Tuesday, July 7, 2015

Meanwhile In China...

We've touched on the wild move in Chinese stocks several times over the course of the last year and most recently highlighted the 28% drop in the Shanghai Composite Index from its June 12 highs. The tweet above, by Josh Brown of Ritholtz Wealth Managment, illustrates just how active Chinese authorities have been in their efforts to stem the slide in stocks.

The Wall Street Journal noted this morning:

"Chinese stocks fell Tuesday, casting doubt on the government’s ability to stem the slide.

Over the weekend, Beijing took its most aggressive action yet to boost its markets, suspending initial public offerings and lending cash to investors to buy stocks. China’s brokers vowed to buy shares until the Shanghai Composite hits the 4500 level.  But the market fell 1.3% Tuesday to 3727.12, putting it down 27.9% from its peak and 17.2% below the promised 4500 level. More worrying is that the market performed worse than the index makes it seem.
China’s smaller Shenzhen stock market fell for the second straight day, putting it down 5.3% for the week while the ChiNext board, composed of smaller cap stocks, and dropped 11.2% to 2352.01. Both indexes are off more than a third from June highs..."
As a result of the near non-stop selling that's taken place in Chinese equities over the last month, we've seen the US traded FXI etf retrace the entirety of its near 30% YTD gain through April and now go negative on the year.

To be fair, the FXI is basket of large cap Chinese stocks that trade on the Hong Kong stock exchange and not indicative of the entire Chinese market.  In fact, even though the Shanghai Composite is down nearly 30% in last month, it's still up over 80% over a the last year.

So while their market whips around and China's government attempts to get order (aka the uptrend) restored, we thought that finding some historical perspective in which to place this market action would be helpful. Fortunately, the New York Times offered just that in an article yesterday by Neil Irwin.  As it turns out, the meteoric rise and subsequent plunge in Chinese stocks isn't all that out of the norm.

Per Irwin:
"The data, though, suggest that the market declines thus far aren’t as outlandish as the Chinese government seems to think. The Shanghai composite index began an upward tear in late 2014, soaring 151 percent from the start of July last year to the June high…
As it turns out, if you look at a slightly longer time horizon, the kind of volatility in Chinese stocks witnessed over the last year isn’t that uncommon. The 2010 to 2013 period was more aberration than trend in the steady, consistent rise in prices."

He goes on to illustrate (citing Bloomberg) just how much more volatile Chinese equities have been relative to an index of global stocks over the last decade.  They saw incredible volatility in the 2007-2008 boom/bust cycle and then several times again after the 2009 bottom. Partly to blame, he says, is the Chinese stock market being less developed than its counterparts and the companies that do actually list on a Chinese exchange commonly have questionable business models and accounting protocol.

Lastly, Irwin asserts that this most recent rise and crash was also brought on by a dramatic increase in investor speculation.  As stocks exploded higher, they were not accompanied by an increase in company earnings.  This led to the p/e ratio of the Shanghai Composite going from a very modest 10 all the way up to 26 and back down to where it sits now at 19.  At the same time, the Chinese economy has slowed from the unsustainable double digit growth of the mid to late 2000's to settle in the 7-8% range in recent years.  This is not necessarily the backdrop that warrants a doubling of any stock market.  However, when spurred by lowered interest rates and quantitative easing a market  of eager investors can move beyond reason.

We'll be watching to see what, if any, policy response by the Chinese government can help to ease the current rout in stocks.  Until then, investors over there are likely to feel further pain as forced margin calls and trading halts mount by the day. 

Ryan Worch is the Managing Director of Worch Capital LLC. Worch Capital LLC is the general partner of a long/short equity strategy that operates with a directional bias and while emphasizing capital preservation at all times.

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