The overheated Chinese market II - Article from Bloomberg

Shanghai Traders Make Trillion-Yuan Stock Bet Backed by Debt

Shanghai traders now have more than 1 trillion yuan ($161 billion) of borrowed cash riding on the world’s highest-flying stock market.

The outstanding balance of margin debt on the Shanghai Stock Exchange surpassed the trillion-yuan mark for the first time on Wednesday, a nearly fourfold jump from just 12 months ago. The city’s benchmark index has surged 86 percent during that time, more than any of the world’s major stock gauges.

While the extra buying power that comes from leverage has fueled the Shanghai Composite Index’s rally, it’s also sending equity volatility to five-year highs and may accelerate losses if a market reversal forces traders to sell. Margin debt has increased even after regulators suspended three of the nation’s biggest brokers from adding new accounts in January and said securities firms shouldn’t lend to investors with less than 500,000 yuan.

“It’s like a two-edged sword,” said Wu Kan, a money manager at Dragon Life Insurance Co. in Shanghai, which oversees about $3.3 billion. “When the market starts a correction or falls, it will increase the magnitude of declines.”

In a margin trade, investors use their own money for just a portion of their stock purchase, borrowing the rest from a brokerage. The loans are backed by the investors’ equity holdings, meaning that they may be compelled to sell when prices fall to repay their debt. The Shanghai Composite rose 0.4 percent at the close on Thursday.

Bubble Concern

Chinese investors have been piling into the stock market after the central bank cut interest rates twice since November and authorities from the China Securities Regulatory Commission to central bank Governor Zhou Xiaochuan endorsed the flow of funds into equities. Traders have opened 2.8 million new stock accounts in just the past two weeks, almost on par with Chicago’s entire population.

The outstanding balance of the margin debt on China’s smaller exchange in Shenzhen was 502.5 billion yuan on April 1. That puts the combined figure for China’s two main bourses at the equivalent of about $242 billion. In the U.S., which has a stock market almost four times the size of China’s, margin debt on the New York Stock Exchange was about $465 billion at the end of February.

For BNP Paribas SA economist Richard Iley, the surge in Chinese margin purchases is among signs of a bubble fueled by individual investors. More than two-thirds of new investors have never attended or graduated from high school, according to a survey by China’s Southwestern University of Finance and Economics.

“Leverage cannot rise forever,” Iley wrote in a report last month. “The more the stock of margin debt climbs, the greater the risk of a disorderly unwinding of leveraged positions once net redemptions begin to accelerate.”

Shanghai Composite Flirts With 4,000 as Hong Kong Equities Surge

China’s Shanghai Composite Index briefly surpassed 4,000 for the first time since 2008, extending the world’s biggest stock-market rally as investors bet authorities will increase monetary stimulus to bolster economic growth.

The benchmark equity gauge surged to as high as 4,000.22 before paring gains to close 0.8 percent higher at 3,994.81. The index has doubled since January 2014 as traders borrowed a record amount of money to buy shares, new investors opened stock accounts at an unprecedented pace and government officials endorsed the rally. A gauge of Chinese shares in Hong Kong jumped 5.8 percent for the steepest gain since December 2011.

China’s central bank has cut interest rates twice since November and analysts predict authorities will ease policy further to keep economic growth above their 7 percent target. The nation’s individual investors, who account for about 80 percent of equity trading, may view the 4,000 milestone as a signal to boost holdings, according to Shenwan Hongyuan Group Co., the nation’s second-largest brokerage by market value.

“Breaching the 4,000 level can be read by retail investors as a bullish signal,” said Gerry Alfonso, a director at the international business department of Shenwan Hongyuan in Shanghai.

While the market’s rapid ascent has fueled concerns of a bubble, Shenwan Hongyuan estimates the Shanghai index may rise to 4,500 as individuals shift more of their assets into equities. The gauge is still well below its all-time high of 6,092.06 in October 2007.

Mobius Outlook

The Hang Seng China Enterprises Index in Hong Kong rallied 5.8 percent at the close, while the Hang Seng Index advanced 3.8 percent to the highest level since May 2008.

Industrial and financial shares led gains in both Hong Kong and Shanghai. Citic Securities Co. and China Railway Group Ltd. both surged more than 4 percent. Gome Electrical Appliances Holding Ltd. jumped 35 percent in Hong Kong after Citigroup Inc. recommended the stock over its mainland rival Suning Commerce Group Co. because of cheaper valuations.

Net purchases of Hong Kong shares through the Shanghai exchange link surpassed the daily record within the initial half hour of trading Wednesday, before filling the 10.5 billion yuan quota for the first time.

China’s stocks may fall 20 percent as shares have risen too fast, Mark Mobius, who oversees about $40 billion as the executive chairman of Templeton Emerging Markets Group, told reporters in Hong Kong.

Relative Value

The Shanghai Composite is valued at 15.3 times estimated earnings for the next 12 months, compared with the five-year average of 10.2, according to data compiled by Bloomberg. In the technology industry, the best-performing part of the market this year, shares are trading at an average 220 times reported profits, the most expensive level among global peers.

A big retreat is unlikely unless authorities take steps to cool the market, said Wang Zheng, the Shanghai-based chief investment officer at Jingxi Investment Management Co., which oversees the equivalent of $322 million.

The Shanghai index slumped 7.7 percent on Jan. 19 after the China Securities Regulatory Commission suspended three of the nation’s biggest brokerages from adding new margin trading accounts and said securities firms shouldn’t lend to investors with less than 500,000 yuan ($80,594).

The gauge has since rebounded 28 percent as the central bank governor and the CSRC endorsed the flow of funds into shares. China needs strong support from the equity market as the economy faces relatively large pressures this year, the official Xinhua News Agency reported on Tuesday.

Booms and Busts

Valuations have climbed too high, Vincent Chan, the head of China research at Credit Suisse Group AG, said in an April 2 phone interview. He sees a correction that will take the Shanghai gauge back down to 2,800 by the end of the year, amounting to a drop of about 30 percent. Losses may accelerate as margin traders liquidate their positions, he said.

The outstanding balance of margin debt on the Shanghai Stock Exchange surpassed 1 trillion yuan for the first time this month, a nearly fourfold jump from just 12 months ago, while investors opened a record number of new trading accounts in the week ended March 27.

China’s stock market has a long history of booms and busts. The Shanghai Composite has recorded more than 50 bull and bear markets, defined as a move of at least 20 percent from a recent peak or trough, since Bloomberg started compiling the data in 1990. The current gain of about 100 percent compares with an average advance of 122 percent during previous rallies.

“It’s the nature of the Chinese bull market that every 7 to 8 years, a few investors get rich quickly,” Earl Yen, the chief investment officer at CSV China Opportunities Ltd. in Shanghai, which oversees more than $200 million, said in a phone interview on Tuesday. “Then the bubble bursts and mass retail investors stay away from the market.”