Those who understand the benefits of trading international companies likely are drawn to Chinese stocks because of the high growth rates of the Asian country. However, it’s a fallacy to assume the Chinese stock market moves in sync with GDP. To achieve the desired objective, investors need to understand more about China’s stock market.
Every market has its own cycles. American traders are aware of the cycles in the United States and the fundamental factors behind those cycles. It’s important to have similar knowledge about the Chinese market.
China’s stock market, which is extremely young compared to the U.S. market, has experienced six legs. The first leg ran 1990-1995, and the market was experimental during that period. The second leg was a bull market trend from January 1996 to June 2001. The third leg was a bear market from June 2001 to June 2005. The fourth and fifth legs are similar to the powerful run seen in the Nasdaq in 1998-2002. Currently, the Chinese stock market is working on a recovery.
Each leg in the cycles has its own features that reveal a unique personality.
The testing period (1991-1995) was characterized by an overwhelming demand for stocks. In those days, pioneering investors had to travel to Shenzhen and Shanghai to purchase stock certificates. The certificates were so undersupplied that investors had to borrow other people’s identification cards to buy the desired amount of stocks. Chaos reigned in August 1992 when thousands of investors were not able to buy forms for a draw for certificates. They surrounded banks and city government buildings of Shenzhen. The government (not investment banks) had to issue 500,000 more certificates.
Underlying the supply issue was the experimental nature of the market. The market did not have full governmental support. The issue of capitalist nature was secondary. The primary debate centered on whether the country should focus on real economy, such as international trade and domestic infrastructure, or virtual economy, like the stock market.
This excessive demand for an experimental market validated one thing: More demand was to come. This situation was the basis for the bull market of 1996-2001 (see "Early run"). The general public demanded stocks — any stock they could get hold of. The exuberance was countered by under-performing earnings and governmental efforts to counter the market emotion. These two forces formed the up and down mini-cycles within the bull market.
During this bull cycle, the market went from a broad-market index level of around 500 to a peak of 2200 in June 2001. The GDP grew by 54%. The market outperformed GDP.
The opposite was true for the ensuing bear market (June 2001- July 2005). The market was halved by July 2005. During the same period, GDP grew by 67%.
This leg had the following features:
- The industry was not mature: Investors were surprised by security law violations; executives of brokerages were found embezzling client funds; mutual funds were found ghost trading with each other and portfolio documentation did not reflect true holdings.
- The market was not mature: The Chinese government was slow with the IPO pipeline. More importantly, state enterprises were not open to the public. Investors did not get the right instruments for the upside of the growing economy.
- Further shocking news was that investors found that in aggregate they were minority owners of the stock they bought. Majority ownership was represented by non-circulating shares held by the government and management. The majority owners were waiting in the shadow for the expiration of the non-circulating period.
- When they were floated on the market, these non-circulating shares almost brought the stock index below 1000 and the government had to put forward a combination of measures to save it. It is hard to ascertain which one of the measures addressed market concern. However, the market was supported at the 1000 level and the bull market subsequently resumed.
Riding the bull
The July 2005 to October 2007 bull market run was similar to the 1998-2000 Nasdaq market (see "Powering higher"). A striking similarity was that both were IPO driven. The Nasdaq market was driven by the IPO of Amazon, Priceline, etc. The Chinese stock market was driven by the Shanghai IPO of PetroChina, China Life, etc. Investors finally had the opportunity to own treasuries of government holdings. They were picking the best instruments to benefit from the GDP growth.
In hindsight, the government might have managed market expectations. PetroChina, for example, first was offered to the public in the United States in the form of American depositary receipts. The stock went from $13 in June 2000 to $190 in November 2007. The company also went public in Hong Kong before coming back to the mainland — again a success. In November 2007, PetroChina finally was offered in Shanghai for a price of 16.7 yuan. The stock went up to 48 yuan on the IPO day.
The rapid drop from October 2007 to December 2008 also was similar to the Nasdaq meltdown. In both cases, investors found they had paid outlandish prices. In Nasdaq, the peak-to-trough decline was 4697 in March 2000 to 1172 in September 2002. In Shanghai, the peak-to-trough drop was 6092 in October 2007 to 1820 in December 2008.
Both domestic and international fundamentals were at work in this bear market leg:
- Although Lehman brothers and AIG did not have significant presences in China, the impact of the financial crisis still was huge on the Chinese economy. There was a dramatic decrease of export orders by Chinese manufacturers in September 2008.
- Investors found they were minority owners all over again, only this time they were much more a minority in the total capitalization. The non-circulating shares in the shadow were bigger than they ever imagined.
- Like the 2001 bear market, this market bottomed in January 2009 without resolving any of the fundamental issues. From January 2009 to present, the market has been in an economic recovery leg (see "Sideways recovery," below). There are two main features to this leg:
- The market is acting without underlying economic development. For example, the market rallied 12% in 10 trading days in October 2010. The action possibly could be traced to QE2 in the U.S. However, it could not be explained by economic development in China.
