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Reality Check for China's Stock Market

|Includes: Morgan Stanley China A Share Fund (CAF), FXI, GXC, HAO-OLD, PGJ

At the end of last week, I pointed to evidence that the Shanghai stock index was being driven by the availability of liquidity rather than fundamental performance.  I said we might expect to see continued volatility, up and down, as official reassurances that go-go credit continued to clash with sluggish economic realities.

Since then, Shanghai has seen two big drops, down 5.8% on Monday and 4.3% today, Wednesday.  The interesting thing is that both sell-offs were initiated, not by liquidity fears (which the government could easily counter), but by poor company results.  Yunnan Copper (000878:CH) led the way down on Monday, after posting a half-year loss.  Wednesday's decline was driven by Maanshan Iron & Steel (600808:CH), which posted a loss for the second consecutive half-year period.  Similarly dismal performance by Hong Kong-listed China plays, including Ping An Insurance (2318:HK) which reported a 45% drop in first-half profits, contributed to the overall turn in sentiment.

The fact is that reality is catching up with China's bull market.  Nearly every company I talk to on the ground in China tells me that they are struggling.  Exporters, of course, are bearing the brunt, but even firms focused on the domestic economy are relieved if they can just match last year’s results.  The borrowed money flowing into the Shanghai stock market can ignore these facts for a while, but not forever. 

Concerns over liquidity tipped the market into bear territory, but the reality of poor performance is driving home the point that Chinese stocks are, in fact, overvalued.

Disclosure: No positions.