Has The Chinese Market Rallied Too Far Too Fast?

by: The Panoramic View


The Shanghai index recently rallied past 4,000 for the first time in 7 years.

Many market commentators have pointed out that the rally is fueled by unwarranted speculation by dumb money.

The Chinese government will tighten margin requirements as the market rallies further and further. This could lead to more volatility ahead.

The Shanghai index recently rallied past 4,000 for the first time in 7 years. As the Chinese market has rallied, many pundits have stated that the rally is due to unwarranted speculation by dumb money rather than due to solid fundamentals.

In many ways, the critics are right. The Chinese economy isn't doing that well. The main drivers of the past Chinese economy, housing and manufacturing, are weak. The price of newly built housing continue to fall year over year while China's PMI hovers dangerously close to the break-even 50 level. The dumb money is indeed playing a part in the rally - according to Bloomberg, 5.8% of the new Chinese market participants can't even read. Because many of those new market participants are momentum traders rather than fundamental investors, the valuation of many stocks listed on the Chinese indexes are wildly out of sync with their underlying fundamentals.

There are extenuating circumstances, however. First, a moderate decline in housing prices is not necessarily a bad thing for China. Declining housing prices are bad for other countries because the majority of the other countries' middle class own their own homes. If housing prices fall, the middle class feels less confident and spends less. Less spending leads to less jobs, which leads to lower housing prices. This creates a vicious cycle that could lead to a recession. In China, most of the middle class don't own their homes. Falling housing prices would make housing more affordable for the Chinese middle class, and could trigger more consumption from the new homeowners buying new dishwashers, washing machines, etc. to outfit their homes. This activity could stimulate the economy rather than harm it.

Second, judging the Chinese economy solely by its latest PMI reading is flawed. Given that China is moving away from manufacturing and moving towards higher value added services, it is important to look at a broader measure of the Chinese economy rather than looking solely at its manufacturing sector. Given that China's IT sector is doing well, a broader reading of the Chinese economy will likely show that the economy is doing better than what the PMI shows. Third, although individual stocks listed on the Shanghai index are wildly mispriced, the overall index is still fairly valued. The Shanghai index trades at a forward P/E of 15 versus the S&P 500's forward P/E of 17.

I do believe that too many people thinking the same way is dangerous. Those playing the momentum game may reap great rewards as stocks rise, but they will be very exposed if stocks fall and their exposure could have systemic consequences. Runaway indexes have suffered sharp corrections before. One such sharp correction occurred in October 1987 when indexes around the world fell by 15-22% in a single day. Although markets quickly recovered their 1987 losses, the fall did substantial damage to the economic system - some economists believe that the BOJ would have tightened much earlier if 1987 had not occurred. The BOJ tightening in 1987 could have saved Japan from its lost decades. From this perspective, the Shanghai index falling 20% in one day would cause significant damage to the Chinese economy as the Chinese central bank may have no choice but to inject liquidity into the system at a time when lowering interest rates isn't necessarily the best choice.

Because the Chinese government wants to prevent a 1987 scenario, I believe the government will make it harder and harder to speculate as the index rises further and further. The government will likely raise margin requirements like they did in February and this could lead to the index falling by 6 or 7% in one day. I don't think the rally is over, but there will be more volatility ahead.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.