Chinese Economic Collapse Imminent? How Investors Can Protect Themselves

Chinese Economic CollapseThe benchmark Shanghai Composite Index cratered 6.5% last Thursday on news of a fund dumping several Chinese banks and the raising of margin requirements. But this doesn’t mean we are in store for a Chinese economic collapse. The Great Wall is not falling.

Just like it was in 1987, 2000, and even more recently, Chinese stocks trading in mainland China have vaulted sky-high; driven by easy money, frenzied speculative trading, and the opening of the Hong Kong Shanghai Stock Connect in November 2014.

The Shanghai stock market is up about 50% since March…so to expect a correction is not out of line.

Shanghai Stock Exchange Corporate Index-2015Chart courtesy of www.StockCharts.com

Chinese Economic Collapse Uncertain, But Correction Sure

I wouldn’t be surprised to see the Chinese stock market fall another 10% or more. We are seeing hundreds of thousands of new margin trading accounts being set up in China.

The problem I see is that the investors are neophytes who probably know very little about the concept of proper financial trading or investing. They see the stock market as a virtual Macau where they can bet on the direction of stocks. Better yet, with the odds of winning at 50%, the stock market is superior to playing the slots or card gambling games at the casinos.

From my experience of having travelled to Asia, I can confidently tell you the folks there love their gambling. This makes the rise in the Chinese stock market a speculator’s delight.

The problem is knowing when to jump ship. Based on the market action and what has driven up stocks, I would definitely be lightening up on Chinese positions; especially those that trade in China.

Now, whether China is heading for an economic collapse is another issue. The country is clearly stalling with declines in foreign investment, exports, imports, and overall spending. The result is that the country’s gross domestic product (GDP) has been steadily declining from the golden years of double-digit growth to what will likely be a breach below seven percent either this year or in 2016 if the global economy doesn’t turn higher.

The Chinese government has slashed its projected GDP growth target to seven percent for this year. Of course, whether the number is accurate is a whole different story. My thinking is that the Chinese economy is probably already growing at the six percent level.

The government is lending hundreds of billions of dollars on infrastructure projects, some of which are questionable, in order to stave off a hard landing. But this cannot last. Consumers will need to pick up their spending to drive GDP—a strategy the government is trying to push.

What to Do Given the Chinese Market Froth

Longer-term, I remain bullish on China. Shorter-term, I’m wary.

Risk management is no different with domestic versus Chinese stocks. Lighten your load and say sorry to some profits.

You can also establish a put hedge on Chinese stocks or on the Shanghai market via direct trading on the index, or via puts on domestic exchange-traded funds such as the iShares China Large-Cap ETF (NYSEArca/FXI).

Note that this strategy is only meant for illustration and not as specific advice.