Chinese Market Crash: Opportunity or Disaster

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On July 8th I spoke with Charles Payne about the Chinese market crash and what it means for investors.  Much of the pullback has been by actions taken by China’s government, starting in January, to reign in what was viewed as excessive use of leverage in the equity  markets.

Frankly, most investors having anything to do with China should do so in a limited fashion or a small portion of the overall portfolio and view it as a trade. The reality is that China is and will be for the foreseeable future highly volatile for many reasons. Most importantly, it is a decidedly opaque market. While the nation’s leaders are giving ample lip service, and may be quite honestly working to improve the veracity of financial reporting, it still has a long way to go. It is very difficult to consider, at least from this far away, money put into Chinese shares an actual investment in part because it is tough to have a high level of confidence concerning the value of the underlying company when confidence in the validity of the information reported is at best questionable.

Second, unlike most other major stock markets around the world that are dominated by professional money managers, retail investors account for around 85% of the trades in China. According to The Economist, almost 8 million new retail trading accounts were opened in the first three months of 2015 alone. In April regulators increased the number of accounts an individual can hold from 1 to 20, which led to a whopping 4 million accounts being opened on average every week since then! On top of that, during the 2007 market crash, Chinese investors were not able to buy shares on credit. Over the past few years, rules were relaxed such that officially a 2-to-1 leverage ratio was allowed, although with some creativity, investors could manage much more leverage.

Since the beginning of the year the government has taken multiple steps, such as increasing cash requirements for margin accounts and placing restrictive controls on attempts to circumvent rules around the use of leveraged trading to reign in what it feared was excessive leverage, culminating in a move on June 12th to again tighten controls that started the profound sell off. Since then the government has reversed course by taking steps ranging from reducing the amount of cash required for margin accounts to pushing government owned companies and their executives to actively buy shares in order to halt the slide. The future inclusion of Chinese stocks in emerging market indices will undoubtably increase demand over time, which will be a tailwind to stock prices, but investors would be well served to expect any investments in the nation to be highly volatile and most definitely not a core portfolio holding.

 

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