80% Chance China Will Rally… Before Final Crash, Says Pettis

Even after crashing last week, the Shenzhen Index has returned an amazing 87% over the last year. The big question is whether the market finds a floor (with lots of government assistance) or just keeps sliding toward some level where fundamentals matter, wherever that might be. Michael Pettis, professor at Peking University’s Guanghua School of Management, offers his self-described copout prediction.

“The Chinese stock markets probably have at least one more good rally in them before they come crashing down, but I wouldn’t bet the farm. I would especially distrust owning shares in the big banks,” he writes.

Two factors that made a Chinese crash likely

Although Pettis hadn’t predicted a looming market crash, he wasn’t surprised by it when it came either (and if you’re familiar with his writing you know that timing the market isn’t something he’s even trying to do). He says that the combination of unprecedented margin debt and strategic convergence created the potential for a violent break.

Margin debt is pro-cyclical because when markets are going up people’s capacity to buy also increases without changing the relative level of margin that they’re using. It can also create a cushion against small bump if investors hold a bit of this new capacity in reserve. Either way, whether investors pile new paper wealth into more (also overpriced) stock or give themselves breathing room, margin debt supports a bull market. But when prices fall far investors are forced to sell when they can’t meet their margin calls – pushing prices lower and starting the cycle again. Once again, margin debt is pro-cyclical, but the process works a lot faster on the way down.

That’s more widely understood now than it was before the global financial crisis, but what people may not know is the extent of margin debt in China. David Keohane at The Financial Times reports that margin debt as a percentage of market cap has reached 3.4%, which is probably too high (it’s about 2% in the US) but also understates the problem. Margin debt has reached 8.5% of free float, which is apparently without precedent.

Speculative herding in the Chinese stock market

The other factor is strategic convergence or herding: since a lot of investors are thinking about the Chinese market in the same way, they are likely to respond to the bad news in the same way as well. Specifically, Pettis says that the broad consensus is that Chinese equities are “a totally bullshit market” but that the government will continue to support it for a while longer.

So if the most recent money flowing into the market (it doesn’t even have to be a majority of investors) is made up of people looking to cash in on the bubble and then dash out when the government either loses patience with or control of the situation. Like margin debt, this mentality is pro-cyclical and can unwind a lot faster than it pushes prices up.

Why Pettis thinks we’ll see another rally

But there may be something to the consensus. The Chinese government has cut interest rates and relax the margin lending rules it had been tightening, while Chinese brokers have pledged billions of dollars to shore up the stock market. Even though he doesn’t think the Chinese government is happy about high stock prices, Pettis argues that it still needs the bull market to boost consumption spending by retail investors who feel wealthy, to give state owned enterprises (SOE) a way to raise money without having to issue even more debt, and even to privatize some SOEs down the road (IPOs are being pared down for now). As long as they believe that the stock market can help them achieve more important policy goals, transitioning to a consumer society while getting debt under control, China’s leaders may be willing to put up with a stock market cut loose from fundamentals.

Even if official support isn’t enough, he says that the government still has other options at its disposal.

“Wealthy Hong Kong investors can also be induced to buy under arrangements in which Beijing guarantees losses – and there have been credible rumors in the past of such arrangements,” Pettis writes.

So Pettis expects that the Chinese government will be able to stabilize the stock market, but only temporarily. At some point the high prices, detached from economic reality, will have to come down, and when they do the fallout will be severe.