- The market is in the process of digesting non-circulating shares. For example, a total of 1.5 trillion yuan of PetroChina shares were eligible for circulation in the secondary market starting Nov. 8, 2010. Over time, the non-circulating shares will be in full circulation.
Throughout the cycles, the market has been trading in a triangle formation while experiencing normal demand and supply. That extra endpoint is the Chinese government. To make profit in China, investors need to understand the role of the government.
The visible hand
In the era of QE2, discussion of government influence on the stock market is much less accusatory than fact finding. Indeed, the Chinese government has been active. Veteran trader and publisher Quan Fang has discussed publicly that understanding the role of the government is key to investing in China.
For Fang and his generation, the role and effectiveness of government influence was crystallized as early as Feb. 19, 1997. When news broke that Deng Xiaoping had passed away, a "flash crash" — like selloff was triggered. Not unlike the 2010 U.S. flash crash, the market came back shortly after it bottomed. Rumors of the time were that the Chinese government had instructed major players to buy up the market through a "red line."
The red line itself may not exist. But there are a number of ways the Chinese government has influenced the market in the past:
- Direct stock purchase by the government investment arm plus share buybacks: A joint action by the Ministry of Finance, Huijin Co. and the State Asset Commission on Sept. 18, 2008, included both direct bank stock purchases and support for public companies (majority owned by the government) to buy back shares.
- Interest rates: The government lowered interest rates in 1996, 1999, 2002 and 2008. In China, the target of interest rate action is real economy. For example, the 1999 action was a response to the Asian crisis. The 2002 action was related to post-9/11 global deflation. The 2008 action was a response to the financial crisis. However, interest rate actions did have a measurable effect on stock indexes.
- Taxation: China taxes investors through a transaction tax instead of capital gains. The May 1997 tax increase resulted in a 10% drop in the market. The tax was raised again in May 30, 2007 after a series of People’s Daily special commentaries. This time the market dropped 6.5%. (Chinese investors call it "The big 5/30 drop.") On the flip side, the government had reduced taxes in November 2001, January 2005 and April 2008. Transaction tax reductions were used to boost the market in bear cycles.
- Special commentary of the People’s Daily, the Communist party’s official newspaper: There have been 22 special commentaries in the market’s history. In June 1999, the commentary caused an almost 400-point rally in 15 days. In 2001, a strategically published commentary sent a nationwide message to view the 1000-level as support. In 2007, a series of five commentaries were published in an effort to control an overheated market (this was much less effective). There were four commentaries in 2008 and two in 2009, all in support of a market recovery.
The use of special commentary invokes a 2000-year-old Chinese legend. Back then, arrows were made of animal bones rather than metal. In the legend, a deposed prince went into the army to serve as a commander. (The king found a new love. A new prince was designated as crown prince. The prince’s mother was found dead...). The deposed prince was a good warrior and unique commander, unique because his arrows always had a hole in them. A sharp sound was heard when he shot the arrow. He ordered his soldiers to shoot in the direction of his "sounding arrow." Anyone who failed to obey would be beheaded. Over time, his troop exclusively followed his lead instead of looking for themselves to find the target. One day, the king was on a hunting trip. Suddenly, a lone sounding arrow was shot in his direction...
Financial sounding arrows exist in one form or another in stock markets around the world. Market participants learn to recognize them and follow them. The Chinese version was a brainchild of premier Zhu Rongji in 1996. (He was mayor of Shanghai then.) He sensed over-exuberance in the marketplace and proposed to Premier Li Peng in December to send an official message to "educate" market participants. After a few days of meetings, Li decided to use a special commentary in the People’s Daily for this purpose. Today, investment houses in China study the wording of these commentaries as closely as traders in the United States study the FOMC Beige Book.
Back in the early 1990s, China introduced the stock market as a way to tap into the market mechanism to better allocate financial resources. According to Adam Smith, markets are moved by an "invisible hand," or their own self-regulating nature. For anyone interested in investing in the Chinese stock market, it’s important to understand that it is debatable how government intervention can undermine this market mechanism.
American traders are drawn by China’s high GDP growth. However, Chinese stock fundamentals are unique and in many cases exist outside of U.S. economic influence. Even domestically, that GDP growth does not necessarily match changes in the stock market — so much so that using GDP growth as a surrogate for stock performance can be misleading.
Careful students of the markets may have found that the imbalance of supply and demand is a persistent feature throughout previous cycles. In the early days, when demand outstripped supply, it represented one end of the imbalance. In later years, the overwhelming non-circulating shares represented the other end of the imbalance. From time to time, the supply vs. demand issue overtakes GDP growth as a guiding factor in the stock market.
The influence of the Chinese government can be found from major turning points to mini-cycles within each leg. Investors need to heed these financial sounding arrows. Investors also need to familiarize themselves with measures the government has employed. In the era of financial globalization, it is your knowledge, rather than your passport, that determines your investment success.
Yong Liu holds masters degrees in physics and computer science and has worked at Nortel networks and Nav Canada Inc. Liu consults on trading automation for financial institutions in China. Reach him at email firstname.lastname@example.org.