Never chase a peaking market or try to bottom-hunt amid a market downturn.
In the short term, the market has limited downside thanks to government intervention, but the upside has been weakened by deleveraging efforts.
So, A shares are likely to trade sideways in the near term.
Investors could watch for three catalysts.
First: the outstanding margin financing figure.
The market meltdown has been mainly triggered by deleveraging of massive margin trading, which is unlikely to come back to its previous peak any time soon.
However, margin data could be a gauge for investors’ risk appetite.
Any pick-up in margin financing activity could be a sign that investors are willing to take on more risk and drive up the market.
Nevertheless, outstanding margin financing has already fallen 40 percent from the peak level, leading to a range-bound market in recent days.
Second: any change in market turnover and growth in the number of stock accounts, which could reflect investors’ interest in A shares and their risk appetite.
Third: stock market breadth, a better metric than the overall market index.
Although the Shanghai Composite Index has rebounded more than 10 percent from the bottom, less than 3 percent of stocks have climbed above their 50-day average.
So, the market recovery may be a bit disappointing.
Meanwhile, what if Beijing manages to lift the market and A shares continue their upward rally or even surpass the previous high of 5,166 points on the index?
That would be a sign the greed of investors has eventually won, and A shares could run up quickly, as the central government is poised to ease monetary policy further to bolster economic growth.
The market rally could be similar to the one in September 2008, when the authorities unveiled a 4 trillion yuan (US$644 billion) stimulus package.
The Shanghai Composite Index may then exceed its record high of 6,124 points in October 2007.
At that point, A shares will have become extremely expensive.
Every time the market cap of A shares reached almost double China’s gross domestic product, the Shanghai market has dropped 56 percent on average the following year.
Government intervention can create a severe moral hazard.
That is to say that since it is the government that would control the market’s direction, market players would take that as a guarantee they could not lose on their investments.
Any sign of the government withdrawing from the market could lead to an even more serious sell-off.
That could harm company earnings and undermine broad economic growth.
That’s why there has been no sign of further government intervention since the Shanghai market regained the 4,000-point level.
This article appeared in the Hong Kong Economic Journal on July 16.
Translation by Julie Zhu
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