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China's stock market: how to make sense of the bloodbath
Published by

11 January 8.10am

Hargreaves Lansdown is not responsible for this article's content or accuracy and may not share the author's views. News and research are not personal recommendations to deal. All investments can fall in value so you could get back less than you invest. Article originally published by Forbes.

Where China Invests In America

The bloodbath in China’s stock market started the New Year with excruciating pain. But investors must remember the news is always most despicable and nauseating at the bottom. Bull markets climb the proverbial wall of worry. Contrarian investors always say, especially for long-term investors, the best time to buy is when there’s blood on the streets including your own.

iShares FTSE China Large-Cap ETF - the flagship China ETF - dropped 10% the first week of the year. Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (ASHR), tracking the 300-largest stocks traded in the mainland, plunged 13.3%.

“A good chunk of the blame for the turmoil in China can be traced to factors that are unlikely to significantly reverse in the foreseeable future: an aging population, a labor shortage that grows worse with time, and reduced demand from other emerging market economies that have been hit hard by the collapse in oil and commodity prices,” says Ken Weber, president of Weber Asset Management in Lake Success, N.Y.

Weber added: “Because China represents a large share of global demand for industrial metals, food commodities and other basic materials, the world now has too much capacity – a problem that could persist for decades as advancing technology continues to turn scarcity into abundance.”

Here’s how investors can make sense of the bloodbath, which may be very overblown.

Circuit Breakers Backfired

China’s new circuit-breaker rules for the Chinese A-share market were meant to limit selling. But they seemed to exacerbate the sell-off by making investors want to flee for the exits even more. The government axed the circuit-breaker system Thursday night.

The past week’s sell-off resembles that of summer 2015, which came with poor business reports, foreign exchange reserve losses and confusion about policymakers’ intentions, according to Barclays.

“Arguably, the economic news was not necessarily that poor and the surprise effect should also have been less pronounced after last year’s adjustments,” Christian Keller, an analyst at Barclays, wrote in an economic report released Friday. “However, the fact that market reactions were as tumultuous as they were suggests that China’s economic situation has become inherently unstable.”

Global Overreaction to Yuan Devaluation

China’s stock market volatility infected commodities and global stock markets, which also felt stress from North Korea’s nuclear test and more Mideast turmoil. The SPDR S&P 500 ETF (SPY) - the most widely traded U.S. fund - fell almost 6%. iShares MSCI EAFE ETF (EFA), tracking foreign developed markets, also dropped about 6%. Vanguard FTSE Emerging Market ETF (VWO) crashed 8%.

The global stock markets may have overreacted as there’s relatively little foreign money invested in Chinese stocks.

Markets feared China’s devaluing the yuan would jumpstart a currency war and that economic growth is slowing much faster than expected. The yuan fell its most in five months and is likely to weaken further. But the yuan was arguably overvalued and needed to be adjusted, says Nigel Green, CEO and founder of the deVere Group with nearly $10 billion under management.

“The modest currency adjustment that triggered panic in the markets is a structured and necessary part of China’s transition from an export-led economy to a more consumer and services-driven one,” Green said in statement. “The yuan has risen considerably, which was eroding China’s competitiveness and was contributing to the slowdown in the country’s export trade.”

The yuan’s depreciation will help boost the China’s exports and help its international trading partners, thereby supporting the global economy, says Green.

Monty Guild, founder of Guild Investment Management in Los Angeles, believes China’s central bank had no other option than to devalue its currency although it diminishes consumers’ purchasing power.

“At the beginning of 2016, China’s currency was grossly overvalued against its trading partner,” says Guild. “At its peak a few months ago. The yuan had increased by over 40% at its peak against the basket of trading partners over the last four years.

“Because they wanted to reverse this over appreciation, China has said several times since November 2015 that they would start  a soft peg of their currency against all of their trading partners currencies not just the U.S. dollar.”

Guild recommends investing in China after its stock market falls another 10% to 15%. Corporate profits for some fast-growing sectors are still growing much faster than the economy, he says.

He forecasts China’s economy will grow 6% versus 6.5% in the government’s five-year plan

No Correlation Between Stocks and Economy

The stock market sell-off has raised questions about the China’s economic health. However, the correlation between China’s stock market and the economy is practically nil.

