China Stocks Crash over 7% Friday, Tests Bear Market Levels!

Easy come, easy go

Almost everywhere, the public appears to think that there will be no end to credit inflated asset booms. So they may have forgotten what bear markets look like at all.

Well, recent developments at China’s stock markets may have come to remind them that there is such as a thing called boom-bust cycles, where bear markets have not been merely figments of imagination. 

Following last week’s 13+% (weekly) crash, today’s broad based over 7% rout virtually erased marginal gains eked out during the early week where Chinese stocks have become a vertiginous rollercoaster ride.

Yet, two successive weeks of meltdowns has brought Chinese stocks at the threshold of the bear markets.

The Shanghai Composite knocks at the bear's door...

...while the Nasdaq version the ChiNext has clearly entered the bear's lair. Charts and table above from Bloomberg.

From  Marketwatch: (bold mine)

China’s stock markets plunged toward bear territory Friday, a sharp turnaround after a year of strong gains.

The Shanghai market SHCOMP, -7.40% , China’s largest, was off almost 20% from its recent peak, while the second-largest Shenzhen market 399106, -7.87% was off more than 20%, entering bear-market territory. The country’s startup stocks 399006, -8.91% have lost a quarter of their value since hitting a record high earlier in the month.

The Shanghai Composite Index became one of the best-performing markets globally last year after years of dismal performance. This year, it has been up as much as 60%, as local investors--cheered by a series of stimulus measures introduced by China’s central bank last November--have borrowed a flood of cash from their brokerages to invest in the stock market. The benchmark hit its highest level since the global financial crisis on June 12.

But investors have started to question the longevity of that stimulus-driven rally, and analysts are sounding louder warnings that China’s market has reached unsustainable levels. A selloff over the past two weeks has taken a big bite out of earlier gains.

The Shanghai Composite Index was on track Friday for its sharpest daily percentage loss since 2007. The move down follows a 13% loss last week.

The smaller Shenzhen Composite Index is now down more than 20% from a recent peak. The benchmark was last down 8.1% at 2,496.3 Friday, well off its record high of 3,140.66 earlier this month.

The selling has been particularly dramatic among riskier startup stocks. The ChiNext Price Index has tumbled from its record close of 3,982.25 on June 3.

Selling frenzy spilled over to Hong Kong...

The Hang Seng Index HSI, -1.78% , off by 2.2% on Friday, has been steadier as volatility spikes in the mainland. Hong Kong is up around 13% this year, compared with Shanghai’s more-than-30% rise.

Chinese government's intervention seemed to have failed to prevent the meltdown...

To be sure, China’s central bank has introduced new easing measures in the past couple of days: removing a cap on banks’ loan-to-deposit ratio and injecting cash into the financial system. Still, some investors fret that those steps don’t go far enough, and limit the likelihood of more potent measures, such as another cut to the amount of reserves banks are required to hold.

Just a reminder of what I wrote last week

...vertical price actions of stock markets are likely symptomatic of both Ponzi dynamics and the Greater fool theory in action.

Ponzi dynamics require fresh money to bid prices aggressively higher from existing shareholders (mostly insiders) at current levels. Since vertical price actions have manifested sustained manic bidding up of stocks, which are likewise indications of pyramiding, then more fresh funds are required to sustain this manic trend. Otherwise, given the stratospheric state of stock prices, this would mean an avalanche of profit taking sellers.

Meanwhile the greater fool is when “an investor buys questionable securities without any regard to their quality, but with the hope of quickly selling them off to another investor (the greater fool), who might also be hoping to flip them quickly. Unfortunately, speculative bubbles always burst eventually, leading to a rapid depreciation in share price due to the selloff.” (Investopedia)

In short, manias are manifestation of one way trade crowd dynamics whose actions are premised from Greater Fool expectations backed by mostly credit financed (Ponzi) manic bidding of securities.

The credit crackdown or the reaching of credit limits (given record margin trades) could partly be responsible for the dearth of fresh speculative money to push prices at current levels.

I'm quite certain that the Chinese government will not only continue to intervene but will likely escalate the degree of rescue efforts to avert bears from taking command of her equity markets.

The stock market boom has inflated balance sheets of debt laden corporations, has served as an alternative channel for firms to access public's funds via equity, has provided short term profits and "confidence" to the speculative public, which bear markets threaten to reverse. 

And bear market in stocks will not only negate these temporary benefits, but will also expose on the vulnerabilities of the Chinese economy, particularly, the fragility of the the hissing credit financed property bubble and of the excess capacity in the industrial sector. Thus a bear market in stocks will likely trigger a financial crisis in China.

And a China crisis will have worldwide repercussion.

Hence, the Chinese government can be expected to move mountains to prevent two bubbles from imploding.

So huge volatility in Chinese stocks (in both directions, this week should be an example) can be expected.

Also the Chinese government will likely exploit geopolitical and regional tensions to deflect the attention of her constituency from internal economic and financial troubles, as well as, to rally nationalist fervor in support of the incumbent government. 

But finally I foresee all interventions to prevent her bubble from bursting to ultimately fail in a not so distant future.