“The lofty pine is oftenest shaken by the wind, high towers fall with a heavier crash, and lightning strikes the highest mountain first”
Over two millennia have passed since these words were written but perhaps we could all have benefited from heeding their author Horace as June 12th proved to be a day of further positive gains for the Shanghai Composite Index as it closed at 5166.35, up over 250% on the year marking the strongest market rally since October 2007. Q2 results would soon be published indicating record growth in the Asian equity markets as a group, catapulting the region to second only to the US in global market share, a portion of the pie to which China contributed $18tn by the end of May.
Other comparisons with US equity markets should have been higher on Chinese regulators’ agendas, specifically how the median stock on the SCI was trading at 82 times earnings whilst price-to-earnings ratios for US counterparts averaged 21. More importantly, by the start of June almost 80% of the investors involved in Chinese equity markets were speculative ‘retail’ investors, a type of investment that is typically highly leveraged and exhibits ‘herd-like’ behaviour, following the ebb and flow of the consensus surrounding the market.
A three-year bull run that led to inflated valuations and colossal market margin debt meant many had already predicted that the dragon bubble would burst, but few knew it would be now. That included the People’s Bank of China that found itself with an impossible choice; to honour its recent market reforms and allow the equity markets, as they had outlined, to correct themselves with possibly devastating consequences, or risk a legitimacy crisis and intervene to the extent only a command economy could.
From Bull to Bear
Alarms went off towards the end of June as all three major Chinese equity indices tumbled, the SCI posting a 7.4% drop on the 26th June. The PBOC took action over the weekend, cutting interest rates by 25 basis points and suggesting reserve ratio requirements for institutions may be cut. It was to no avail, as Monday saw the SCI drop a further 3.3%, overshadowed by a collapse in the Shenzhen Composite Index of 6.1%. The MSCI Asia Pacific Index sported 16 times as many stocks down as it did those gaining and even the Japanese Topix Index fell 2.5%. An exodus of leveraged investors from the market was driving panic selling and battling the PBOC’s efforts to bring the market back under control. Volatility went through the roof as the 10-day average hit its highest level since 2008, and the next day saw the biggest intraday swing on the SCI since 1992 (432 point move) amidst speculation of further government intervention.
High levels of margin trading create multiple problems for regulators, the first of which is the exaggeration of market swings as these retail investors co-ordinate their purchase and sale of stock with a ‘herd’ mentality, any sudden change in the market can snowball into something far bigger. When margin levels are $358bn as in China, you are at the mercy of the herd.
More importantly for regulators, vast leverage usually comes hand in hand with overpriced valuations. The Chinese equity markets sported some stocks trading at 82 times earnings, an unsustainably high level. The Chinext 100, a small-cap-heavy index similar to the NASDAQ lists many of the stocks that led the rally of the Chinese equity markets. By the 7th of July it had dropped 37% of its total value and yet its mean stock traded at 48 times earnings, compared to an average price-to-earnings ratio on the NASDAQ of 22.
By the 7th of July, just over three weeks since the indices peaked, the stock rout had cost Chinese equity markets $3.2tn, a value greater than the total market capitalisation of the Australian Securities Exchange, to approach $4tn by the end of that week.
Market Economy or Command Economy?
The PBOC faced an impossible choice, but it placed itself in a difficult position the moment it allowed margin levels to rise so high. Its choice to intervene as strongly as it did is controversial, and has left many concerned the economy and especially confidence in the equity markets will not be the same again for a long time.
The initial cut of 25 basis points was followed by further interest rate cut threats, including the suggestion of an additional cut in Q3, however many analysts suggested a clear and decisive reduction of 1% instead of 4 smaller cuts would have been better, emphasising the PBOCs commitment to supporting the equity market. The first strong move from the PBOC was to suspend IPOs, since these offerings can often draw funds away from current listings and reduce liquidity, however the Chinese markets had 552 companies waiting for IPO approval with 178 IPOs already in the pipeline. Bloomberg estimates the suspension cost was approximately $71.4bn to the market, a drop in the ocean with what we know now.
More aggressive intervention followed, first with the halting of trading as the PBOC froze 1,331 companies by the 8th July and investors found themselves frozen out of half of the market. The 100 listings on the Chinext could be split into two categories, the 50% that had been halted, and the other 50% that were down 6% or more. Across all the Chinese equity markets over and above the 1,331 frozen listings, a further 747 dropped below their 10% daily trading limit so that on the 8th July investors faced a mere 28% of the market. Not content with halting listings the PBOC banned state-owned enterprises from selling listed stocks and went one step further, placing a moratorium on selling for six months for all major stockholders (5% or more). Tom Orlik, Bloomberg’s Chief Asia Economist, displayed concern for the most recent interventions and was not alone in alluding to the level of investor confidence they could possibly hope to maintain after such command economy controls had been put in place. Almost all analysts questioned why investors would return to a market where as soon as market sentiment turned negative they were banned from cutting their losses.
The China Securities Finance Corporation asked the PBOC for 500bn Renminbi to support the market, an amount Michael Every from Rabobank described as pointless in an equity market valued over $6 trillion. Analysts displayed further concern for the long-term solution associated with propping up the stock market with quantitative easing, since at some point the stocks would have to be reintroduced to the system, and as one strategist commented:
“or are they [PBOC] just going to own their own stock market now?”
The Chinese economy, although at a 25 year low for growth, seems to be relatively unfazed by the market instability save for automobile sales, however Chinese officials will have to work incredibly hard to win back the investor confidence they have lost in the last month. The legitimacy of their equity markets must be repaired before they can hope to build back up to previously found heights, and next time let’s hope it is intrinsic value that is built not borrowed, not a bubble the size of Australia. For now, it remains to be seen how long the bear wishes to run rampant in Asia.