Re­al­ity pays a visit to China’s stock mar­ket

▶▶It’s not just clumsy trad­ing rules that have made the main­land’s stocks so risky ▶▶“They’re try­ing to prop the mar­ket up above sus­tain­able val­u­a­tions”

Bloomberg Businessweek (Asia) - - CONTENTS - −Zeke Faux and Bloomberg News

“This is in­sane,” said Chen Gang, chief in­vest­ment of­fi­cer for Shang­hai Heqi Tongyi As­set Man­age­ment, on Jan. 7, the day stock trad­ing in China lasted only 29 wild min­utes be­fore mar­ket cir­cuit break­ers shut it down. Un­like some would-be sellers that day, he says he un­loaded all his firm’s equity hold­ings by the time the exit door closed. The cir­cuit break­ers, put in place just a few days be­fore, called for an all-day trad­ing halt if shares dropped 7 per­cent.

Those rules have taken much of the blame for China’s lat­est mar­ket chaos. The China Se­cu­ri­ties Reg­u­la­tory Com­mis­sion said they had a “mag­net ef­fect”—as shares fell, peo­ple may have rushed to get sell or­ders in while they still could, pulling prices down to the trig­ger point even faster. (An­nounc­ing last call to a bar full of drinkers tends not to en­cour­age mod­er­a­tion, ei­ther.) The fo­cus on poorly de­signed trad­ing curbs may, how­ever, dis­tract from a less ex­otic source of risk: spec­u­la­tion.

The me­dian stock on main­land ex­changes still trades at about 57 times earn­ings—at least twice as ex­pen­sive as any other ma­jor mar­ket. (Lead­ing China stock in­dexes don’t look nearly so pricey but are weighted to fi­nan­cial com­pa­nies, which tend to carry lower val­u­a­tions.) In spite of cur­rency in­sta­bil­ity and con­cerns about slow­ing eco­nomic growth, in­vestors are treat­ing the typ­i­cal Chi­nese com­pany as if its po­ten­tial is some­where be­tween that of Google and Face­book.

A boom in ini­tial pub­lic of­fer­ings made parts of the stock mar­ket look more like a lot­tery. Shares of Bei­jing Baofeng Tech­nol­ogy, a de­vel­oper of on­line video play­ers, soared 4,200 per­cent in 55 trad­ing days af­ter go­ing pub­lic on the Shen­zhen stock ex­change in March. (The stock then dropped 31 per­cent be­fore sus­pend­ing trad­ing in Oc­to­ber.) With the mar­ket crowded with novice retail in­vestors, other com­pa­nies sim­ply re­named them­selves to look like tech stocks, re­call­ing the 1960s “tron­ics” and 1990s dot-com booms in the U.S. “There are stocks that are ba­si­cally junk, but they’re trad­ing at out­ra­geous val­u­a­tions be­cause there’s a lot of mar­ket ma­nip­u­la­tion,” says Jian Shi Cortesi, a money man­ager at GAM In­vest­ment Man­age­ment in Zurich. “The way down is al­ways very volatile.”

China’s stock mar­ket didn’t used to be so ex­cit­ing. Un­der Pres­i­dent Xi Jin­ping’s ad­min­is­tra­tion, ar­ti­cles in state-run me­dia en­cour­aged peo­ple to in­vest, fos­ter­ing a be­lief that the govern­ment

would make sure ev­ery­one prof­ited. The bench­mark CSI 300 in­dex climbed 150 per­cent in the 12 months be­fore the mar­ket slide that be­gan in June, and it’s still up 53 per­cent from the start of that run. The na­tion has more than 90 mil­lion in­di­vid­ual in­vestors, com­pared with 87.8 mil­lion mem­bers of the Com­mu­nist Party.

Now retail in­vestors are hav­ing doubts. Hua Jie, a 56-year-old re­tiree in Sichuan prov­ince, says she hasn’t been this down­beat on the na­tion’s stock mar­ket since she be­gan in­vest­ing more than a decade ago. “I no longer want to play this game,” says Hua, a for­mer sales­woman at a con­sumer elec­tron­ics store in Chengdu. “I’ve lost faith in the reg­u­la­tors.”

