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History repeating itself

by William Baunton

Thu 2 Jul 2015

History repeating itself Enlarge Chart loading Image

What the chart shows: Shanghai Composite Index, 2005-15, with points in stock market cycle identified by Liz Ann Sonders, Senior Vice President and Chief Investment Strategist at Charles Schwab.

Why it is important: Shares in Shanghai have experienced a strong bull market run since the end of 2014, with stocks on the Shanghai Composite Index rising 150% in value in under a year. On 12 June, the Shanghai Composite hit a seven year high of over 5,100. That day the market took a turn in the cycle. The euphoria of the bull run turned to scepticism when the 5,000 mark was breached. Sentiment is now turning from uneasiness to near-panic as stocks plummet. Frenzied selling since 12 June has wiped nearly 25% (or over 1,000 points) off the index, dropping below 4,000. On 22 June, shares swung 7% in a matter of hours. In the past two weeks, Chinese stocks in Shanghai and Shenzhen have combined lost over $2.5tn in value, equal to the value of the entire FTSE 100.

With the economy slowing, the renminbi too high for the comfort of many exporters, and the Chinese authorities possibly needing to undertake quantitative easing (on a scale that could be the largest in the world) to soften the landing, the disconnect between economic fundamentals and prices is clear. Some shares are trading at 100 times earnings, with the market on average trading at about 20 times earnings. The People’s Bank of China over the weekend cut the one-year lending rate by 25 basis points in response to the stock market tumble, as well as lowering reserve requirements. In another timely announcement, the government publicised plans to hand over up to $322bn to the manager of the country’s biggest pension fund, the National Social Security Fund, to strengthen the demographically challenged Chinese pension system. The fund managed $205bn at the end of 2013, and ranked number 26 among the OMFIF Top 500 Global Public Investors. The ultimate aim of this move is to shift more pension assets into the domestic stock market.

The relatively underdeveloped stock market has experienced a bubble before. In almost identical, although more extreme, fashion, in 2007 stocks in Shanghai more than tripled in value in less than a year. The Shanghai Index reached an all-time high of just over 6,000 in October 2007. Within six months, as can be seen in the Chart, almost all these gains were wiped out. The symptoms appear to be the same now as they were then, with high price-earnings ratios (although nowhere near the heights of 2007) and sentiment quickly turning when a barrier is breached. Back then it was 6,000, this time it appears to be 5,000.

Many are pointing to the cooling real estate market as the reason behind the bubble. With the property market down over the last year, investors diverted capital to stocks – aided by looser monetary policy and increased lending by banks. The big questions are how far will stocks fall and what will be the effects on global markets. In February 2007, when Chinese markets were almost completely shut off to outside investors, the Shanghai index tumbled 9% in one day, the largest drop for the index in 10 years. This sent ripples through the global markets with the Dow Jones in the US dropping 416 points (3.3%), the largest one-day slide for the index since 11 September 2001. With China becoming ever more open through initiatives such as the Shanghai-Hong Kong Stock Connect, QFII and RQFII, Chinese stocks should be watched closely for signs that turbulence could spark wider upheavals.