“China’s economy is growing at a 7% pace, give or take. That may be disappointing to some people, but it’s no basis for a crash,” High Frequency Economics, based in Valhalla, N.Y. reported Friday. “If a normal Rate of return on Shanghai stocks is 18% yearly and the carnage in the markets has moved the yearly gains in the broad indexes from 58% to 4% in two months, then maybe they have overshot ‘normal’ and we can look for a bottom.”

“Do not blame China’s economy for trashing the world’s equity markets,” High Frequency Economics added. “We blame skittish investors, not a poorly performing economy. For all its faults and flaws, China’s economy is doing more than its fair share to absorb the excess productive capacity in the world’s commodity markets.”

China’s stock market stabilized Friday, gaining 2%, after the government ditched the circuit breakers. The China Securities Regulatory Commission also continued a ban on stock sales by major shareholders, which were due to expire Friday.

China Still Reigns Supreme

Despite the epic slaughter the first week of the year, some China stock market indexes remain global leaders on a one- and three-year basis.

“The Chinese stock market is still, even after the two days of violent selloffs, up 42% over the past three years and the best performing market in the world,” Junheng Li, founder and president of JL Warren Capital LLC  in New York City wrote in a client note Friday. It’s “reflecting the massive boom/bubble from September 2014 through June 2015, which even the rout in the early summer of 2013 and the dreadful first week of 2016 have not (yet) undone.”

Earnings growth for large companies in Shanghai and Shenzhen stock exchanges, as tracked by the CSI 300 index, are still superior to those in the U.S. and Europe, according to JL Warren Capital. These markets are abbreviated as SPX and FTSE, respectively, in the table below. NKY represents Japan.

Chinese companies grew earnings at a 19% clip over three years versus 15% for U.S. stocks. European earnings declined 15% over the same period. On a one-year basis, Chinese companies saw nearly 12% earnings growth compared with 9% for Japan, 8% for the U.S. and almost 2% for Europe.

Contrarian Buying Opportunity

The sell-off presents a buying opportunity for U.S. stocks, say contrarian investors.

“The U.S. continues to have the strongest economy in the world,” says Weber of Weber Asset Management. “We see an opportunity mainly in domestic growth stocks, especially among technology-driven disrupter companies gaining market share at the expense of traditional firms that never moved beyond cost cutting.”

Weber believes the global stock markets will stabilize in a month or two. But there are plenty of reasons for volatility to persist: China’s woes, turmoil in the Middle East, economic weakness in Latin American countries, and poor progress in Europe’s recovery.

Mark Blair, founder of Blair Wealth Management, is also using the sell-off as a chance to buy high-quality companies for cheap. It reminds him of 2008 and 2009.

“The sale (in stocks) will get even better as the leaders of China conclude the obvious: they cannot micro-manage the world’s second largest economy,” says Blair, who manages $22 million in Newtown Square, Penn. “Markets are much too complicated for governments to manage. Remember the Soviet Union? Recent efforts to manipulate the nascent stock market and depreciate the yuan to foster exports will lead to distrust and more bad moods among investors, further depressing prices.”

Comparing 2016 to 2008 is “either grandstanding or just plain ignorant,” says Paul Schatz of Heritage Capital in Woodbridge, Conn. By 2008, the housing bubble had already popped. Banks were over leveraged. Corporations had very little cash and have hoarded truck tons of cash ever since.

“Today, the massive leverage has also been purged from the system. Banks are sitting on more than $2 trillion in cash and corporations have another $1.5 trillion,” Schatz wrote in a client note Friday. “Housing is stable and lenders are tight with their money. The economy may not be hitting on all cylinders.

“But it’s far from teetering on collapse. There are no Lehman’s, Bear Stearns, Fannies, Freddies, AIGs and the like hanging on by a thread.”

This article was written by Ky Trang Ho from Forbes and was legally licensed through the NewsCred publisher network.

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Article originally published by Forbes. Hargreaves Lansdown is not responsible for its content or accuracy and may not share the author's views. News and research are not personal recommendations to deal. All investments can fall in value so you could get back less than you invest.

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