With the Shanghai stock market down more than 20 per cent this year, it is tempting to read the fall in stock prices as an indication that Chinese investors believe the economy is poised to slow dramatically.
But analysts should be cautious in how they interpret the recent gyrations in Chinese stocks.
We are used to thinking about markets as machines that discount expected cash-flow, and that stock price levels generally represent the market's best estimate of future growth prospects. This, however, is not always the case, and it is certainly not the case in China.
Why not? Investors in any market will follow a variety of different investment strategies, and the performance of the market will reflect the mix of these various approaches.
Broadly speaking there are three such strategies: speculative strategies, which involve taking advantage of short-term changes in supply and demand factors; relative value strategies, which seek to exploit differences in the relative value of assets; and fundamental or value strategies that seek to buy long-term cash flows.
It is the latter strategy - perhaps most famously characterised by Warren Buffett - that gives the market its predictive ability. By constantly switching out of assets with diminished cash-flow expectations and into assets with rising cash-flow expectations, fundamental and value investors turn the market into a machine that discounts long-term cash-flow expectations, and in so doing, makes predictions about the future.
