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Swimming Naked

Posted on August 4, 2015

"Only when the tide goes out do you discover who's been swimming naked." - Warren Buffett

2015-08-04_chinese_stocks.pngUnless you’ve been living under a rock or have absolutely no interest in financial news, you have probably heard some mention of the violent sell-off in Chinese stocks over the past couple months. The recent weakness in Chinese stocks is on the back of a strong bull run where stocks more than doubled in a little less than a year. The shift in sentiment and price has prompted the hand of the Chinese government to take extraordinary measures in order to curb the sell-off. The current drama unfolding in China has many of the same characteristics of a classic bubble (see Dutch Tulip Mania, the Roaring 20’s, or the Internet Bubble as a couple examples), but with a couple key differences that may end up creating some long-term repercussions for China.

Although China is considered an “emerging market” its stock market is second only to our own in size. It is also a highly active market with more than four times the volume in a given day versus the NYSE. On average, around 3% of the entire Chinese stock market exchanges hands on any given trading day, compared to 0.3% for the NYSE. The market is also dominated by small, retail investors which account for 80% of the market compared to developed markets in the US, Europe, and Japan which are heavily skewed toward large institutional investors. In essence, the Chinese stock market is a compilation of small investors, many of which lack experience and education, with short time horizons that frequently trade stocks. The end result is a market driven almost entirely by shifts in sentiment and momentum, which acts more like a casino than an investment vehicle.

With that setting, it is easy to see how small marginal changes in policy or sentiment can create big waves in a nation of 1.4 billion people. Such was the case a little over a year ago when Chinese authorities liberalized some of the laws governing margin trading and IPOs (initial public offerings). Further setting the stage, the Chinese government had also just successfully orchestrated a “soft landing” in Chinese property prices by passing laws and regulations which limited the number of properties each person could own as well as tightening lending standards and levying a new tax. The success of the government intervention in the property market did two things: 1) it pushed investment capital out of real estate in search of the next hot investment, and 2) it gave the impression that the government would backstop bubbles in Chinese assets.

The faith in the Chinese government combined with easy money in the form of margin set the stage for one of the more impressive run-ups in stock prices in recent history. Small retail investors couldn’t borrow money fast enough to buy Chinese stocks as the two Chinese exchanges increased 135% and 150% in less than a year. The dramatic increase in stock prices was heralded by the Chinese authorities as the realization of President Xi Jinping’s rhetoric of the “Chinese dream” – a broad notion that promises power, wealth, and well-being to Chinese citizens. The People’s Daily, which is the official paper of Communist Party, ran articles trumpeting the rise in stock prices stating that it was “only the start of a bull market” while nonchalantly asking “what’s a bubble?” then answering their own question by stating “tulips and bitcoins are bubbles.”2015-08-04_banana_stand.jpg

Reports surfaced of Chinese workers and farmers quitting their jobs in order to day trade the red hot Chinese stock market.  Look no further than the embedded photo which was taken in April. I think it is safe to say that when the banana salesmen is trading stocks from behind his cart, you are in the froth of a stock market bubble. At the peak, a total of $365 billion was borrowed in margin accounts, a fivefold increase from the prior year, in order to plow more money into Chinese equities. Chinese IPOs would go public and their share prices would increase by thousands of percentage points in a matter of weeks. Chinese stocks were bid up to an average P/E (price-to-earnings) multiple of 70 versus the worldwide average of around 18.

Perhaps the best indicator of how the Chinese stock market was being fueled by local speculators was the divergence between the A-shares and H-shares. For some background, A-shares are stocks that trade in Shanghai and are primarily held by local, Chinese investors. They are also the only shares of stock available to mainland Chinese investors. On the other hand, H-shares trade in Hong Kong and are open to non-Chinese investors. As the chart below shows, the run up in A-shares has dramatically outpaced that of their H-share counterparts as measured by two US traded ETFs which track each index.

2015-08-04_Chinese_Stocks.png

Like all good bubbles, the Chinese one eventually burst in the middle of June right around the time that MSCI decided not to add Chinese A-shares to its emerging market index, which is the most widely invested EM stock index (it is doubtful that MSCI’s decision actually popped the Chinese stock bubble, but it is interesting none-the-less). As everyone’s favorite and highly quotable stock market maven stated in the opening quote, it is at these points of inflection when the “tide goes out” that you discover who has been “swimming naked.” With so much borrowed money in the system, there were plenty of “naked” Chinese investors which were quickly wiped out by the dramatic shift in sentiment and price. The outcry was loud as Chinese investors looked to the same savior that orchestrated the soft landing in the real estate market and had championed the rise in the stock market…the Communist Party of China.

The response by China’s leadership was swift and wide reaching. Over the course of a little over a month, the Chinese authorities implemented the following:

  • Cut interest rates to record low levels and lowered reserve requirements for some lenders
  • Issued a moratorium on all IPOs
  • Implemented a six month freeze on sales of shares held by company directors and large shareholders
  • Ordered state-owned enterprises (SOEs) not to sell shares
  • Created a “market stabilization fund” of $19.3 billion to purchase stocks
  • Relaxed margin rules to allow pension funds and SOEs to buy stock
  • Ordered brokerage houses to buy stock on their own books
  • Lowered trading fees
  • Passed new laws to make short selling much harder and riskier

The amount of government intervention in the Chinese stock market over the past two months makes the actions of the Federal Reserve over the past five years look like child’s play. The Chinese government probably felt that their creditability was at risk with a rapidly declining stock market, so they made the risky choice to do whatever it took to try to stem the tide. To date, some of their intervention appears to have stopped the bleeding, but for how long and at what cost?

In the past, President Xi has publicly declared that China’s economic success hinges on the ability to let market forces play a greater role in the allocation of resources. In other words, China will only gain the support of other developed nations if they start conforming more to the western standards of commerce and free markets. Unfortunately, this wisdom went right out the window when “what is best for the country in the long-term” ran smack dab into “what feels best right now” (a common problem in all leadership decisions). Whether or not the moves by the Chinese authorities will end up saving the day remains to be seen, but in doing so they have most likely pushed back the timeline on being fully embraced by western investors. The recent response of China’s leaders to the stock market crash is characteristic of a much larger issue facing China – how does a nation fuse communist beliefs with free-market economics? The answer will quite possibility determine China’s future prosperity.  


elliott_headshot_bw.jpgAuthor Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.


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