China's stock market is not China. Observers of the global economy, as well as ordinary investors, should keep that thought firmly in mind.
The amazing ascent of the Shanghai Composite index ground to a halt a month ago. Its subsequent plunge has sparked fears that the slide signals wider difficulties in the Chinese economy, and stiffer headwinds for global growth.
However, those anxieties are nearly certainly overdone. While it's never great news to see stock prices slide, the relationship between Chinese equities and underlying economic reality is tenuous.
Back in 2007 and 2008, the Shanghai index endured a battering that makes its recent troubles look like a love tap. It lost two-thirds of its value, and tumbled from more than 6,000 to less than 2,000.
Despite the equity freefall, China's economy raced ahead. It grew 9.6 per cent in 2008 and 9.2 per cent in 2009.
More recently, the market took off in the second half of last year – just as evidence was growing of a slowdown in the Chinese economy.
The lesson here? China's stock market makes a poor weather vane when it comes to economic forecasting. The Shanghai and Shenzhen bourses don't so much reflect changes in the macro outlook as they measure shifts in psychology among China's savers.
This is only natural, since unlike the case in North America or Europe, mom-and-pop traders call the tune in China. Individuals are responsible for about 80 per cent of the trading in Shanghai and Shenzhen, and those small investors have a history of stampeding in and out of the market.
They had good reason to jump into stocks a year ago. Chief among the bullish factors was a new trading link between Hong Kong and Shanghai that would bring a flood of foreign money into the mainland market.
There was also a slowing real estate market and a regulatory crackdown on high-yield investments that left Chinese investors parched for juicier returns.
When those investors surveyed their options in mid-2014, the stock market stood out: After several miserable years, it was undeniably cheap, with most stocks trading for only about 10 times forecast earnings. Even better, regulators had opened the door in 2010 to margin financing, which allowed investors to buy shares with borrowed money.
Cheap money and a rush of small investors sent the market rocketing to high after high. Fears grew of a new bubble that would rival the 2007 monster.
But the recent slump suggests that won't be the case. Investors appear to be shying away from the frothiest sectors of the market.
Many of them may be eager to cash in their gains. Even after a 30-per-cent slump over the past month, the Shanghai index still stands more than 70 per cent above where it sat a year earlier.
The Chinese government's heavy-handed attempts to halt selling suggest it's afraid that the slide will pick up speed if left to its own devices. However, it's also possible that Beijing is simply trying to bring sanity to a market it regards as infected by irrational panic.
The recent fall has purged the index of much of its frothiness. The Shanghai Composite now trades for about 19 times earnings, Bank of Nova Scotia economists noted on Tuesday. That puts the index in the same ball park as other global markets.
It also underlines the sharp contrast between the current slide and the spectacular 2007 collapse. Back then, Chinese stocks changed hands at about 70 times earnings – stratospheric valuations that demanded an adjustment to bring them back to reality.
Today's prices, especially among the biggest listings on the Shanghai exchange, don't possess anywhere near the same scary quality. Just the opposite: Kinger Lau, chief China equity strategist for Goldman Sachs, argued in a report this week that Chinese stocks will rise by 27 per cent over the next year as government measures to support the market pay off and valuations grow.
To be sure, there's always the possibility that stock market losses could ripple through the Chinese economy in unexpected ways. Much of the worry focuses on "umbrella trusts" that borrowed money from savers in exchange for a promise of a fixed return. The trusts then loaned the money to hedge funds that used the cash to make highly leveraged bets on stocks.
However, even if such trusts do blow up, the impact seems likely to be limited.
The Scotiabank economists note that China's stock market is relatively small in relation to the overall economy. The total market value of all stocks is less than 70 per cent of gross domestic product, compared with 120 per cent or more in Canada and the United States.
Moreover, only a very small proportion of Chinese households are directly invested in stocks. While about half of Americans own stocks, fewer than 8 per cent of Chinese citizens dabble in equities. As a result, the stock slump is likely to be "a relatively minor and short-lived drag on economic growth," according to Scotiabank.
"Concerns about the wider economic implications of movements in Chinese equities have been blown out of proportion," David Rees of Capital Economics says. "Changes in trading activity may have some transient impact on GDP growth. But there has been no evidence of wealth effects influencing economic activity and we do not believe that the government's intervention in the stock market signals a shift away from economic reforms."
Ian McGugan