China’s Stock Market: Why the Rally Will End

China’s Stock MarketRecently, widely followed investor Dennis Gartman told CNBC that China’s bull market is just getting started. However, looking at the fundamentals, I wonder how long this bull market will last. (Source: CNBC, May 24, 2015.)

Stock Market Flying High

The stock market in China has been going up at a dramatic pace since July of last year. The Shanghai Stock Exchange Composite Index jumped up more than 125% from 2,030 to 4,657 points now.

Shanghai Stock Exchange Composite Index Chart

Chart courtesy of

The Chinese stock market is so hot that government officials are a bit worried it might run out of control. Early in May 2015, one of the Chinese official newspapers, People’s Daily, warned the public, “Don’t forget the risks in a bull market.” It described the stock market rally as “a surging wave of red hot enthusiasm,” and asked people to be aware of the dangers during “the blind pursuit of profit.” (Source: International Business Times, May 4, 2015.)

However, it seems the buying frenzy cannot be stopped. The Shanghai Index gained more than 10% just last week.

Real Economy Facing Challenges

Compared to the soaring stock market, the real economy in China fails to show similar strength.

The Purchasing Manager’s Index (PMI) for China was at 48.9 in April. The PMI is an indicator for the economic health of the manufacturing sector, with readings below 50 indicating contractions. The index has been below 50 for two consecutive months and April’s reading is the lowest of the previous 12 months. (Source: HSBC/Markit, May 4, 2015.)

The challenging situation is not just in manufacturing. The statistics published on May 13, 2015, suggest China’s factory output, retail sales, and fixed asset investment all missed expectations. (Source: CNBC, May 13, 2015.)

Trade data looks even gloomier. In April, China’s exports dropped 6.4% year-over-year. Imports plunged a more dramatic 16.2%. Trade data suggests that demand is weak among China and its trading partners.

To help get the economy back on the growth track, the Chinese central bank has lowered its benchmark interest rate three times in the past six months.

However, it seems that lowering benchmark interest rates is not enough. Despite the central bank’s continuous efforts, the real cost of borrowing is still high for businesses. This is, in part, due to the continuous decline in producer prices. Deflationary pressure puts the real cost of borrowing at around 10%. Yikes!

What It Means for Investors

China’s soaring stock market simply does not reflect the performance in the real economy. Fundamentals suggest that the current rally in the Chinese stock market cannot last forever.

China’s slowdown is not just relevant for investors in the Chinese stock market. A lot of U.S. businesses have operations in China. China also does a lot of manufacturing work for foreign companies. Weak demand in China will pose constraints on future revenue growth for U.S. multinationals. The contraction in its manufacturing sector also implies shrinking business outsourced by foreign companies. Last but not least, trade data tell us that global demand is weak.

Looking around the world, China is not the only country with a high stock market and a slowing economy. In Japan, the stock market is high, in part, because central banks have been buying stocks. In the U.S., investors are rushing to the stock market because the returns on other assets are too low. In the worldwide economic slowdown, investors need to be very, very cautious.