The Problem with the Chinese Stock Market

The problem with the Chinese Stock Market

The Problem with the Chinese Stock Market

Last week, the mainland Chinese stock markets were on a roller coaster and the world markets were along for at least some of the ride. A lot of investors are nervous, which is understandable. Their financial future might be at least somewhat dependent on what happens in the Chinese market. The financial media isn’t helping anyone calm down (isn’t that always the case?).

Should you be worried? Our answer, as always, is no. Of course, that’s assuming you have a well-diversified portfolio built around your risk tolerance and objectives.

This Is Part of Investing

The financial media specializes in predicting the end of the world. In fact, it’s their job, and they’re good at it. The more worried you are, the more money they make, because you’re watching their shows, buying their magazines, and clicking on their ads. Don’t let them scare you.

Investing in stocks means taking risk. That’s why we do it. If you build your portfolio correctly, you will get “paid” in the form of higher expected returns over time for taking on risk. But risk is risk, which means the market is going to drop sometimes. Sometimes it drops a lot. This goes doubly so for emerging markets (which China emphatically is).

China’s Market May Be Emerging, But It Still Matters

Emerging markets tend to be a little more unruly. They’re relatively immature, they are still sorting out issues with market structure and regulations (which is behind many of China’s current problems), and they just bounce around a lot more – both up and down.

When you invest in the emerging markets space, you want to make sure you are fully diversified and not take large bets on any particular country – especially emerging markets. Systemic issues (often regulatory or legal) can cause an issue with the market. That’s what we’re seeing here.

The world normally doesn’t take much notice when an emerging market has a really bad (or good) week. Emerging markets do their thing and tend to have little impact on the broader world markets. This time, not so much.

China may not be a large player in the world stock market – at least in terms of market cap – but they are a huge player in terms of the real economy. That being said, the moves we saw in the US market aren’t really that big by comparison.

This Has Happened Before and It’ll Happen Again

Last August, China was causing similar problems, and I looked at just how common really bad days are for the S&P 500 Index. I looked at the daily S&P 500 returns from January 1926 until the end of June 2015 and found that bad days are much more common than people think.

To put last week in perspective, on Thursday the S&P 500 Index went down 2.37%. That seems like a lot – and it is – but on average, the S&P 500 Index drops at least 3% a little over three days per year[1]. In other words, we should expect to see something like Thursday at least every four months. Looking at it from this angle doesn’t make it any less painful, but it means we shouldn’t be running for the exits.

So What is Going on in China?

Well, that’s a really good question. It’s impossible to have a definite answer, but a couple of things look like proximate causes. This is not a replay of last August. It’s similar, but significant differences exist.

The biggest difference is the amount of margin loans floating around. The Chinese markets are built on retail investors, who tend to be relatively unsophisticated investors. The stock market is new, and the Chinese government has been pushing it as a surefire path to riches, which led a lot of people to take margin loans so they could buy even more. Adding this leverage in was incredibly dangerous, as we saw last summer.

What’s the Good News?

The good news is that margin loans are not nearly as common as they once were. The amount on loan is down 49% from its peak. This is a very good thing. Margin loans, when used to buy more stocks, can be incredibly dangerous. Adding leverage on top of already volatile investments rarely ends well. The good news is that margin loans are probably not the source of the current problems. But something has to be.

What’s the Bad News?

The media has latched onto something called “Circuit Breakers” – market rules that temporarily halt trading if the market goes down by a certain amount. If the market continues to decline, trading will halt for the day. Circuit breakers exist to give traders a chance to catch their breath and think about what is going on in order to prevent everyone from feeding on each other’s panic. Circuit breakers are common. Most, if not all, of the major stock markets have them.

The problem here is that the rules basically did the exact opposite. Instead of calming everyone down, they made people panic even more. As the market went down, people didn’t want to get stuck holding their positions if trading was suspended, so they panicked. It’s like a bank run – everything is fine until someone thinks it might not be, then everyone wants their money and the banks collapse. We saw the same story here – the market declined, people wanted to get their money out, the market dropped even further, and a vicious cycle resulted.

This vicious cycle and China’s general volatility are at least partially tied to how much of the market is dominated by retail investors, who are the same worldwide – they buy when the market’s going up and sell when it’s going down. The problem is, the Chinese market doesn’t have as many long-term investors who are willing to come in when the market is going down to buy up the shares people want to sell.

