Top Four Reasons That Explain The Chinese Stock Market Bubble

Published on 11 Aug, 2015

Chinese Stock Market Analysis

How would you envision a bubble of epic proportions? Consider this: in the last 12 months, the Chinese markets created value enough to give each individual on the planet about $900. During this time, China’s steep stock market climb created US$6.5 trillion in value. It was roughly about 70% of China’s GDP in 2013, or about 40% of the New York Stock Exchange’s total value. In fact, it was enough to pay off Greece’s debt 20 times over. No other stock market has ever grown in this proportion in absolute dollar terms across a 12-month period.

This unimaginable propulsion has taken the play far beyond the fields of individual investors. Most companies in China have been finding stock investing an attractive option as the economy is struggling with weaker demand, excess industrial capacity, persistently high borrowing costs, and more. According to WSJ reports, 97% of the growth in Chinese manufacturers' profits now has been stemming from day trading. Manufacturing companies in China have been shutting down their operations and putting their cash in the stock market, with the hope to make some profit.

And then the inevitable happened. The Chinese stock market is in a free-fall mode, with the Shanghai Composite Index 40% down since June 12th, 2015. The margin trading turmoil has shifted and could be equal to 6 trillion Yuan (U$970 billion) of borrowed money into the market, putting an equivalent of nearly 10% of China’s GDP at risk.

Here are the four reasons for the Chinese stock market bubble:

1. Leveraged Investing: Relentless Borrowing

One of the main reasons for the mayhem is that millions of Chinese citizens have borrowed money and poured their cash into shares, which inflated prices to unjustifiable levels. When prices began to dip, these investors were forced to sell shares in order to repay the borrowed money and cover losses. The vicious circle of selling is creating panic and further pushing down prices.

According to China Securities Depository and Clearing Co, the equity market currently has more than 90 million individual investors. Most companies whose share prices were rising were not actually improving; the prices were on the upward swing because demand was high and people were bidding relentlessly.

Most retail investors were investing in shares beyond what they had to invest by using their money as collateral to borrow more money-a phenomenon termed as leveraged investing. In simpler words, China today is experiencing what the US had faced in 1929.

SSE Composite Index

Piling In-Number of new A-share accounts opened

2. Unprecedented Mega Valuations

In Shanghai Stock Exchange (SSE) Composite, about 94 percent of Chinese stocks have been trading at higher valuations than the index. Industry pundits suggest this as a consequence of its heavy-weighting toward low-priced banks. Here, we’d have to use average or median multiples to get a different picture. Chinese shares cost more than thrice than any of the world’s top 10 markets, and almost double of what they were priced at in October 2007 when the SSE Composite peaked.

The Chinese Stock Market Bubble - Projected median

3. Higher Volatility Than S&P

Chinese stock market has always been more volatile than stocks globally because retail participation ranges at about 80% to 90% of trading in the Chinese equity markets. After climbing for months, the mainland exchanges recently witnessed its steepest drop since 2008. In fact, the Chinese stock market has witnessed bigger fluctuations over the past 30 days than any other market, except Greece.

Higher Volatility Than S&P

4. Disconnected Chinese Stock Market And The Real Economy

Strangely enough, the stock market bubble still exists despite poorly performing Chinese economy. Its GDP, in the first quarter of 2015, grew by just 6% Y-o-Y, the slowest since 2009. Imports, retail sales and investments have also declined.

The slowing economy and surplus supply in some cities have caused a price slump in the property market, which has long been considered a safe and reliable investment option for Chinese households. Hence, there’s a major shift of investments from property to the equity market.