By Craig Stephen at Marketwatch
With Shanghai stocks just having completed their worst weekly performance since 2008, it’s now impossible to ignore the question of whether China’s bull market has come to a close.
Last Friday, the Shanghai Composite Index SHCOMP, +2.19% ended down 6.4%, taking it to a 13% drop for the week. Reports that over 400 individual shares fell by their 10% daily limit suggest further selling pressure will follow through to this week.
It’s often said that with China’s “policy-driven” stock market, the bull market will continue for as long as the government wants it to. But the real wild card is predicting how China’s momentum-trading novice investors will react to the latest correction.
One way in which Beijing’s fingerprints can be seen on China’s bull market is with the practice of systematically underpricing new offerings to whip-up a retail-led investor frenzy.
In China, the regulator acts as a gate keeper to the stock market, not just by deciding who gets to list, but also by deciding the prices for those listings. This has led to an effective cap on the price of new offerings, where if a company wants to receive listing approval, they cannot price higher than 23 times earnings.
The result is that investors in initial public offerings have been all but guaranteed free money from a limit-up gain of 44% on the first day, with a majority of new stocks advancing by more than 200% in their first month of trading.
It is hardly surprising that this performance has fed an almost manic interest in equities, with literally millions of new stock-trading accounts opened on a weekly basis.
In such a momentum-driven share market, the behavior of new retail investors could be pivotal. At some stage, it would seem inevitable that the supply of retail investors and the supply of new offerings will reach their natural limits, at which point the market will be unable to keep absorbing ever-increasing amounts of paper.
We may have already reached that point.
Bloomberg noted last week that its IPO index of new Chinese issues had turned, having dropped 10% from its high on May 27 as some new listings start to correct. Likewise, the latest data revealed that new trading accounts may have also topped out. While 1.41 million new trading accounts opened last week — a huge number — it was the third consecutive week of slower growth in new accounts, which peaked at 1.9 million in the week ending May 29.
While this might be a crude proxy for investor sentiment, it does suggest that the maximum point of retail interest may have already passed.
This comes as the supply of equity paper is ramping up, with a deluge of new IPOs set to hit the market.
Last week, Guotai Junan Securities — China’s third-largest brokerage by profit — locked up 2.35 trillion yuan ($378.6 billion) of funds in its initial public offering. In total, 20 IPOs launched to investor subscriptions last week, tying up an estimated 6 trillion yuan.
The reception of these new issues by a stock market already in correction phase will be critical. If these debutantes cannot continue to deliver stellar first-day gains, will retail investors be able to hold their nerve? After all, this rally appears to be underpinned by little more than momentum and the expectation of ever-higher prices.
While there have already been various comparisons to China’s boom-and-bust stock rally of 2007, the difference this time around is the complete absence of fundamental support. Back then, the government was implementing a massive stimulus program, and at least commodity prices were also moving higher.
Today, the dominant factor aside from the IPO boom has been domestic asset-switching for households in response to a reversal in interest-rate policy. As the property market slowed and interest-rate cuts made holding savings products less attractive, it led to a massive re-weighting of household savings towards equities.
Rate cuts have also contributed to the stock rally by helping to support margin debt, which reached a record 2.24 trillion yuan as of last Tuesday.
Here again, the government has the potential to add more fuel to the rally by further cutting interest rates and/or bank reserve requirements.
Yet it was noted that the central bank stood on the sidelines as money-market rates moved higher. China’s seven-day interbank repurchase rate, which is the borrowing cost among banks, jumped from 2.2% to 2.73% over the week.
There was speculation that authorities are seeking to manage the market lower and remove some of the froth. But this is a high-risk game, playing with the psyche of China’s retail-investor herd. If greed is replaced by fear, bust could again quickly follow boom.