Posted tagged ‘free markets’

China’s Quandary: The Natural Forces Within a Stock Market

July 9, 2015

China’s Communist government, in an attempt to save face and promote predictability and harmony, is taking highly unusual, intrusive measures to fight free market forces as the total value of the Shanghai stock market drops. 1  There is much media hype—with the fervor and emotion one expects from a real-time sports commentator—about how devastating the losses are. Yes more than 3 Trillion, or 30%, of the total value of all companies traded on the Chinese Stock Exchange have been lost over the last month1 is a large number. Yet we need to put this in context to determine if it is unreasonable.

The buying and selling of stocks is essentially the trading of ownership stakes in a company. What someone is willing to pay for that ownership stake may be more than it is actually worth. A loss or drop in market value occurs when collectively people are willing to pay less for a stock than before. Sometimes this causes a snowball effect when, given the new price, (1) more people are willing to sell to avoid further paper or real losses, and (2) buyers are willing to pay less given more supply (those willing to sell) and a perception the price may fall further.

To substantiate this consider a stock’s price to earnings ratio. This common financial measure shows how much an investor is willing to pay based upon how profitable a firm is. Earlier this year stocks traded on the Chinese Stock Market had an average price to earnings ratio (P/E) of 50.2 This is well above historic market norms and is indicative of stocks being overvalued. (For a developed economy this would mean a company share fundamentally worth $10, could be trading on a stock market for $30-$40 a share). The natural course of events is the market will balance the actual, fundamental value of stock with what people are willing to pay for it. This is when sharp decreases (or increases) in the value of a stock or the stock market as a whole occurs. As I heard eloquently presented an Alliance Bernstein investor roundtable in the early 2000s (and had been attributed to many): “the most powerful financial force is regression to the [historic] mean.”

The vast majority, 85%,2 of stockholders in the Chinese stock market are retail investors (individuals) and not institutional investors (investment professionals). As such, the unreasonable prices and valuations paid for the stocks are determined principally by individuals. These investor, as a whole globally, tend to made more emotional buy/sell decisions and conduct less research than professionals. Given strict Chinese regulations that limit foreign ownership, much of this overvaluation and stock market volatility is from the local individual investors. This creates an unusual position for the Chinese culture: a people that values uniformity, predictability, and face are in a position where the natural order of supply and demand takes place because of the overvaluation of the prices of stocks. This runs in direct contrast to these values and communist philosophy and creates a conundrum.

The free market system, when free of corruption and manipulation is beautiful because it self-regulates. The inherent checks and balances are that people, of their own-free will, make the buy and sell decisions. Once there is government intervention, this natural balance is impeded as winners, losers and protected companies are chosen in a manipulative way. Failure to let a market correct itself is akin to collective disillusionment or lying. One could equate the current frenzy to the collective realization that the emperor actually has no clothes and an urgency to act on that truth. The government is claiming that “short-sellers”—those who made financial trades indicating a stock is overvalued and is expected to drop in value—are manipulating the stock market3 and causing the revaluation seems misguided. (In actually these trades are more likely bringing a degree of truth.) Essentially the Communist Party is taking actions to perpetuate the irrational values being paid for stock prices. (As an aside, while the United States and European Union have taken action to assist the markets, it was not in manipulating the price paid for a stock. The efforts, in part, lower the interest rates for money kept at or borrowed from banks to incent companies and individuals to spend or invest money instead of leave it in saving accounts not earning interest. That is a subject for another article)

Yet again the forgotten financial lessons may not have been relearned: Markets do not only go up. Revenues, net income and other fundamental financial measures do not only grow at increasing rates year over year. Markets, even the Chinese stock market, do not usually grow 100% a year. And lastly, the most powerful force in a stock market is regression to the historic mean.

 

References

  1. Webb, Quentin, “Trade halts add to China’s Potemkin market problem,” Reuters, retrieved 7/9/15, http://blogs.reuters.com/breakingviews/2015/07/09/trade-halts-add-to-chinas-potemkin-market-problem/
  2. Shun, Samuel and Goh, Brenda, “China stock market freezing up as sell-off gathers pace,” Reuters, retrieved 7/8/15, http://www.reuters.com/article/2015/07/08/us-china-stocks-idUSKCN0PI04Q20150708
  3. Taplin, Nathaniel, “China points finger at ‘manipulators’ as shares slump again,” Reuters, retrieved 7/2/15, http://www.reuters.com/article/2015/07/03/us-china-markets-idUSKCN0PD03020150703