China to Investors: Don’t Forget That Stocks Can Lose Money Too

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After the longest-ever rally in Chinese equities, investors are getting a reminder that the $7.3 trillion market isn’t just a one-way bet.

China’s securities regulator jolted traders after the close of local bourses Friday when it banned a source of financing for margin trades and made it easier for short sellers to wager that stocks will fall. The Shanghai Composite Index fell 1.6 percent on Monday, following a tumble in offshore futures and exchange-traded funds linked to the world’s second-largest stock market.

While China bulls drew some comfort from the central bank’s biggest cut to lenders’ reserve requirements since 2008 on Sunday, the selloff shows how vulnerable the Shanghai Composite is to a pullback after going 455 calendar days without a 10 percent drop from a recent high. The benchmark gauge posted an average peak-to-trough retreat of 28 percent after six previous rounds of policy intervention to curtail stock speculation since 1996, according to Bank of America Corp.

“Institutional investors as well as authorities have had some concerns over the sharp rise in prices and trading,” Michael Kass, a New York-based money manager at Baron Capital Inc., whose $1.53 billion emerging-markets fund has outperformed 95 percent of peers tracked by Bloomberg over the past three years, said by e-mail on Friday. “This will likely cool some of the recent enthusiasm.”

Valuations Climb

The Shanghai Composite’s 115 percent surge from last year’s low on Jan. 20 is challenging authorities as they seek to weigh the benefits of rising share prices against the risk that individual investors will get burned by excessive speculation.

Traders in Shanghai have borrowed a record 1.2 trillion yuan ($194 billion) to buy equities via margin trades, while new investors have opened an unprecedented number of stock accounts this year. The Shanghai Composite trades at 16.5 times estimated earnings for the next 12 months, the highest valuation in five years, even after data last week showed economic growth slowed to the weakest pace since 2009 in the first quarter.

On Friday, the China Securities Regulatory Commission prohibited the margin-trading businesses of brokerages from using so-called umbrella trusts, which allow investors to take on more leverage. Authorities also allowed fund managers to lend shares for short sales, a move that will make it easier to execute bearish bets, and expanded the number of stocks available for this kind of trading.

Leverage Risk

The announcements came a day after CSRC Chairman Xiao Gang said in a speech on the regulator’s website that investors should “fully evaluate risk in stock market investment” and be cautious.

“The regulator is trying to reduce leverage,” said Lu Wenjie, a Shanghai-based analyst at UBS Group AG. “There could be a pullback in the market.”

Chinese authorities last targeted margin trading on Jan. 16, when they suspended three of the nation’s biggest brokerages from adding new margin accounts after they let customers delay repaying financing. The Shanghai Composite Index sank 7.7 percent the next trading day, its steepest drop since June 2008.

In a previous campaign to cool markets between April and June 2007, regulators and state media repeatedly warned that the stock market was overheating. The benchmark continued to rally to a peak in October before collapsing. By November 2008, the index had crashed 72 percent as the global financial crisis spread.

Boom-Bust

Announcements over the weekend from Chinese policy makers helped counter the impact of moves to rein in speculative trading.

The nation’s reserve-requirement ratio will be lowered 1 percentage point effective April 20, the People’s Bank of China said on its website Sunday, the second reduction this year and the largest since November 2008. The CSRC said on its microblog Saturday that new rules on stock lending aren’t meant to suppress the equity market.

For Eric Brock, a Boston-based money manager at Clough Capital Partners, any retreat in Chinese shares will provide a buying opportunity.

“Chinese authorities want to make sure there isn’t a boom-bust scenario in the equity markets,” Brock, who manages $4.5 billion in assets, said by e-mail. “We would expect the pullback to be brief and an opportunity for foreign investors who haven’t yet participated in the bull market.”

At least one technical indicator suggests Chinese shares have room to fall. The Shanghai Composite’s 14-day relative strength index climbed to 83.2 Friday, the second-highest among global benchmark indexes tracked by Bloomberg after the Kospi index in South Korea. Levels above 70 indicate to some traders that shares are poised to decline.

“In the short run, this move will increase volatility and potentially cause drawdowns,” Wayne Lin, a money manager who at QS Investors in New York, said by e-mail on Friday. “In the long run, it represents the gradual evolution of the Chinese equity markets by improving price discovery. In theory, better price discovery leads to a more efficient market with better allocation of capital.”

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