China's Shanghai Composite Index (SSE) has been the world's best performing major market index this year, but it has tumbled nearly 20% since hitting its Aug. 4 peak. Many analysts are concerned that the decline is evidence that China's rapid recovery is unsustainable, but the more plausible explanation is that investors are simply taking profits in a hot market that's long been due for a correction.
The SSE, Chinas' benchmark index, zoomed 91% from the start of the year to Aug. 4, hitting a high of 3,478.01. Even with the recent pullback it remains up about 67% from last year's low of 1,664.93.
Since Aug. 4, however, the SSE has slumped 19.8%, including a 4.3% drop yesterday (Wednesday) to close at 2,785.58. Contributing to the market's decline has been a sharp drop in lending, concern about an imminent possible tightening of credit, a strain from an increase in initial stock offerings, and the failure by Beijing to take action to put a floor under China's stock prices. But the biggest reason for the drop has almost certainly been profit taking.
"There are any number of rumors and reasons for why the China markets have been falling," Peter Lai, a director with DBS Vickers Securities, told Reuters. "But ultimately, those are all excuses for investors to take profit on the big rally this year."
To be sure, investor panic over tighter lending and Beijing's reluctance to throw the stock market a lifeline have contributed to the decline, but they - like the profit-taking that has driven the downward spiral - is likely to be short term in nature. And while the correction probably has more room to run, Asian analysts believe there's good reason to believe that this bear-market swoon will turn back into a bull-market rally before October, due to a looming national day of observance.
To begin with, the Shanghai index is historically volatile. Shanghai Class A have in the past traded as low as 10 times earnings and as high as 60 times earnings. They're currently about 25 times their projected 2009 earnings, which suggests there is still room to fall, but a much greater potential for a rally.
"The Chinese market is very trend-oriented because there are many individual investors," Philippe Zhang, chief investment officer at AXA SPDB Investment Managers in Shanghai, told Bloomberg. "It can rally very quickly and go down strongly as well."
And, as stated earlier, there are some very good reasons why investors chose now to take a breather - beginning with lending.
New bank lending plunged to $52 billion (355.9 billion yuan) in July from $220 billion (1.53 trillion yuan) - a 77% drop. However, that drop was largely expected as China's $585 billion stimulus package and lax lending policy helped pave the way for growth in the first half of the year.
Chinese banks lent about $1.08 trillion (7.37 trillion yuan) in the first half of the year, nearly double the total loans extended throughout all of 2008. Even with the slowdown, analysts still expect total lending to exceed $1.5 trillion ($10 trillion yuan) this year.
That means the Chinese economy will remain flush with liquidity for the foreseeable future. And just to be on the safe side, the China's State Council has issued a directive to banks to provide more loans to smaller firms.
"We will give appropriate subsidies to financial institutions to support them in extending loans to small companies," the council said following a regular weekly meeting.
It also will extend measures to reduce the social security contributions paid by smaller firms that are facing difficulties and will increase tax support and direct government funding for them.
"The slowdown in new lending is an excuse for investors to exit a market that's risen too fast and gotten too expensive," AXA SPDB's Zhang told Bloomberg.
Another reason Chinese stocks have slipped is that the government hasn't stepped in to put a floor under prices.
"Investors are disappointed that regulators failed to take any concrete steps to support the market, while sentiment is extremely shaky after the market's tumble over the past two weeks," analyst Chen Huiqin at Huatai Securities Co. Ltd. in Nanjing told Reuters.
But that could change - and soon - due to the looming observance of the 60th anniversary of the Chinese Communist Party's rule. That celebration is scheduled for Oct. 1.
Jing Ulrich, head of China equities and commodities at JPMorgan Chase & Co. (NYSE: JPM), said that "in the event of future correction, the Chinese authorities will be prepared to put a floor under the stock prices." That support could include an elimination of taxes on stock transactions and a slowdown of measures that are designed to absorb excess liquidity.
"Liquidity conditions will remain favorable, as authorities may accelerate mutual fund approvals and insurance and pension funds could step up their equity purchases," she said. "We believe the 'A' share market will resume its upward trajectory after this period of correction."
If the market doesn't stabilize quickly enough, or if government measures don't have the desired impact on the market's momentum, then the Communist Party may be prompted to more direct action as its 60th anniversary approaches. In fact, the approach of the anniversary alone could trigger a rally by spurring a shift in public sentiment.
"The widespread belief that Beijing doesn't want the markets to fall before Oct. 1 will become a self-fulfilling prophecy," Guoyuan Securities Co. Ltd. strategist Simon Wang told The Wall Street Journal.
Wang pegs support for the SSE at 2,600 - which is about 7% below yesterday's close, and which would represent a total decline of 25% from the Aug. 4 peak.
[Editor's Note: For a related story on the prospects for China's stock market - this one a question-and-answer session with Money Morning Investment Director Keith Fitz-Gerald - please click here. The story appears elsewhere in today's (Thursday's) issue of Money Morning.]
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