Chinese Stocks are Freefalling Again, but Don’t Expect a Crash Just Yet

After three weeks of stability, Chinese stock markets are nosediving once again.

Yesterday, the Shanghai Composite Index (SCI) plunged 8.5%, finishing the day on 3,726 points. The Shenzhen CSI300 didn’t fare any better. It closed on 3,819 points, down 8.6% for the day. The selloffs continued on Tuesday, sending the SCI 100 points lower near close of trade.

This turn of events would be surprising if it wasn’t so predictable. But we should be careful about making any doomsday predictions just yet.

The latest selloffs aren’t a sign that a Chinese collapse is imminent. Despite the losses, Chinese authorities have the power to stop the rot. And they’ll do exactly that.

We’ve already seen authorities act aggressively to prevent recent selloffs. Last month, Chinese markets lost 30% of their market cap in the space of three weeks. The authorities promptly stepped in. Ever since, Chinese stocks have recovered half of the losses they incurred during those three weeks.

But this was only possible because authorities imposed strict market controls. Some of these were:

  • Suspending 700 company stocks from trading
  • Announcing a $26 billion investment plan to buy up stocks through brokerages
  • Lowering interest rates to 4.85%
  • Cutting capital requirement rates for certain lenders
  • Allowing investors to use homes as collateral for stock purchases

The result of all this was a 15% market recovery. At least, that was before the selloffs resumed on Monday.

Why Chinese stock investors are panicking

Chinese markets are tanking because the so-called ‘malicious shorters’ are back.

Short selling is a speculative market instrument. It involves borrowing shares from lenders, then selling them back onto the market. But the trick is to know whether the price of those shares will rise or fall. Chinese sellers are having an easy time of predicting the trajectory of share prices.

When prices fall, traders can buy back those shares and resell them to the lender. The best bit is that they get to pocket the difference. Potentially, it’s a very profitable strategy. But it can also worsen the stability of the market, as it’s doing now.

Why are short sellers coming back now? Westpac’s international economist Huw McKay explains:

I think there’s been some pent-up selling pressure in [Chinese markets] over the last couple of weeks. [This pressure] hasn’t been released due to the very firm hand that the authorities have been holding over that market. But it all got released today’.

The reason why this pressure got release today was because of last week’s economic data.

Last Friday, Chinese authorities announced industrial profits fell by 0.3% year-on-year. The Manufacturing Purchasing Index (PMI) contracted for the fifth consecutive month.

But the relationship between Chinese stocks and the economy is questionable.

The truth is that the stock markets, on their own, have little influence on the wider economy. Writing in the Sydney Morning Herald, Malcolm Maiden explains:

[The] sharemarket is not a crucial source of equity funding for Chinese companies yet. [The Chinese] sharemarket won’t influence the economy.

‘China’s domestic sharemarket market is priced in the local currency and closed to foreign investors. It is dominated by private Chinese investors, backed by margin loans, that are not a large part of China’s overall debt load. [And it’s] not yet a crucial source of equity funding for Chinese companies.

What the stockmarket jitters influence instead is domestic demand. Investors losing money have less of it to spend elsewhere. And that, more than anything, has the potential to dent economic growth.

Authorities to soften the impact of selloffs

Regardless of how bad the selloffs look, authorities will act to snuff this latest episode out in the same way they did last month. They have room to move to stabilise the markets. Whether that means buying up more stocks, or locking sellers out of the market, then that’s what they’ll do.

The China Securities Regulatory Commission indicated as much today. They said they’d continue to provide stability to prevent ‘systemic risk’.

Eventually, though, this problem will need to play itself out. Chinese stocks remain overvalued, even with all the selloffs. The average share price is still far in excess of its expected P/E ratio.

One way or another, stocks will need to correct themselves back to pre-2014 levels. What the authorities are doing now is postponing the inevitable. Maiden explains:

Even if Beijing does step in and manage to stabilise the domestic market…it will only be a step along a longer path.

‘If the market is stabilised, selling will be deferred, not eliminated. Selling by individual investors hit by margin calls on debt funded share [still needs] to be completed. About two-thirds of that process is complete on Goldman’s estimate’.

All of which is to say that further selloffs are a certainty. Just don’t bet against authorities putting it off as long as possible.

Mat Spasic,

Contributor, Markets and Money


PS: In the long run, the fallout from a Chinese market crash will have big repercussions for Australia. As domestic demand falls, so too will China’s need for our resources. Materials are the second largest sector on the ASX, and they’ll take a hammering when this happens.

The Daily Reckoning’s Vern Gowdie predicts a major correction for the ASX in the future. Not only does Vern predict a major crash, but he’s convinced the ASX could lose as much as 90% of its $1.8 trillion market cap.

Vern is the award-winning Founder of the Gowdie Family Wealth advisory service. He’s been ranked as one of Australia’s Top 50 financial planners.

He wants to help you avoid this coming wealth destruction. That’s why he’s written ‘Five Fatal Stocks You Must Sell Now’. As a bonus, this free report will show you which five blue chip Aussie companies could destroy your portfolio. You almost certainly own one of them. To find out how to download the report, click here.

Markets and Money offers an independent and critical perspective on the Australian and global investment markets. Slightly offbeat and far from institutional, Markets and Money delivers you straight-forward, humorous, and useful investment insights from a world wide network of analysts, contrarians, and successful investors.

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