1. Striking similarities between Nasdaq 2000 and 2015 Shanghai Composite Index: The fourth quarter of 1999 marked the beginning of the dot com boom, projections for online companies were huge and people rushed into buying stocks. On Sept 6, 1999 the NASDAQ was sitting at a value of 2,887. Six months later, on March 6, 2000 that value had grown by 74% to 5,048 and the market peaked. People wanted to cash in on gains and those projections of huge earnings that would last forever were discovered to be, essentially, made up. Just over a month later, on April 10, 2000 the value dropped by over 34% to 3,321. The index continued to fumble for a couple of years before starting to climb again.
Coming to the China, early 2015, the construction was booming, businesses were growing and had increasingly optimistic outlooks of their profit projections and the stock prices shot up as investors bought up the stocks as fast as they could. On Dec 12, 2014 the Shanghai Composite Index had a value of 2,938. Six months later, on June 12, 2015 that value climbed 76% to 5,178. The market was overbought and people cashed in their gains. Nearly a month later on July 8, 2015, the value dropped over 32% to 3,507.
2. Margin loans to finance stock purchases: Quick explanation – buying on margin is borrowing funds from your broker to buy stocks. Eg. If you have Rs. 2,000/- and the stock price is Rs. 40/- you can buy 50 shares, but if you want to buy 100 shares, you will have to borrow Rs. 2,000/- from your broker. Any gain from selling the stocks will first be used to pay back Rs. 2,000/- and ofcourse you will have to pay interest on the outstanding borrowed funds. But in case the stock falls below a certain level, the broker will ask you to compensate the shortfall by making a margin call, which if you don’t pay, will result into him selling the shares.
The Chinese government has been loosening the restrictions on margin trading over the past few years. As a result, Chinese brokers had extended 2.1 trillion yuan (INR 21.8 trillion) of margin finance by June 15, to investors, double the amount at the start of the year. Another 1.7 trillion yuan (INR 17.7 trillion) may have flown into stock market investment from wealth management products, online lending sites and other sources, according to Bloomberg survey of analysts. This initially led unsophisticated investors to pour money into the market, however when cracks appeared in the façade of larger companies, things began to take turn for the worse. Margin calls for ordinary investors led to a vicious cycle of selling, resulting in the drop.
3. Everyday Chinese citizens dominate the market: Unlike many of the world’s stock markets, about 85% of Chinese traders are retail. Another survey found more than two-thirds of the most recent batch of new investors didn’t even graduate from high school. Many seem to be investing with borrowed money (refer point 2) based on faith in the central government (refer point 4). “Remember during the dot-com boom where everyone from the taxi driver to your grandmother was investing and making money? That is exactly what it is like in China. I have staff quitting their day jobs to do day trading”- An American working for an international bank in Shanghai.
4. Government action: With the sudden drop in the Chinese stock market, the Chinese government was worried that the selloff would induce a further drawdown, so they quickly enacted measures like banning shareholders with 5%+ stake in the company from selling shares for 6 months, ordered state-run institutions to buy up equities, suspended trading on half of publicly traded companies. This has acted as a temporary band-aid but investors may now expect authorities to intervene during every drawdown and this overreliance on government stimulus can wreak havoc on the equity market’s growth patterns.
In effect, the Chinese stock market is a call option, where investors don’t pay any premium. Many retail investors are trading on margin, placing the majority of their net worth in the market, and not hedging downside risk because they are confident that the government won’t allow for a faltering market.
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Source: Investopedia/ CNN/ Google search