The Chinese stock market is extremely vulnerable to additional episodes of selling. In the process, this could lead to a Chinese economic collapse in 2015 or 2016.
A few weeks ago, I discussed the real threat and contagious impact of a bigger correction in the Shanghai Composite Index (SSE), which had been down 32% but has since rallied to a 22% drop. The Chinese government is going all-out to try to save the Chinese capital markets from collapsing. This includes ordering the country’s 21 largest brokerage houses to buy stocks. There are also about 25% of Chinese listed stocks frozen and not allowed to be traded.
The artificial support appeared to be working, but I truly doubt it will be sustainable. In fact, I do not support the use of artificial mechanism in the stock market to the same degree the Chinese government is using. The NYSE employs some safety features that prevent a quick sell-off. But what China is doing is completely different. Beijing should allow the natural forces of supply and demand in the stock market to take place to determine the trading level.
The Problem with China
The problem is the government was a big reason for the initial 140% run-up in SSE in less than a year and is now scrambling to correct its error. What the government did was encourage investors (including those with no knowledge of how stocks function) to invest in Chinese stocks and support the country’s objective to create wealth and drive consumption.
Sounds great. But making margin finance interest extremely low and not honestly telling neophyte investors (including farmers, laborers, and other low skill jobs) about the risk in buying stocks was simply wrong. I’ve heard stories of investors losing their entire life savings betting on stocks to move higher. Many also ended up with massive margin debt.
It’s not Vegas or Macau. The stock market is not an online gambling venue as tens of millions of Chinese investors may unfortunately be led to believe. The fact that there is legally no gambling allowed in China outside of Macau makes the stock market more attractive as a venue for gamblers.
To make matters worse, no shorting is allowed along with limited derivatives. This means that as a mainland Chinese investor, you cannot set up hedges to protect against downside weakness. The mechanics of the Chinese stock market are not conducive to fair trading.
How the Downfall of Chinese Stocks Will Cause a Chinese Economic Collapse
It doesn’t take a genius to realize that the trillions of dollars vaporized in the Chinese stock market will drive lower consumer consumption. This will not be good for the government’s push to drive domestic spending as a way to grow the Chinese economy.
Additional downturns in the Chinese stock market will only make things worse.
The chart of the SSE from 2005 to the current is scary. Note that the superlative surge in Chinese stocks from 2006 to a peak in 2008 that was accompanied by rising relative strength and moving average convergence/divergence (MACD) as reflected by the circles. We then witnessed a subsequent crash from 2008 to 2009.
Fast forward six plus years and the chart shows a frightful resemblance to another period as indicated by the circles: we saw a superlative rise from mid-2014 akin to the 2006-2008 moves. Note the weakness in the current relative strength and possible MACD reversal on the horizon.
Chart courtesy of www.StockCharts.com
If I were a Chinese investor on the mainland, I would be looking to get out before the potential crash. Of course, investors on this side of the Pacific can employ put options or shorts on vehicles such as the Deutsche X-trackers Harvest CSI300 CHN A (NYSEArca/ASHR).