The China bubble

The United States isn't the only place where bubbles form. The Chinese stock market may have just burst its own bubble.

China's Shanghai Composite Index declined 8.5 percent Aug. 24 in what came to be known as "Black Monday," capping off more than a month of decline.

The composite, a key means of measuring Chinese stocks, tumbled 30 percent over a little more than a month, amid a colossal drop to 3,200 from roughly 5,200 as investors exited the market.

It helped fuel global meltdowns, including one in the United States, as other markets mirrored declines, showing that global markets truly are interconnected.

"This is probably the biggest drop in the stock market here since 2007," Drew Bernstein, co-managing partner of Marcum Bernstein & Pinchuk, the Chinese arm of accounting firm Marcum, said of the crash in China. "People are very disappointed. They thought the government would provide more support."

Jesse Mackey, chief investment officer at 4Thought Financial Group, said the Chinese government has long manipulated its markets, buying shares to prop up stocks.

At least initially, the difference may be that the Chinese government didn't step in to cover losses, although China later cut interest rates.

"The markets there are far less liquid. They are manipulated by the government," Mackey said. "They step in and buy when they think it's the right time. They manage it like their own hedge fund."

Although the Chinese market plummeted, potentially helping drag down U.S. stocks, they're very different from U.S. markets in many ways.

Chinese stock markets have grown to be among the biggest in the world in terms of market capitalization.

The Shanghai Stock Exchange rose from a $4 trillion market capitalization at the start of 2015 to more than $4.8 trillion for 1,058 companies by July, according to the World Federation of Exchanges.

The Shenzhen Stock Exchange started the year at $2.3 trillion, rising to $3.3 trillion for 1,696 companies by July.

They are big, but still much smaller than giants such as the New York Stock Exchange, with 2,458 companies and $19.4 trillion market capitalization, and NASDAQ, at $7.5 trillion and 2,803 companies.

They aren't rife with investment by large funds and institutional investors the way U.S. markets are. They're instead primarily a market of individuals.

"Probably close to 85 percent of [the investors in] the market are Chinese," Bernstein said. "In a direct way, it didn't affect many more people, other than the Chinese."

Chinese markets have been growing rapidly, possibly creating a bubble, which burst and possibly spurred concerns in the United States. Money poured into the market, even as the economy slowed.

As many as 170,000 trading accounts were being opened on Chinese exchanges on busy days, according to data from BNP Paribas. Funds were flooding the markets.

"More than 11 million brokerage accounts opened in a year," Bernstein said. "More than two-thirds [of the investors] never finished junior high school. You had a type of trading mentality here similar to penny-stock trading. They trade on what they perceive to be inside information."

Savio Chan, CEO of U.S. China Partners, said recent drops in the Chinese markets followed a run-up that proves what goes up also comes down, rather than revealing a weak economy.

"The Chinese stock market has been rising for the last 18 months tremendously," Chan said.

Chinese markets ran up recently even as companies' performance didn't warrant it, leading some to worry they were overvalued, fueling the decline.

"Although the economy was growing, fundamentals of companies, dividends and earnings were down," Bernstein said." It shows you how far the Asian market has to go before it can be considered a reliable market."

Chinese markets formed a bubble as investors bought on margin, Bernstein said. When stocks dropped, they had to sell to cover their costs. As China built its market, it soon discovered the agony that can accompany the ecstasy of rapid rises.

"You had a combination of a soaring stock market, endorsed by state media and fueled by loose margin lending and credit policies," Bernstein said. "Normally, when you have a bubble, it occurs when the economy is good. People overestimated the matrix."

U.S. stock markets play a major, even central, role in the economy, but many said Chinese markets are less pivotal to the Chinese economy. Americans may misunderstand the role the Chinese markets play in that nation.

"If you look at the overall economy, it's very small," Chan said of Chinese stock markets.

The China bubble, however, got so big that 21 U.S. companies announced plans to delist from U.S. markets and trade on Chinese markets, as stocks there soared.

"The whole thing that drove this made little sense," Bernstein continued. "What drove the market in China? What drove companies to consider delisting from the U.S. to the China market was high valuations. That was the driver of companies back to China."

He believes that recent events could cause U.S. firms to scuttle plans to list on Chinese markets.

"It's going to be interesting to see if the independent directors of these companies need to consider what will produce the best outcome for the shareholders," Bernstein said.

While both U.S. and Chinese markets have fallen, global investors are likely to continue seeking out American stocks. But they may keep away from Chinese markets.

"From the standpoint of U.S. investors investing in China, there's a way to go for that," Bernstein added. "The people you see investing in China are typically [venture capital] and hedge funds that have their ability to do due diligence."

Published: Fri, Sep 11, 2015

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