Why Chinese Stocks May Need to Fall Another 20%

China stock market abstract
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Barely a week into the New Year, 2016 is already shaping up as a bigger and better sequel to 2015 for stocks. Only that, instead of watching a feel good flick, it better resembles something out of a horror film.

Sharemarkets haven’t so much hit the ground running, as they’ve run into the ground. ASX shares have plunged for five straight sessions. On Thursday alone, the ASX200 lost 2.2%. The All Ords finished the day even lower, down 2.1%.

Spates of unwelcome milestones were reached. It was officially the worst start ever to a year on the ASX. In the space of a single week, it’s tumbled 5.4%, shedding $78 billion. Not since August 2011 has there been a week like the one just past. And there’s still a whole day of trading to go.

At this point, a spell below 5,000 points seems likely, if not probable. Prior to start of Friday trade, the ASX200 was suspended above this threshold at 5,010 points. As of 11am AEST, the market was down almost 1%, to 4,973.

However you look at it, there’s a sickness in financial markets around the world. And there’s no better example than China.

We’ve already seen numerous futile attempts by Chinese policymakers to stem the tide of market panic. Following the massive selloffs that began in June last year, they’ve been hard at work halting the procession of losses. Yet their success has come in fits and spurts.

The second half of last year saw little respite for Chinese investors. From a high of 5,166 in June, the Shanghai Composite Index (SCI) dropped to 3,092 points. By September of 2015, the SCI had shed almost 41% of its value. It took just four months for the carnage to unfold.

Of course, it’s important to view this decline in the context of the SCI’s meteoric rise.

As recently as October 2014, the SCI was only at 2,420 points. It doubled in size in less than a year. Despite the recent selloffs, the SCI is still some 600 points better off than it was 14 months ago.

Unfortunately, knowing that doesn’t make the selloffs any less painful. That’s especially true given the impact they’ve had in dragging down global markets as well. Instead, all it does is show that markets have fallen as quickly as they rose.

The artificially driven stock market

The sheer rate of collapse across Chinese markets suggests most of the growth was artificial. At the very least, we could say that it was orchestrated. In other words, markets rose as they did because they had no other choice. Everything was geared towards it. How?

Prior to the start of the stock boom in 2014, Chinese policymakers had other worries. They were fearful about expanding the already large housing bubble. They wanted to get people out of property, and into something else. They persuaded people away from the property market. They promoted getting rich through stocks, and it worked. Playing the markets became fashionable. A get rich quick scheme of sorts that everyone wanted a piece of.

It became so widespread that it spawned a whole movement. Everyday mum and dad investors, with no prior experience or exposure, were buying shares. Trading accounts boomed. A month in which 3 million accounts were opened was ‘average’.

There’s a great image that illustrates the speed at which this played out. This picture shows a man tending to his banana stall. And right next to his bananas is a computer tracking the ebbs and flows of the markets.

It’s no surprise then that Chinese stocks grew as quickly as they did. And, as the evidence suggests, they grew too big for their boots. Stock prices grew rapidly, despite no obvious reasons for doing so. Company earnings and profits simply didn’t match up with rising valuations.

Some correction was necessary. And with the SCI losing 41% in four months, it got exactly that. But we have to wonder whether Chinese markets remain overvalued.

Is there scope for further selloffs in the coming months? In all likelihood: yes.

The government can try to control markets as much as it likes. But it can’t, and won’t, fix the underlying problems. It can place all kinds of stop gap measures. But these are temporary repairs, not solutions.

It’s worth remembering that, between 2011 and 2014, stock market activity was largely stagnant. The SCI never rose above 2,500 points. It traded in a band between 2,000 and 2,500 for three years.

Then, overnight, it doubled in size. You can’t call this organic growth. It was the perfect meeting of two factors that helped fuel the rise of Chinese stocks.

The rush of millions of new investors was one side of the coin. At the same time, China’s the loosening of monetary policy made a huge difference. As interest rates fell, the system was flushed with new credit. Since 2012, interest rates have fallen by 2%, to 4.35%. Not surprisingly, the volume of market activity rose as it did. Easy credit will always find a home in riskier assets like stocks. And China proved no exception to the rule.

Relaxing of capital controls could push Chinese stocks lower

Already this week we’ve seen trading halted twice in China. These came as a result of a new round of yuan devaluations. The People’s Bank of China cut the yuan’s reference rate by the largest margin since August this week.

Because of this, the stock market ‘circuit breakers’ were triggered. These are mechanisms designed to stop markets when stocks plunge too quickly. The system halts trading for 15 minutes in the event that losses amount to 5%. And it suspends trading for the day if losses hit 7%. When the CSI 300 index lost 7% on Thursday, trading came to an abrupt end.

The effects of this snowballed across the globe. European markets were down by roughly 2%. The S&P500 shed 2.37%, with the Nasdaq down over 3%. The ASX200 lost 1.3% on the back it.

According to reports, the circuit breaker system is itself being suspended. That’s because officials now believe it causes more harm than good. And they’re right on that one. The system only appears to confuse things, adding unnecessary fear in the markets. On top of which, capital controls won’t help attracting foreign investors into China. Which is something that China takes seriously. It’s slowly opening up its markets to outsiders. But gaining the trust of international investors will involve more transparency. And it means capital controls have to go.

The end of the circuit breaker system won’t solve the underlying issues though. Nothing can stop Chinese policymakers from pumping money indirectly into stock markets. Policymakers can, and probably will, continue to flood the system with credit. And that likely includes injecting capital in troubled sectors and companies.

However, if recent rate hikes, alongside lower banking capital requirements, haven’t worked so far. Chinese markets fell off a cliff despite the creation of a vast amount of new credit. what’s going to change in the future? In all likelihood nothing will.

The promise of further assistance might stem the flow of market panic across Chinese markets for a few weeks. But it can’t hold it back forever.

So where does the market go from here? We have a couple of guidelines that might show us a likely future. One of these is the valuation of the SCI prior to the boom. The index would need to fall another 20% to reach the point it was last at in 2014. And that might be where it ends up.

Ultimately, Chinese investors still have a lot of growing up to do. They’re still finding their feet in the stock market. The recent boom, and bust, is a sign of the naivety that runs through its market. Yet as they mature, Chinese markets will settle into a more typical rhythmic pattern that we see elsewhere.

Until then, it might be necessary for the correction to take them back to square one.

Either way, you suspect we haven’t seen Chinese markets hit their nadir. When George Soros says he sees echoes of 2008 for the coming year, you can see why another 20% decline might not be so crazy.

Mat Spasic,

Junior Analyst, The Daily Reckoning

PS: Like Chinese markets, the ASX hasn’t had a great week to kick off the new year. Unfortunately, 2016 may not provide any respite for investors.

The Daily Reckoning’s Vern Gowdie says we’re heading towards a much larger crash.

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

Vern wants to help you avoid this coming wealth destruction. His special report, ‘Five Fatal Stocks You Must Sell Now’, will show you how. In it, Vern shows 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.

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