What On Earth Is Going On With China’s Stock Market?

If you haven’t heard, the Chinese stock market is a picture of wild chaos and volatility in recent times.

The Shanghai Stock Exchange Composite Index was in panic mode yesterday, having declined by some 8.5%. That represents the largest daily percentage loss that China’s benchmark index has suffered since February 2007.

There also seemed to have been contagion within Asia’s stock market, with many major stock market indexes falling. In Singapore, the SDPR STI ETF (SGX: ES3) – an exchange-traded fund which mimics the fundamentals of the market barometer, the Straits Times Index (SGX: ^STI) – had slipped by 1.2% yesterday.

Stocks in China have a daily loss-limit of 10% and according to The Business Times, more than 1,700 stocks in the giant Asian nation had hit that limit yesterday.

Just what is going on over there?

Going back in time

It may be helpful to first go back to how it all started. There are many theories about the genesis for China’s stock market bubble, but this is the one that I like best.

To prop up the economy during the global financial crisis of 2008-09, China’s government had intervened heavily, leading to an increase in production of many commodities like metal and coal. The problem is that there wasn’t enough demand to soak up that supply, which then led to problems for many companies.

The end result is that growth in China’s gross domestic product (GDP) started slowing down, as you can observe in the table below:

Year Annual GDP Growth
2006 12.7%
2007 14.2%
2008 9.6%
2009 9.2%
2010 10.6%
2011 9.5%
2012 7.8%
2013 7.7%
2014 7.4%

Source: World Bank

As that was happening, many provincial governments and state-owned enterprises were taking on increasing levels of debt, leading to heavy debt-burdens. This – along with the slowdown in growth – led the Chinese authorities to cut interest rates with the hopes of boosting the economy.

Excess capital from cheap credit and easy money then started worming its way through to China’s stock market. At the same time, there was also a freeze on initial public offerings in China, thus creating even more demand for shares of companies that were already listed.

As the stock market in China climbed, the Chinese media started to assume a cheerleader-like role. This attracted many first-time investors into the stock market.

The Washington Post reported that around two-thirds of Chinese stock market participants had low levels of education and were inexperienced with investing. Stories of Chinese farmers giving up their fields to speculate on stocks were not uncommon.

The culmination of everything I had described above was the more than 100% rally in the Chinese stock market which peaked in June and which took place in less than a year.

Foolish Summary

Sadly (and perhaps rightfully), all bubbles end the same way – they pop or deflate.

It happened with Japanese stocks when they peaked at more than 100 times their trailing earnings in late 1989; the Nikkei 225, Japan’s widely-followed stock market benchmark, is today still only around half its all-time high of nearly 39,000 points in December 1989.

It happened again with dotcom stocks in the early 2000s when the tech-heavy NASDAQ index in the U.S. became worth 156 times its trailing earnings at its peak in March 2000 only to then crash by almost 80% by the time it bottomed-out on October 2002.

No one knows when and/or where Chinese stocks will find their trough. But there’s something we do know – the bubble has burst.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Stanley Lim does not own any companies mentioned above.