Investing

How Far Can Chinese Stocks Fall?

shanghaiDespite all the “unconventional” measures that Chinese regulators have tried, it looks like Chinese stocks are once again in free fall. If you think quantitative easing and zero interest rates for seven years are unconventional — so admits the Federal Reserve — how about straight up forbidding selling, arresting short sellers, banning negative news reports about stocks and suspending trading in entire sectors?

If quantitative easing is unconventional, then the rest would certainly qualify as ludicrous. But no matter. None of it seems to be working right now. As for the question of how far the capital markets in China can conceivably fall from here, the answer is, another 40% is very possible. Here’s why, with reasons based on both technicals and fundamentals.

In terms of technicals, take a look at a very long-term chart of the Japanese Nikkei, just for reference. The Nikkei topped at 38,915.87 way back in December 1989, before some current young New York Stock Exchange floor traders and hedge fund analysts were even born. By September 1990, it had fallen 46%. By June 1992, it had fallen 60%. It only finally bottomed in April 2003, down over 80% from its highs, for an astonishing 13-year long secular bear market.

If we count the even lower bottom in February 2009, back when the whole world was bottoming at the same time, the Japanese secular bear market lasted more than 20 years for an 81% loss. This is what happened in a developed Asian nation, a worst case scenario that we now know can theoretically happen.

ALSO READ: Could China Devaluing the Yuan Actually be Good Long-Term?

If we move to a long-term chart of the Shanghai Composite Index, we can find a similar spike to the Japanese Nikkei in 1989. For China it occurred in October 2007 at 6,092.05. Exactly one year later, the Shanghai Composite had fallen to 1,728 for a loss of 72%. The most recent high at 4,941.71 on May 27 was still 19% below the 2007 peak.

Thinking just in terms of chart shapes, Chinese stocks could easily head down to the 2,200 level where they were before the recent parabolic move began last October. That would be another 40% loss from where we are now. Parabolas, when they begin to break, often follow the rest of the way until fully broken.

Fundamentally though, what causes all this? Many say economic contraction, but this confuses cause and effect. What causes both economic contraction and stock market crashes is a shift in money supply growth. Going back to Japan, take a look at a maximum term chart of its M2 money supply levels from 1960 until today. You will notice a steady curve from 1960 until 1989 when money supply growth suddenly flattens out.

If you zoom in just a bit, you will see small and sudden spurt upward where the slope goes nearly vertical just before the flatline, which may have fueled the final stages of the Japanese bubble way back when. The flatline that followed was enough to bring the whole thing down, never to fully recover.

Fundamentally, how far down we can go in China depends on how much money China’s central bank, the People’s Bank of China, decides to print. On the one hand, the yuan supply is increasing. On the other hand, the central bank’s balance sheet is shrinking, 3% down since February, for the longest sustained decrease on record.

This implies that the People’s Bank of China is done printing for now, even though the fractional reserve system in China is still increasing the yuan supply secondarily. With the central bank out of the picture for now, at least as a major player in yuan supply increase, a further 40% loss in Chinese stocks is a real possibility.

ALSO READ: Credit Suisse Opines on Chinese Devaluation

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