Some alternative theories on what is driving China’s Stock Market to new highs

Written by Zennon Kapron || December 10 2014

Conventional wisdom and the written history of capital markets would have it that the value of a particular stock is based on the potential of future returns in the form of dividends and the underlying book value of the company. Not ones to stick with tradition, China’s mainland investors have often defied this basic tenant of reason and developed their own ideas about what the price of any particular stock should be.

In general, it’s useful to remember that investors have choices in what to invest in, so although China has been growing and salaries increasing, generally, any investment in the stock market is a re-allocation of existing investments or capital gains. Although the investment choices in China are slightly more limited than those in other countries, the idea still applies.

If you haven't been following the news, the Shanghai Stock Market has gone from being the red-headed stepchild of global markets to the best performing of 2014 based on the index's return. The market has also topped in terms of volume, setting a global record only a few days ago.

This is not unprecedented in China. From 2000-2008, the Shanghai markets went on a 500% run-up as speculators piled into markets. The party ended over the course of 2007-2008 when the market gave back most of the gains. 

Previously most stories, including our own, have pointed to the HK-Shanghai connect as the primary driver behind the recent market rise, we wanted to take a look at some alternative theories. So in no particular order, here are some of the theories that we’ve heard over the past couple of weeks: 

Deposit insurance is scaring people into the stock market

Context: Last week the Chinese government made some initial indications that deposit insurance would be a near-term focus for regulators as we move forward into 2015. Underlining the announcement was the tacit undertone that banks would be allowed to fail.

Idea: Either by completely believing that their savings is not safe in banks or thinking that if they are going to risk their money, they might as well do it in the stock market, investors are pulling their money out of banks and putting it into stocks.

Kapronasia’s Believability Index™: Moderate. Certainly there will be an attitude shift in consumers about the sanctity of Chinese banks, but realistically we have not, and are unlikely, to see the too big to fail thesis tested in China anytime soon, in public anyway…

Bitcoin is flat, investors are moving on

Context: Bitcoin was the best performing asset in the world in 2013, especially if you sold at the right time, but even if you just held for the entire year, it eclipsed nearly everything. Towards the end of 2013, China started driving prices. Since then, the digital currency has fallen considerably, and although still volatile, its gains are a bit too low for the average Chinese investor, although there are plenty still actively trading on zero-fee Chinese exchanges. 

Idea: Although many people in China and elsewhere made a tremendous amount of money passively speculating on Bitcoin, many were left out of the massive price increase. Seeing their opportunity with the Shanghai market, they are getting back into speculation, but just with a more traditional asset.

Kapronasia’s Believability Index™: Low. The number of people who actually did and even that still do make money from Bitcoin is small. Even if they shifted into the stock market, the impact would be small.

Real estate is also flat(ish)

Context: Up until the start of 2014, nearly every real estate market in China was posting year on year price increases, as real estate basically became the only positive long-term returning asset in China. Markets like Shanghai and Beijing grew understandably rapidly, as did 2nd and 3rd tier markets that were driven largely by what could only be considered to be speculation. Through regulation though, many markets have slowed or actually come down from their highs.

Idea: Investors, seeing real estate no longer being the one way bet that it once was, have moved into stocks to find better returns.

Kapronasia’s Believability Index™: High. Although there is an incredible amount of wealth in China that is tied up in and has been created from real estate, the barrier to entry in terms of initial cost is still quite high. Investors who have either been unhappy with the recently less frothy returns of real estate, or were prevented from investing in it because of the basic costs, have certainly moved into the stock market and been responsible for at least some of the drive. 

Good old-fashioned ‘dama’ speculation (with a touch of margin)

Context: The Chinese have a centuries old history of finding and trying to take advantage of get rich schemes.

Idea: The mainland China stock market is a get rich scheme.

Kapronasia’s Believability Index™: Highest. If this were a game show, the lights would be flashing and the winning music playing. Dear reader, as much as we would like to tell you this rally is based on stock fundamentals and genuine belief in the market fundamentals, it is not. The Chinese love a good rally and this is it.

After 6+ years of mediocre returns, the context of the HK-Shanghai connect and lack of other similarly high-return assets is driving investors to the market. If you read news and commentary about the mainland market, nearly everything is pointing to ‘increased investor interest’, which is in turn driving additional interest as more investors pile in.

Rumors about dama, middle-aged women famous for driving up the price of gold, tea and everything in-between, are back in the news as it once again has become fashionable to hang out in securities houses.

Same, same, but totally different

But have we hit the peak? Likely not. Despite some rather grim economic indicators, there is likely a bit more growth in store for the market. The SSE Composite Index grew nearly 500% from 2000-2008 before the wheels came off. Right now, the Shanghai Stock Exchange Composite is trading just over 3000, which is less than double the 52 week low of 1900. If the market went on a run as before, it could get well up to 8000+ before things settle down (admittedly a rudimentary analysis). 

Fundamentally, it doesn’t really make sense either. Although a GDP growth of 7% is still enviable, companies are in what could largely be a more tenuous position than they were 6 years ago. Markets have been reforming, but real risks lie right below the surface in the form of shadow lending, insider trading, bad risk management, etc..

What might be the biggest worry though, is the fact that so much of this is coming from margin trading. Trading on margin wasn't an option for investors during the first run-up a decade ago, but with new rules instituted last year, the increasing amount of debt fueling the rise of the market is worrying (see chart below). Although a stock market crash can be crippling. A crash in a market heavily driven by margin could be devastating. 

This is by no means a recommendation to invest in anything whatsoever. Everyone needs to make that decision on their own. It is however a recommendation not to overlook the obvious. The HK-Shanghai connect, deposit insurance, etc., were all potential reasons behind the current run, but the real reason is the one you could have likely guessed from the beginning: speculation.


If you haven't had a chance, check out this article from Bloomberg on Five Charts That Show China’s Stock Boom Is Unprecedented. A couple of the charts are below.

Shanghai Stock Market - Margin Debt Levels

Shanghai Stock Market Turnover