China’s bull market isn’t finished yet, despite the wild ride

If you have never  ridden a roller coaster at a theme park, perhaps because you worry your heart might not take all the excitement, then the thrills and chills of buying Chinese stocks may not be for you.

There has been severe turbulence in the Shanghai and Shenzhen markets over the past three to six months, very rare occurrences in the short 25-year history of the Chinese capital market, and international investors are stunned. What has caused this phenomenon, and what should be done to prevent the sudden surges and 8declines in the future?

First, it is generally known that the recent round of rapid rises in the stock market lacks fundamental economic support. China’s macroeconomic growth rate has hit a record low of 7 per cent, and the stock market, after a seven-year bear market that persisted since 2008, started its gradual recovery in the second half of last year, and 8increased dramatically this year. This phenomenon contradicts the basic principles whereby the stock market acts as a barometer for the economy. So, in the absence of both strong macroeconomic support and profitability among a majority of Chinese companies, the rapid growth of the market in such a very short period planted the seeds for disaster.

Of course, the Chinese market is still developing, and historically, its ups and downs have rarely followed any economic laws. This has made it difficult for it to become a channel for investors to share the fruits of  growth in recent years.

Second, margin trading and short selling, namely leveraged trading, which started in 2010, boosted  uncertainty in the market. During the  downturn, it was uncommon for stocks to be bought and sold through leveraged trading, but once the bull market seemed certain, investors gradually increased this trading method. The amount of funds used for leveraged trading through formal and legal channels such as securities and fund companies is estimated at about 2.3 trillion yuan (HK$2.9 trillion).

Obviously, compared with the total floating value of about 40 trillion yuan in the Shanghai and Shenzhen markets, this 2 trillion yuan, which accounted for about 5 per cent of current total tradeable market capitalisation, may have great influence on market swings, but will not quickly change the entire market in the short term.

Third, one of the major reasons, or the core factor, that has resulted in the current turbulence  is that a large number of individual investors buy and sell stocks by financing five to 10 times the value of their own funds. Since the start of the stock market recovery late last year, many investors, believing the bull market and high returns were just around the corner, borrowed money through different channels to invest. Thus, the entire stock market was transformed into a margin trading mechanism similar to a futures market. For example, investor C has one million yuan for stocks, and he uses this as margin to finance five to 10 million yuan from friends, banks or other sources. Their agreement may stipulate that if they make money, they will share the earnings according to certain percentages; but if they start to lose money,  the fixed limit  is only one million yuan. When the market declines, if 8investor C is 8financed  at a ratio of 10:1, a 10 per cent drop means he has lost his one million yuan; 8according to the agreement with his lenders, he must sell all his stocks to stop the loss. Such sell-offs are a major reason for the continuous fall in the market over such a short time.