Speculative China forays call for caution
With the Shanghai stock market down more than 20 per cent this year, it is tempting to read the fall in stock prices as an indication that Chinese investors believe the economy is poised to slow dramatically.
But analysts should be cautious in how they interpret the recent gyrations in Chinese stocks.
We are used to thinking about markets as machines that discount expected cash-flow, and that stock price levels generally represent the market's best estimate of future growth prospects. This, however, is not always the case, and it is certainly not the case in China.
Why not? Investors in any market will follow a variety of different investment strategies, and the performance of the market will reflect the mix of these various approaches.
Broadly speaking there are three such strategies: speculative strategies, which involve taking advantage of short-term changes in supply and demand factors; relative value strategies, which seek to exploit differences in the relative value of assets; and fundamental or value strategies that seek to buy long-term cash flows.
It is the latter strategy - perhaps most famously characterised by Warren Buffett - that gives the market its predictive ability. By constantly switching out of assets with diminished cash-flow expectations and into assets with rising cash-flow expectations, fundamental and value investors turn the market into a machine that discounts long-term cash-flow expectations, and in so doing, makes predictions about the future.
The level of market prices is the sum of these predictions.
But the various investment strategies are only useful to the extent that there are tools available to pursue these strategies profitably. China's markets, however, are still too underdeveloped to permit many of the investment strategies.
Poor macrodata, inaccurate financial statements, and many of the factors that make speculation exciting in China, make it difficult for relative value investors, and nearly impossible for fundamental and value investors, to ply their trades. Also, a weak corporate governance framework makes it nearly impossible for investors to predict the behaviour of management. And with interest rates heavily controlled by the People's Bank of China, and subject to policy shifts, investors are not even sure what an appropriate long-term discount rate might be.
On the other hand, speculative investment strategies have plenty of the necessary tools. Large shifts in underlying liquidity, lots of frantic government signalling, sudden changes and reversals in trading and investment regulations, insider activity, and so on, ensure that there is plenty of information for speculators.
Under these conditions it is not surprising that the Shanghai market is extremely speculative and that most investors, whether they admit it publicly or not, are largely engaged in what in other markets would be termed speculative behaviour.
Take most fund managers out for late-night drinks and they will readily admit that the two most useful pieces of information that they crave is information about changes in underlying liquidity conditions and information about which way the government would like to see markets go.
A market driven almost exclusively by speculators, and with little to no participation by fundamental or value investors, is not a market that pays much attention to long-term growth prospects.
It is driven largely by fads, technical factors, liquidity shifts, and government signalling.
So what does the decline in the Shanghai stock market tell us? It might be saying something about the impact of the European crisis on export earnings. It might suggest that liquidity in the system is being driven into real estate rather than into stocks. It may reflect contagion and nervousness about the fall of stock markets abroad. But we should be cautious about reading too much into it.
In fact attempts by Beijing to hammer down real estate bubbles in the primary cities without addressing underlying liquidity expansion may simply push asset price bubbles elsewhere, and this could easily cause a surge in the Shanghai stock markets.
Michael Pettis is a finance professor at Peking University and chief strategist for Shenyin Wanguo Securities (HK)