More Volatility in Sight for China's Markets

Includes: FXI, PGJ
by: FP Trading Desk

Remember those stories you read earlier this month about China's stock market melting down? Well, forget about them. The market is on the threshold of making a full recovery after its recent bout of volatility.

Unfortunately, the quick recovery will likely lead to even greater volatility down the road.

The Shanghai stock exchange [SSE] composite index hit a record high on May 29 and then headed straight down for a number of days until it had corrected by about 15% - a nasty decline that had many investors questioning the longevity of the bull market there.

The dip was no mystery. Chinese stocks had been on an incredible run that saw them rise about 300% over the past two years, pulling miles ahead of any fundamental underpinnings.

The economy was, and is, cruising along at a growth rate of 11.1% in the first quarter. But valuations had reached nosebleed levels, trading at about 45-times earnings, according to Bloomberg. To put that in perspective, the S&P 500 (NYSEARCA:SPY) currently trades at 18-times earnings and Brazil's high-flying benchmark index, the Bovespa, trades at a mere 14-times earnings.

Clearly, China was in a class of its own that drew some comparisons to the ill-fated Nasdaq in the late 1990s, and Japan's Nikkei 225 in the late 1980s.

Even more alarming is the fact that Chinese authorities have been trying to clamp down on speculation among domestic Chinese investors, who have flocked to the stock market in recent years. With few other investment opportunities open to them, the Chinese have been opening stock trading accounts at a frenetic pace to get in on the rush toward equities, driving up prices and valuations.

In early June, authorities increased taxes on stock trades, hoping the rising costs would curtail speculation and reduce the chances of creating a massive bubble, the bursting of which could damage the Chinese economy. The new rules sent investors into a panic selling mode - for a while. They were drawn back by the discounted prices and assurances from authorities that the new taxes would be good for the market.

Since then, the Shanghai composite index has regained nearly all of the lost ground. It is now just a 2% rally away from hitting a new record. Based on its current steep trajectory, a new record looks like a sure thing in the days ahead if authorities stay on the sidelines.

That is not good news, though. The further the Chinese stock market rises without a meaningful setback, the greater the chances of a messy correction somewhere down the road.

How messy? Right now, investors are learning that stock market volatility within China is unlikely to have any meaningful impact on the rest of the world, which is why the recent volatility has not spread to other markets.

But the bigger this bubble gets - some observers refer to it as "bubbly" at this point - the greater the chances that there will be some spillover into the Chinese economy and those countries that rely upon it for commodity exports.