Many in­sti­tu­tional in­vestors, too, have been quick to bail as mar­kets turn south. Hedge funds of­ten have agree­ments with in­vestors re­quir­ing liq­ui­da­tion if their hold­ings drop below a cer­tain value. That may have helped ac­cel­er­ate the early Jan­uary rout.

China’s se­cu­ri­ties com­mis­sion sus­pended the cir­cuit break­ers af­ter the Jan. 7 shut­down. Pol­i­cy­mak­ers need to “grad­u­ally ex­plore, gain ex­pe­ri­ence, and make ad­just­ment” to the sys­tem, com­mis­sion spokesman Deng Ge said in a state­ment. For­mer U.S. Trea­sury Sec­re­tary Ni­cholas Brady, who’s cred­ited with im­ple­ment­ing cir­cuit break­ers in the U.S., says the prob­lem is that China didn’t al­low stocks to fall enough. In the U.S., trad­ing is halted tem­po­rar­ily af­ter de­clines in the Stan­dard & Poor’s 500-stock in­dex of 7 per­cent and then again at 13 per­cent; trad­ing is sus­pended for the day only if losses reach 20 per­cent. “The right thing to do is widen their band,” says Brady.

So the cir­cuit breaker part of the prob­lem seems re­as­sur­ingly fix­able. Mo­hamed El-Erian, chief eco­nomic ad­viser at Al­lianz, called the tur­moil in China’s mar­kets “self-in­flicted wounds,” ar­gu­ing in a Bloomberg View edi­to­rial that “there are steps the Chi­nese govern­ment can take to en­sure that the pain is tem­po­rary.”

Eu­gene Fama, the No­bel prizewin­ning econ­o­mist at the Univer­sity of Chicago, says there’s lit­tle ev­i­dence that rules like cir­cuit break­ers ei­ther pre­vent or cause volatil­ity. “In panic sell­ing, prices go down, and they bounce back up. I don’t even know that you would want to get around that,” he says.

Xi’s ad­min­is­tra­tion is likely to keep try­ing. The state-con­trolled in­vest­ment funds that the govern­ment di­rected to buy shares last sum­mer—nick­named the Na­tional Team—prob­a­bly spent more than $200 bil­lion on eq­ui­ties in three months, ac­cord­ing to an­a­lysts at Gold­man Sachs. Of­fi­cials even bought stocks to pro­ject sta­bil­ity in the days be­fore a planned 12,000-sol­dier pa­rade in Septem­ber to com­mem­o­rate Ja­pan’s World War II sur­ren­der, ac­cord­ing to peo­ple fa­mil­iar with the mat­ter.

Mar­ket in­ter­ven­tions re­sumed in Jan­uary, with buy­ing fo­cused on shares in com­pa­nies with large weight­ings in bench­mark in­dexes, the peo­ple say. Reg­u­la­tors also ex­tended re­stric­tions, which were just about to ex­pire, on share sales by ma­jor stock­hold­ers. Even so, on Jan. 11, with the cir­cuit break­ers re­moved, stocks plunged an ad­di­tional 5 per­cent. “They’re try­ing to prop the mar­ket up above sus­tain­able val­u­a­tions. That’s the fun­da­men­tal prob­lem,” says Pa­trick Cho­vanec, New York-based chief strate­gist for Sil­ver­crest As­set Man­age­ment Group.

The un­ruly stock mar­ket seems to be giv­ing the Xi ad­min­is­tra­tion se­cond thoughts about its plans to loosen the reins through­out the econ­omy. The govern­ment hasn’t yielded con­trol of the state-run com­pa­nies that led China’s boom or forced them to re­duce their debt. “That sys­tem is go­ing to have to change dra­mat­i­cally, and I don’t know if the govern­ment is go­ing to let it,” Fama says.

The bot­tom line Cir­cuit break­ers may have made China’s mar­ket crash move faster, but fix­ing them won’t put an end to the volatil­ity.

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