The $8 Trillion Penny Stock: China’s Market of Boom-Bust-Repeat

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A securities trading firm in Shanghai
An investor looks at stock quotes at a securities trading firm in Shanghai. Photographer: Kevin Lee/Bloomberg

It looks like the price chart of an over-the-counter penny stock: dizzying gains, abrupt U-turns, harrowing declines.

But this is no obscure security from the rough-and-tumble fringes of Wall Street. It’s China’s Shanghai Composite Index, the yardstick for an $8.1 trillion equity market -- the world’s largest after the U.S. -- where extreme volatility is becoming the norm.

Fueled by record amounts of borrowed money and the whims of more than 80 million individual investors, swings in the Shanghai Composite have climbed to the highest levels since 2008. They’re bigger than every other benchmark index worldwide after Greece, along with a quarter of the 100 most-traded penny stocks on U.S. bourses, according to data compiled by Bloomberg.

“You’d think you wouldn’t see this volatility in such a large equity benchmark,” Ankur Patel, the chief investment officer at R-Squared Macro Management LLC, said by phone from Birmingham, Alabama. “The flows in and out have been so substantial and it’s been driven by retail investors. Those are the same characteristics you see in penny stocks.”

China’s wild ride is unlikely to calm down any time soon, according to Reorient Group and Summit Research Partners. After wiping out a record $668 billion of market value on Friday, mainland stock traders reacted Monday to the central bank’s decision to cut interest rates to all-time lows -- a move some analysts say was timed over the weekend to lift Chinese equity prices from the brink of a bear market.

Novice Traders

Like their counterparts around the world, investors in China are also grappling with the prospect of a Greek default and exit from the euro after the nation’s bailout talks broke down. The Shanghai Composite sank as much as 7.6 percent on Monday after rising 2.5 percent earlier in the day, recording the biggest intraday point swing since 1992.

The gauge’s 10-day volatility reading jumped to 60 on Friday, the highest since November 2008, while its 3.8 percent average intraday move this month is more than four times bigger than that of the Standard & Poor’s 500 Index.

The manic ups and downs are testing the resolve of the China’s amateur investors, who piled into shares at a record pace as the market soared earlier this year.

Liu Chang, 28, says his colleagues in the tobacco industry near Shanghai are vacillating between liquidating their positions and betting on a rally. Wang Yan, a 26-year-old who works for a publisher in China’s eastern Zhejiang province, says her friends are too terrified to even check the balance their online trading accounts.

Rate Cuts

“Given that it’s a very retail-driven market, it’s always going to be more sentiment driven,” said David Welch, the head of equity sales trading at Reorient Group in Hong Kong. “That works both ways, both on the upside and lately on the downside. Until the market becomes more institutional in nature, it’s going to be boom and bust.”

The Shanghai gauge had surged more than 150 percent in the 12 months prior to its June 12 peak, as authorities cut trading fees, made it cheaper to open new stock accounts, expanded investment quotas for overseas money managers and eased rules on margin lending. They also lowered interest rates three times before last weekend and reduced lenders’ reserve requirement ratios twice.

Bulls, Bears

Investors shouldn’t be surprised to see such big price swings in China, where capital markets are still relatively young and many investors are inexperienced, said Brian Jacobsen, who helps oversee $250 billion as the chief portfolio strategist at Wells Fargo Funds Management. Developing markets like Russia, Bangladesh and Argentina have all had similar bouts of volatility in the past few years, he said.

“The swings aren’t anything unique to China,” Jacobsen said. “It’s part of the fabric of trading and reflects the floodgates that were opened to new investors. When floodgates open, some get caught up in the current, and some drown.”

Henry Guo, an analyst at Summit Research Partners in San Francisco, says volatility in China is going to stay elevated as bulls and bears take turns in the driver’s seat.

While optimists point to the prospect of continued monetary stimulus, skeptics are worried that valuations have climbed too far. The median stock on mainland exchanges trades at 82 times earnings, higher than when the Shanghai Composite peaked in October 2007.

“On one side people have concern about the valuations, and on the other people still believe the government is supporting the market,” Guo said. “I expect this back-and-forth to continue.”

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