Rocketing Chinese stocks fall to earth

Investor exuberance in soaring Chinese stocks have been checked by a one-day plunge in the stockmarket.

For most of the last three years, mainland Chinese stocks have gone nowhere. But in the past three months, they have gone beserk. The Shanghai Composite index has jumped by 40% since July and by 32% in the past six weeks.

Turnover on the stockmarket has increased fivefold to over 500 million yuan in the past few weeks. More than one million new stock-trading accounts were opened in November alone.

The boom has "reached outright mania", says Ambrose Evans-Pritchard in The Daily Telegraph. The regulator is rattled. "We hope that all investors, especially small and medium-sized investors, who are newly entering the market, will invest rationally [and] keep the risk of the equity market firmly in mind," the China Securities Regulatory Commission said last week.

New local investors soon got a lesson in the risks of investing in equities. Early this week the index suffered its worst one-day slide for five years, an 8% drop.

Why Shanghai has rocketed

However, analysts have pointed out that the initial surge coincided with a series of articles in the state media highlighting how cheap equities were. Their timing was good: it has become increasingly clear that property is on the slide, while interest rates available on savings accounts are falling.

The articles convinced many that "the government was determined to see the market rise", says Capital Economics. "Resulting enthusiasm has to some extent now become self-reinforcing."

This helps explain why many local investors have been borrowing to finance their share purchases. Margin debt has soared to almost one trillion yuan, around 1.2% of GDP, from almost nothing three years ago.

High-margin debts increase the danger that investors hit by losses are forced to sell more stocks to cover calls for more capital from their brokers. This exacerbates corrections, as this week's nasty slide underlined.

Meanwhile, the shares that have done best so far "mainly represent the growth model that China's leaders say they want to leave behind", says Gabriel Wildau in the FT. Banks and real-estate developers have been among the top sectors. This is because investors believe "a fresh easing cycle is underway" to shore up a sharply slowing economy.

Betting on stimulus

In essence, Chinese stocks are "taking a turn on the monetary merry-go-round", says John Foley on breakingviews.com. Whether investors are right to bet on more stimulus coming soon is unclear. The government may disappoint markets by sticking to its "tough love' plans to wean the economy off excess credit", says Evans-Pritchard.

But valuations are still cheap, which suggests further turbulence is mostly priced in. The market is on a 2015 price-to-earnings ratio of ten and a cyclically adjusted p/e of 12. To invest in mainland stocks (as opposed to Hong Kong-listed ones), try the db x-trackers Harvest CSI 300 ETF (LSE: ASHR).

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