recovery isn’t “sustainable,”
> former Morgan Stanley Asian economist Andy Xie said.“The market is
> in deep bubble territory,” Xie, 49, who correctly predicted in April
> 2007 that China’s equities would tumble, said in an interview with
> Bloomberg Television.
>
> Equities in China remain “a bright spot” among global stocks because
> of the nation’s strong growth potential, Goldman Sachs Group Inc.
> said yesterday. “We think the market concerns about a near-term ‘exit
> strategy’ appear premature as the government remains pro- growth,”
> Thomas Deng and Kinger Lau, analysts at Goldman Sachs, wrote in a
> research note.
>
> Ignoring Goldman's perennially bullish stances on anything that trades
> and incorporates value, the debate is about how serious the credit
> bubble is in China and what measures will be taken to correct the
> imbalances after credit exploded 300% in H12009, producing various
> bubble, including equities, and leading to further excess capacity.
>
>
> Some think there be a brief respite in bank lending while others
> including Xie believe the stimulus plan is inherently flawed and
> unsustainable.

Sep 01 09:17 AM

[Alphameister:]

Mark Bern's highly flawed comment assumes that Chinese stocks were fairly priced relative to fundamental values at their lows instead of deeply undervalued as I and other bulls on China have perceived (to great advantage this year). 7% overall economic growth is more than enough to boost profits by 100% or more in various cyclical industries. If Chinese stocks were underpriced by 40% or more at their lows (as was certainly true of the ADRs I was buying then), a mere 20% gain in profits (from cyclically depressed levels), accompanied by a return to more reasonable valuation multiples would support a gain on the order of 100% by Chinese ADR prices.

There are risks in all markets, but in a world starved for growth, China's ADR market strikes me as the place to be.

Sep 01 09:57 AM

[Alphameister:]

Regarding the original article, did the author really say that "the law of gravity suggests that Chinese stock may have further to fall"?

Sep 01 09:59 AM

[doubleshortetf:]

China is notorious for corruption and the CCP (Chinese Communist Party) ignoring and bending the rules to weasel out of bad financial bet.

This sentence from the Reuters article (link below) captured the unfair game the Chinese CCP and SOEs resort to:

"It's like the father suddenly told the creditors of his debt-ridden son that his son won't pay any of his debt," said a lawyer from the derivatives risks committee of the Beijing Lawyers Association.

reuters.com/articl...

Beijing's derivative default stance rattles banks

* State-owned firms may default on commodity hedges - report

* Bankers dismayed, confused by report; seek more details

* Lawyers question legality of the move

* Traders suspect lurking losses may have prompted warning (Adds analysts comments)

Yep just walk away from bad bet SOEs (state owned company) made on hedging. Talk about bunch of sissies...

This is the government you China fans "invest" in where the corrupt CCP changes rules in blatant mockery of international law.

Sep 01 01:01 PM

[doubleshortetf:]

What goes up comes down, really.

The Shanghai market has already lost roughly 25% from its recent peak, and it took just three weeks to lose what required roughly three months to put on.

Dejavu pre Beijing Olympics meltdown last year...

Sep 01 01:02 PM

[doubleshortetf:]

Take note from Times aptly titled "Why China's Stock Market Bubble Is Fizzling" fresh off the "press".

www.time.com/time/worl...

Here is another dose of reality by Chinese people fondness and penchant for gambling:

"the Shanghai and Shenzhen exchanges are dominated by retail investors driven to frenzy by speculation and sentiment. "

Yet just the kind a market I want to go long now...

Sep 01 04:09 PM

[softwaresod...:]

Not only in China, what about other countries?

Sep 08 11:42 PM