If you don’t follow financial markets too regularly, you might have missed the fast and spectacular drop in Chinese stocks the past few days. We have seen a daily negative 7% performance in the broad Chinese stock market indexes two times in 2016 already. Since experts have been talking about the possibility of a Chinese recession destroying the demand for oil and causing global slowdown, I thought I would explain my take on it for Moola readers. This is not to be scientific, just a personal opinion in what is a very complex market situation.
The Chinese Stock Market Crash Started Because Too Many Investors Borrowed Too Much to Buy Stocks
If you read about margin lending practices in China, they are very similar to the US stock market’s wild west period in the 1920s. Brokers lend out a ton of money to buy stocks, and individual investors are heavily involved. In the US the large institutional investors like mutual funds and pension funds have almost total control of the market because of their huge size. Chinese investors today remind me of how American investors behaved during the tech bubble in 2000.
In the build up to the heyday of American stocks in the 90s, you had grandmothers claiming astonishing returns only to be exposed as frauds. There were doctors with zero expertise in equity analysis purchasing tens of thousands of dollars in shell tech companies with 0 earnings because the corporate name ended in .com. The buildup to the bust of the Chinese equity bubble seems similar. Individual investors would heavily invest in IPOs if the stock identifier had a 6, 8, or 9 in it because those numbers are considered lucky in Chinese culture. Others simply used as collateral their already overvalued holdings to borrow more money to buy more shares. This kind of activity results in pushing up the ratio of Price to Earnings: an important barometer of overvaluation in a stock market. A Price-Earnings ratio simply tells you the multiple investors are willing to pay for a dollar of earnings. In a normal market it might be between 10-20. You are probably looking at value at a ratio below 10 and could be looking at overvaluation at a ratio of above 20 for a broad stock market consisting of a large number of companies. When the Chinese market started to fall, the big indexes like the Shanghai composite probably had Price-Earnings ratios above 40. That number is even more precarious when you realize that Chinese companies can include paper gains from their own Chinese stock market investments.
The Chinese Stock Market Experienced A Needed Correction
To be fair, “needed correction” sounds like “justifiable homicide.” It is a phrase that doesn’t make a lot of sense because why would you ever want a stock market to lose money? Consider that the Shanghai index went up 150% in value from June 2014 to June 2015, according to Nicholas Lardy of the NY Times. That kind of ridiculous gain probably means a precipitous fall at some point. Would you rather have China crash at the same time as the US or Europe? Truly it might be a blessing for the world economy that the difficulty in the Chinese markets right now occurred just before the release of a record breaking positive jobs number for December 2015.
When markets crash, the danger is that panic sets in and people start selling because of the losses they’ve already accumulated. If you look at the Great Depression, this clearly happened in the US. Benjamin Graham, the teacher of Warren Buffet, wrote in his book Security Analysis that he could easily find companies that were trading at a lower value than the cash they had on hand. This kind of panic selling is what poses the biggest danger to global markets because a cold in China can cause the flu for the rest of the world.
China doubled down after the summer crash and allowed things like using apartments for collateral and higher equity percentages for institutional investor portfolios. The apartment as collateral rule is particularly worrisome given there is almost certainly a bubble right now in Chinese real estate. If individual investors make heavy use of putting up their 5 times fair value apartment title to buy more stocks on margin, obviously the ending could be poor. At the same time, the intense interest of the Chinese government in preventing market panic seems to be a calming factor on markets whenever things fall too quickly. After all, in 2008 the Chinese put into place one of the world’s most aggressive stimulus programs as a percent of GDP, so I would expect they would react swiftly to any further crisis in Chinese stocks.
A Circuit Breaker Broke the Market
The Chinese stock market is still in its infancy of development. I met a Chinese guy here in Mexico City who told me that if you wanted to do well in the Chinese stock market, then you needed to pay “experts” for information. I asked him what he meant, and he said that they give you things like secret information to help you make a better investment. That’s insider trading, and it’s something that’s not supposed to happen in developed markets because it creates a class of in the know investors that take advantage of other who do not have that kind of privileged information. You would eventually expect insider trading to decline as China develops as part of the global stock market. Another development that will happen in time is the decline of individual investors picking stocks based on lucky numbers. As the Chinese stock market was built up to meet international standards, circuit breakers were installed for trading on their exchanges. Basically, a circuit breaker is a switch that turns on if the market falls below 5% in a single day. On January 4th that happened, and the response was panic as people couldn’t get their money out. On January 7th, the market only opened for 30 minutes before the breaker got turned on by a greater than 5% fall. After all the negative returns in Chinese markets the past several months, the inability to get their money out caused people to panic sell.
What Does This Mean For You?
I view the weakness in China as a buying opportunity, but not necessarily for the country. The unreal strength of the dollar right now and the further collapse of oil prices after the Chinese market weakness make Emerging markets and oil stocks attractive right now. Of course, I’ve had this strategy on for a while now and have been losing money all the way down, but I’ve been buying more at least.
Remember that markets always have less risk when they’ve fallen in value because you start from a lower price point. If you can buy at a lower price, then naturally that’s better than a higher price. What’s funny is that most individual investors behave in the opposite manner. In April of 2015, the Vanguard Emerging Markets ETF VWO was almost at $45 a share. Today it’s at $30 a share. A diversified basket of stocks across multiple nations and industries is way more attractive at $30 a share than $45 a share, while the same thing can’t necessarily be said for an individual stock.
There are two things that can happen right now. 1) The Chinese markets continue to crash even in the face of a determined government effort to prevent this and the contagion spreads to oil, US, and European markets. In this case we would have another recession on our hands. The recovery in the US labor market seems strong enough to protect US workers from the brunt of this. 2) The Chinese government’s actions as well as the new more reasonable Chinese market valuations calm the market down, the oil producing nations who are being destroyed by close to $30 a barrel oil start pulling back on their production levels, and the dollar finally weakens a little bit providing a return from foreign currency rates as well. I’m betting on scenario 2, and if scenario 1 happens, then I’ll at least have a while to ride out any crisis before I’m forced to go back to the traditional economy.
What do you think about the Chinese stock market? Do you think the government there can prevent further crashes? Should they be this involved in their public market? Comment below!