Written by Michele Geraci.

China’s main stock market, the Shanghai Composite Index, took another tumble this week, falling 8.5% in a single day. It flew in the face of the Chinese government’s rescue package, which was implemented on July 8 to contain a dramatic and prolonged fall in share prices that began on June 12.

There are clearly two forces at play in China’s casino-like “stock exchange”. The first is market forces that tend to push prices down – due to the perception that stock valuations are inflated. The other is the Chinese government, which intervenes to stabilise things. When either of these two forces shows signs of weakness, prices move accordingly.

The future trajectory of the market is therefore largely dependent on which of the two forces is stronger and which one can exert the longest influence. The other (probably more important) consideration to make is to try to understand what the impact of all this market fluctuation will be on the real economy.

Trying to predict stock market performance is impossible. There will be several investment bank analysts (of which I was one a few years back) who will produce detailed models, comparative charts, technical analyses, macro-economic variables, etc., in the attempt to make some meaningful predictions. While I highly respect the work of (some of) my former colleagues, it must be recognised that everyone is navigating this storm without instruments. Visibility is limited and landscapes change continuously. The best thing one can do is to avoid hitting rocks as you see them approaching. Even better is not to set sail at all – by avoiding the Chinese stock market altogether.

The problem with prices

The Shanghai stock market trading volume is mostly dominated by individual investors who use technical analyses instead of fundamental ones when making their investment decisions. As a result there is a disconnect between market prices and the fundamental economics of the underlying companies.

Even if one wanted to perform a more virtuous analysis and go through the financial statements of the nearly 3,000 listed companies, one cannot be sure that the published financial figures are a fair representation of the reality of the company. General opinion in China is wary of the validity of companies’ financial statements. It is said that each company publishes three sets of figures: one for the government, one for the management and one for the shareholder. This latter one, the only publicly available, is the one used by financial market.

Therefore, all the usual valuation techniques must rely on data that are hard to verify. Given that share prices are driven more by “what do most people think the value of the company is?”, rather than “what is the fair value of the company?”, it is just natural and understandable that technical analysis and punting becomes the most reliable method to invest, chosen by the individual players that make up the market.

The general sentiment in China is, however, that current share prices are expensive, based on some of those hard-to-verify fundamental data. For example, Shanghai’s average Price-to-Earnings ratio is higher than other international markets, despite the higher growth rates that China should offer. During the excitement of a bullish market, this knowledge was likely buried in the back of the minds of individual investors, but the perceived overvaluation suddenly makes its reappearance when things look shaky, investors start to sell and this leads to a fall in prices.

This is why, when the market goes up, it does so in a steady and pretty much constant patter. But when the trend reverts downward, it is sudden and violent, as both forces exert pressure in the same direction (technical and fundamental). Add to this the prominence of margins and leveraged buying of shares and the three forces lead to a sudden drop in prices.

Government intervention

The Chinese government has intervened in a big way to halt the June-July drop. This is a risky move, as it distorts market dynamics more and more.

In normal markets, the risk of margin trading/leverage is born by the investors, with securities houses demanding a certain cash-to-market value ratio. This means that if share prices decline, the client must either put up more cash to maintain the ratio, or sell their shares, using the proceeds to replenish the ratio. The Chinese stock market followed this model until a couple of weeks ago.

To halt the dropping index, the government transferred the risk from investors to securities houses who were forced to bear the risk of share prices falling and stop investors from having to sell off their shares. The government then eased this pressure it had imposed on securities houses by transferring the risk onto a state-owned company, the China Securities Finance Corporation, which was injected with funding to guarantee the securities houses.

While they succeeded in stemming the tide of selling, these actions have increased the market’s level of risk. It creates serious distortions in the market and contributes to the – wrong – perception that the government can always come to the rescue of individual investors. And, by taking the risk away from investors and onto a state-owned company, it increases the level of systemic risk when the house of cards comes tumbling down.

Michele Geraci is an Assistant Professor in Finance at the University of Nottingham. This article was originally published on The Conversation and can be found here. Image credit: CC by mthierry/Flickr