By Michael Ide. Originally published at ValueWalk.
Even with trading halted on over a thousand stocks and strenuous government efforts to provide a floor, the Shanghai Composite is down another 5.9% today, but that’s partially because individual stocks are capped at a daily loss of 10% and about 40% of the market has been frozen completely. Even after extraordinary policy intervention, we’re seeing just how difficult it is for a government to actually control the market.
Quick regulations come with unintended consequences
“The index futures exchange CFFEX caps the daily limit of one-way new positions to 1,200 lots for the mid/small-cap CSI500 index, and raised the margin requirement to 30% from 10% for non-hedging short positions. These moves may have pushed back some speculative shorts but may have promoted more selling pressure in the cash market as institutions cannot properly hedge their longs,” writes Deutsche Bank AG (NYSE:DB) (ETR:DBK) (FRA:DB) analyst Yuliang Chang.
While this is just one example, it highlights to broader problem of unintended consequences when setting new rules fast and loose. An institutional investor that might be willing to hedge its position and ride out the correction isn’t able to. With trading halted on so many stocks and the rest hitting the 10% cap day after day, anyone that doesn’t want to get stuck will frantically start selling again tomorrow. It’s ironic, but policies meant to stabilize the market may just be driving people toward the door.
And there are investors out there who would start buying again if stocks were allowed to level out, after all don’t value investors love to say that we should buy when there’s blood in the streets?
“We expect market focus to revert to stocks with strong fundamentals over growth bets as fund managers rebalance portfolios towards value investments,” writes SWS Research analyst Wang Sheng.
But that’s not going to happen until investors believe the collapse has genuinely been stopped and that they’re no longer at risk of getting frozen into a bad trade.
Going private deals may go by the wayside
It also means that Chinese companies listed in the West may not want to head back home.
“Several previously announced going private deals for US-listed stocks have seen deal spreads significantly widen. As of July 7, the overwhelming majority of the going-private deals were with double-digit spreads well over 10%,” MCM Partners writes in a note to investors.
The ‘going private’ deals weren’t really about becoming permanently private, but about re-listing on Chinese stock markets to take advantage of the roaring bull market, which obviously isn’t a factor right now. Even if the market rebounds, the severity of the crash and government intervention should force a re-think. Executives may love buybacks, but being forced to buy back all the stock they’ve sold in the last six months isn’t quite the same thing.
Lack of fundamentals means the stock market crash may not affect China’s real economy
On the bright side, the disconnect between the past market rally and economic fundamentals implies that the current crash may not have a big impact on the real economy either. You may have seen the recent paper showing that leverage is what makes a bubble really dangerous and there’s plenty of that in China. But Nomura Holdings, Inc. (ADR) (NYSE:NMR) (TYO:8604) analyst Yang Zhao points out that “the mechanism that channels the paper wealth of the equity market into real household consumption demand is limited in China.”
The problems have more to do with China’s policy goals: increasing consumption, shifting corporate financing from debt to equity, and privatizing state owned enterprises (SOEs) through (currently disallowed) IPOs. This is one reason to believe that the Chinese government will manage force another rally – it has too much riding on the stock market to walk away let prices land where they may.
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