A Rare Type of Chinese Investor

China doesn’t have as many disciplined institutional investors to apply the brakes when the market is dropping. Institutional investors are pretty uncommon in the Chinese markets for many reasons, but mostly because of the regulations. The Chinese market is tightly regulated, yet the regulations are constantly changing. For instance, circuit breakers are gone now. They didn’t work, so they got rid of them. This seems reasonable, but long-term investors like to know the rules of the game. If the rules are always changing, large investors are understandably cautious.

After last summer’s decline, rules were put in place that prevented large investors from withdrawing their money from the Chinese market (another reason large investors may be wary of the Chinese market). Those regulations ended last week, which likely put everyone on edge. Thursday morning saw new regulations requiring investors who own more than five percent of a company to seek approval before selling their shares – a move clearly aimed at keeping large investors locked up, and keeping stock prices propped up. The markets saw this as too little, too late.

What Should You Do About This?

Absolutely nothing. You don’t need to do anything. That is, assuming you have a well-diversified portfolio built around a level of risk you’re comfortable taking. If you’ve done this, you don’t need to worry.

In the short term, markets are basically random. They do crazy things. As a long-term investor you just need to stick with your plan and stay the course. We always talk about risk and return being related. You get your investment returns for taking investment risk. Well, this is what risk looks like.

Don’t listen to the short-sighted financial media. You want to focus on the long term. You want to stick with your plan and stay the course. That is how you harvest market returns and reach your goals.

Build a well-diversified portfolio that takes the risks you want to take. Contact McLean today.

[1] In the analysis period, the S&P 500 Index went down by 3% or more on 1.28% of the trading days. There are roughly 252 trading days in a year. This means that on average we would expect 3.23 days per year where the S&P 500 Index drops by 3% or more.


McLean Asset Management Corporation (MAMC) is a SEC registered investment adviser. There are many different interpretations of investment statistics and many different ideas about how to best use them. Past performance is not indicative of future performance. The information provided is for educational purposes only and does not constitute an offer to sell or a solicitation of an offer to buy or sell securities. There are no warranties, expressed or implied, as to accuracy, completeness, or results obtained from any information on this presentation. All investments involve risk.

The information throughout this presentation, whether stock quotes, charts, articles, or any other statements regarding market or other financial information, is obtained from sources which we, and our suppliers believe to be reliable, but we do not warrant or guarantee the timeliness or accuracy of this information. Neither our information providers nor we shall be liable for any errors or inaccuracies, regardless of cause, or the lack of timeliness of, or for any delay or interruption in the transmission there of to the user. MAMC only transacts business in states where it is properly registered, or excluded or exempted from registration requirements. It does not provide tax, legal, or accounting advice. The information contained in this presentation does not take into account your particular investment objectives, financial situation, or needs, and you should, in considering this material, discuss your individual circumstances with professionals in those areas before making any decisions.

The content of this publication reflects the views of McLean Asset Management Corporation (MAMC) and sources deemed by MAMC to be reliable. MAMC is a SEC registered investment adviser. There are many different interpretations of investment statistics and many different ideas about how to best use them. Past performance is not indicative of future performance.

The information contained in this presentation does not take into account your particular investment objectives, financial situation, or needs, and you should, in considering this material, discuss your individual circumstances with professionals in those areas before making any decisions.

 

McLean Asset Management Corporation (MAMC) is a SEC registered investment adviser. The content of this publication reflects the views of McLean Asset Management Corporation (MAMC) and sources deemed by MAMC to be reliable. There are many different interpretations of investment statistics and many different ideas about how to best use them. Past performance is not indicative of future performance. The information provided is for educational purposes only and does not constitute an offer to sell or a solicitation of an offer to buy or sell securities. There are no warranties, expressed or implied, as to accuracy, completeness, or results obtained from any information on this presentation. Indexes are not available for direct investment. All investments involve risk.

The information throughout this presentation, whether stock quotes, charts, articles, or any other statements regarding market or other financial information, is obtained from sources which we, and our suppliers believe to be reliable, but we do not warrant or guarantee the timeliness or accuracy of this information. Neither our information providers nor we shall be liable for any errors or inaccuracies, regardless of cause, or the lack of timeliness of, or for any delay or interruption in the transmission there of to the user. MAMC only transacts business in states where it is properly registered, or excluded or exempted from registration requirements. It does not provide tax, legal, or accounting advice. The information contained in this presentation does not take into account your particular investment objectives, financial situation, or needs, and you should, in considering this material, discuss your individual circumstances with professionals in those areas before making any decisions.