The story behind the big stock plunge in Shanghai

Mainland China’s major stock index plunged 6.5% today.  But the losses, attributed to the nation’s central bank and some brokerages draining cash out of the system, follow a 15% seven-day rally.

While the big move to the downside in the Shanghai Composite Index (SHCOMP) may seem “apocalyptic,” investment pros at Bespoke Investment Group point out that the shares trading in Shanghai are notoriously volatile. Bespoke notes that so-called Shanghai A-shares typically move 2.5 times more daily than the USA’s broad Standard & Poor’s 500-stock index. If the higher daily volatility is factored in, today’s 6%-plus plunge suffered by the Shanghai Composite Index equates to a 2.66% more for the S&P 500,  Bespoke said.

So what sparked the wave of selling?

“The catalysts for the move were the removal of some liquidity,” explained Paul Hickey,  Bespoke’s co-founder. The People’s  Bank of China (PBoC) took some “cash out of the system.” And a few brokerages boosted margin rates, which means investors who buy stocks with borrowed cash have to pay higher interest rates on those loans.

Add in the fact that the Shanghai had rallied more than 52% in 2015 heading into today’s session, including a recent 15.4% jump in the prior seven trading days, the index was due for a bit of a breather. Shanghai A-shares have gotten a boost since the introduction of the recent trading link between mainland China and Hong Kong.

The day’s big drop might be a tad overdone, although volatility is likely to continue, Kevin Ferriter of Capital Economics.

“Although numerous triggers have been proposed for Thursday’s nearly 7% fall in the Shanghai Composite, none of these seem likely to have had a large enough impact on fundamentals to explain such a sizable move,” Ferriter told clients in a report. “Instead, it was probably driven by a wild swing in sentiment. With valuations divorced from economic fundamentals, the heightened volatility we have seen is likely to continue.”

Bespoke also advises investors not to overreact to one day’s trading activity and get too negative on Chinese stocks.

“While selling could continue from here a bit further, we would be very cautious about dumping Chinese positions or getting short — until more serious signals are sent by the government in Beijing that the equity rally needs to end,” Bespoke told clients.

“Keep in mind (the stock rally has) been sanctioned almost all the way up and significant catalysts remain,” Bespoke said. “(Catalysts include) still-ample liquidity in the Chinese banking system, global equity index underweights, further liberalization of China’s capital account, and ongoing efforts to stabilize the economy by the central government.  We’d wait for a rebound before adding, but don’t recommend getting beared up on China here.”

[“source-americasmarkets.usatoday.com”]