China’s Meteoric Drop Today – Fluke or Omen?

China’s Meteoric Drop Today – Fluke or Omen?

The Chinese stock market, the Shanghai Composite, tradable under the iShares FTSE/Xinhua China 25 Index ETF (NYSEARCA:FXI) fell by nearly 8% today on news that would otherwise seem rather vapid. Regulators put the clamps on three Chinese brokerages for lending more money for longer than margin trading rules allow.

The news itself should not really be that worrying. Preventing a few brokerages from loaning on margin temporarily is in not nearly earth-shattering news. Rather, it is the reaction to the news that is more worrisome. If Shanghai can trade down 8% in one day off a few brokerages being grounded for a few months, that means the recent rally is being driven by weak credit-addicted hands.

That rally is about 6 months old now. The Shanghai composite has risen 64% since June. However, putting it in perspective, this is only the third most powerful short term rally for the index going back to the early 90’s. Chinese stocks rose nearly 100% from October 2008 until July 2009, and 445% in the two year period from November 2005 until October 2007.

Shanghai Composite

Compared to those two, this rally is a pipsqueak. And still it gets sopped into the biggest decline in 6 years due to a few brokers who got slaps on the hand.

There are two possibilities here. Either this was an overreaction and Shanghai will quickly recover and resume trading higher, or the sudden extreme weakness is a sign of underlying fundamental weakness in the Chinese capital markets, as signaled by the broader economy.

To answer that question, we need to turn to the real economy, which isn’t doing so well. Housing prices registered a 4th straight monthly decline, raising questions as to whether there will be a true housing bust like in the US in 2007-2008, and whether this will trigger a chain of bankruptcies and credit defaults.

The fact that slamming the credit breaks on three brokers for only a few months had such a large impact on its stock market, indicates that any significant credit crunch in the broader Chinese economy could have an even stronger negative effect on Chinese stock prices.