The Shanghai Stock Exchange Composite Index gained 150% from July 2014 to June 2015 but it has declined 29% from those levels till date. Stocks were allowed to rise multi fold leading ultimately to bubble formation in most of the stock markets in China.
The Initial Public Offerings were encouraged for companies in search of capital. The Government that controls the media in China was encouraging investors to buy stocks and increase retail participation even though the bubble was formed only to get bigger and bigger in size.
The Government that controls most of the facets of the economy should not have allowed the bubble to excessively get bigger in size as markets have the tendency to normalize to fundamentally correct levels. Benchmark indices rose more than 150% in a time span of less than a year, at a time when the economy was struggling to grow at 7.7% (growth was comparable to levels seen in the year 1999).
The point to understand here is that rise in the levels of the stock market indices should indicate improving macroeconomic fundamentals that ultimately triggers growth at the industry level and finally percolates to individual companies lastly.
What happened with China is a case for investors to understand the mismatch in the fundamentals of the economy and the growth in the stock prices. The rally in the stock prices ran ahead of the improvement in the macroeconomic fundamentals for the economy and it kept on going for a long time till it ultimately burst. Most of the investors who entered at very high levels may not even recover their money for a long time to come as markets now appear to be only in a correction mode. The Government has not agreed to interfere in the current stock market rout but it says that it would do so only in an extreme situation. The move by the Government to ban trading for investors coupled with funding to stop the fall in the already inflated stock prices is practically of no use in the long run as the bubble has to normalize to acceptable levels. The correction in the market would therefore continue for benchmark indices in China as they have to still normalize to acceptable levels. It is not necessary that all the stocks have to correct but those which rose to unimaginable levels should stabilize to acceptable levels for investors.
Take the case of India where the stock market witnessed a rally to record levels of 30,000 for the Sensex and 9000 for the Nifty till the month of March 2015. The rally can be attributed to the formation of a stable Government at the Centre but prices for most of the stocks did not go in a bubble territory as hopes of a macroeconomic revival was yet to translate into growth for most of the industries and then to the individual companies. In the quarterly results we saw that growth has been tepid for most of the sectors in the economy for the last three quarters and therefore the individual companies in the large cap space are witnessing tepid growth. The benchmark indices of Sensex and Nifty have yet to surpass those record levels till date. They would be only surpassed if the investing community thinks that the improvement in macroeconomic conditions that shows moderate inflation and high economic growth coupled with lower interest rates would help most of the companies report robust growth in revenues and profitability.
The surprise move to depreciate the yuan triggered biggest drop of 2.85 percent in the currency in two decades which is creating a panic situation for most other commodity based economies. The absence of a clear explanation left the market guessing whether the move was a well-considered step on the road to fully freeing up the currency or a desperate effort to prop up exports. Looks like time has come for China to follow pure economic fundamentals to take decisions in the case of currency as investors are still puzzled about the latest move.