Pulling the Reins on China’s Market

Markets around the world started 2007 with gains. In China, the benchmark Shanghai Composite Index continued to trend higher and was up over 9% in January to a record high of 2,975.13 on January 24. But, compared to a 130% surge in 2006, 9% wasn’t much of a surprise.

That said, the Shanghai Composite Index fell about 5% in trading on January 31, the largest one-day decline in eight months’ time, as valuation concerns surfaced amid the strong upward trend that has driven Chinese stocks to such highs. Now, the selloff shouldn’t be a surprise, as the index has been on a steady and impressive uptrend since breaking above its 50-day moving average in early September 2006.

The chart currently shows some topping with resistance at 3,000, with the potential of a bearish double-top formation. In all possibility, we could see some additional near-term selling to as low as support between 2,600 and 2,700, a decline of 3% to 6.8% from current levels. Failure to hold here could see a move to the 50-day moving average at 2,449. It would represent a minor correction, which is always healthy in a strong bullish market.

The selling in the market was also driven by bearish comments from the Shanghai Stock Exchange and other regulators on the risk of the market at current levels. The regulators clearly are trying to avoid a stock market bubble in Chinese-listed stocks.

Moreover, the China Securities Regulatory Commission has taken a step to try to rein in the stock market’s acceleration by suspending the launching of about 10 new mutual funds for a few months. The amount of capital under management at mainland mutual funds has more than doubled over the past six months to over US$110 billion, a reason for the strong market performance in 2006.

New funds have been delayed to prevent stocks from driving higher as new funds in China are required to begin buying stocks within a 10-day window after launching, which could help move the markets.

In the long term, I continue to like Chinese stocks, but be careful in the short term, as there could be more selling. Of course, selling in US-listed Chinese stocks could be impacted, although the selling will be to a lesser degree than stocks on Chinese exchanges.