Bear takes a dead-cat bounce
Whenever I want to know how the stock market in Shanghai is performing, I can ask any of my several Shanghainese friends whose sole occupation is chao gupiao - stir-frying stocks. If they are in a bad mood that day, I know the market is down; if they are in good spirits, the Shanghai Composite must be up.
In March, my friends were in an all-out depression as the Shanghai index declined 20 percent, its biggest monthly loss ever. In mid-April, conversations inevitably started with laments of how the government was not doing enough to halt the decline.
In late April, the China Securities and Regulatory Commission announced a pair of regulatory actions designed to stimulate the market after its free-fall. The first, a block trading system for large sales, was announced on April 20th. In the following trading days the market response was lukewarm, the index went up only six percent. Clearly more investor relief was needed and, on April 23rd, the Commission delivered a cut to the stamp duty (the tax on transfer of stocks) from 0.3 percent to 0.1 percent. The next morning, Shanghai's index increased by 9.29 percent and, for the week, gained 14.96 percent, the biggest weekly gain on the index, ever.
What causes these huge shifts in the schizophrenic Shanghai stock market? It its 17 years of history, the Shanghai market has struggled through periods of under- and over-regulation. An investor once said, "Too much government interference, that's what's wrong with these markets...Things won't improve until the government leaves these companies alone to get on with their business." Was the investor commenting in May 2007 when the Commission raised the stamp duty to cool the exuberant bull market? Actually, it was May 1996, quoted in an International Herald Tribune article about over-regulation in the then bear market. Clearly, when it comes to government regulation, old habits die hard.
Milton Friedman, the late Nobel Prize-winning free-market economist, once said, "The stock market and economy are two different things." Looking at the recent actions of the Commission, the two appear increasingly intertwined. While some regulation is good - corporate reporting standards, for example - micro-management of the stock markets to cool the economy, or to relieve investors of losses, should not be the role of a regulator. These actions have set a dangerous precedent for government intervention in the markets that will only create more financial instability in the long-run.
The main reason for greater instability is the concept of moral hazard. This term, when applied to investing, means taking on too much risk in the belief that one will be bailed out if things go wrong. In April Chinese investors were clearly waiting for the government to come to the rescue, as shown by decreasing trading volumes up to the point of the announcements. Now that the Commission has delivered, the expectation for relief will be increased the next time around.
With underlying market factors still unchanged, any recovery from these regulatory actions will be short-term at best, and we are likely to see more dead cat bounces. The idea of a dead cat bounce is a temporary reprieve from a downward trend but lacking a fundamental change in the factors driving bear market sentiment.
On April 30th, Shanghai Securities News reported that 1574 listed firms had combined 2007 profits of more than 136 billion US dollars. Meanwhile, a commonly reported statistic is that 15% of corporate profits, or about 20 billion US dollars, were from corporate stock market speculation in 2007. This practice was so out-of-control that a year ago the Commission had to prohibit Chinese firms from using their IPO funds for trading: It was easy money as the Shanghai index more than quadrupled in value in the last two years. This year, with the index dropping significantly off its 2007 highs, one might wonder how many companies are now sitting on significant trading losses. Bounce.
Many investors in China are deeply worried about the flood of new IPO shares in the pipeline and state-owned company shares coming out of lock-up periods. The new block-trading system, whereby amounts of shares over one percent of the total outstanding have to be sold in a block trade, seems like a good way to prevent over-supply of new shares. In the days following the announcement, numerous large investors were found to be selling 0.99 percent of their holdings at a time. Bounce.
Of the last four times the stamp duty was modified, the three times it was decreased were in flat or declining markets with no appreciable long-term stimulus and the one time it was increased, in May 2007, the market continued its great bull run. Now tell me again the logic for decreasing the stamp duty to push the market back into bull territory? Bounce.
I think that cat is dead by now.
Republished from May 5, 2008
Jason Inch is a Shanghai-based consultant and co-author of the soon-to-be-released “Supertrends of Future China.” Email: Jason@ChinaSupertrends.com
