The Real Threat from China’s Stock Market Crash

Keith Fitz-Gerald Sep 02, 2015

Conventional wisdom at the moment says that China’s coming unglued and that the country’s stock markets pose a grave danger to global investors. It’s communist, it’s a Ponzi scheme, it’s ruled by insiders, it’s leveraged up to its eyeballs, ghost cities… all the usual tired old arguments are being rolled out as if they’re somehow new again.

In reality, the real risk isn’t being reported. In fact, it’s not even being talked about.

I want to focus on this disconnect today, because the China-bashing crowd is right about one thing – that country’s current challenges definitely affect your money.

Just not the way most people think.

Here’s what you need to know about China to properly (and profitably) position your portfolio.

The Great Fall of China … or the End of the Bling Dynasty?

The ongoing media narrative about China is as brutal as it gets, with legions of talking heads and mainstream pundits whipping up story after story about how the world’s second-largest economy is coming unglued.

For example, author and China expert Gordon Chang, best known for his 2001 book The Coming Collapse of China, noted on CNN recently that “China could be in the world’s greatest depression and they would still report 7%.” He’s alluding to the fact that “everybody” knows Chinese economic data is manipulated.

The implication, of course, is that ours isn’t, which is a lesson in irony if I’ve ever seen one considering what our government’s done to everything from employment figures to manufacturing input.

Meanwhile, well-known China bears like Jim Chanos have returned anew with cataclysmic warnings about why the Chinese market meltdown will mean the end of the financial universe as we know it. “Whatever you might think, it’s worse,” he told CNBC’s Fast Money last August.

Never mind that he’s an avowed short seller – and a good one at that – or the fact that people have been saying exactly the same thing about U.S. markets since March 2009, right before the S&P 500 took off on a generational 186% run.

A little perspective is clearly in order.

First, if China’s market were really the global colossus the media’s made it out to be, you can bet that our markets would have taken that into account years ago and shifted to the Far East accordingly.

But they didn’t, and they won’t for a long time to come.

Look at the following map, which depicts national boundaries commensurate with stock market size. It pretty much tells the story:

usa (1)

“But… but… they’re really volatile,” goes the thinking. The argument states that investors have no business setting their sights on the Red Dragon because our own markets are more stable.

Uh huh… on the heels of the wild 1000+ point drop in the Dow seen on August 24 and the following Wednesday’s 619-point rocket ride higher, ask yourself if you really believe that. I don’t.

No doubt Chinese stock markets can give investors a roller-coaster ride. In fact, they’re the most volatile on the planet at the moment, exceeding even Greece.

But here’s the thing: Chinese markets were still 30% less volatile than the maximum volatility achieved in the world’s six major market crashes since 1929, according to Bloomberg:

chinas_crash (1)

Let me break this down another way.

The Chinese stock market meltdown that supposedly is so critical to U.S. markets is a drop in the bucket compared to the 78% implosion when the Dot.bomb bubble burst here in 2000 and the 84% shellacking in Russia after that country defaulted in 1998.

Keep in mind that the U.S. economy has absorbed far bigger shock waves from overseas economic implosions before. It will again.

China’s Bureaucracy Could Be Your Best Buffer Against Market Turmoil

With the exception of the Nasdaq collapse in 2000, every other major crash in the chart I’ve just shared with you was caused by a breakdown that was either banking or debt-related. China’s stock market “disaster” is merely an internal adjustment that’s bringing prices back down from nosebleed levels. Keep in mind, between June 2014 and June 2015, China’s Shanghai Composite Index rose by 150%.

That, too, is normal for China, where individual investors having little or no experience investing account for an estimated 70% of all stock market transactions. Some 67% of the tens of millions of investors there have less than a high school education, according to a survey reported by The Guardian. So, like our markets at the beginning of the last century, they’re totally ill-equipped to handle the ups and downs that western investors take for granted as a fundamental part of capitalism. But they will anyway, as part of the inevitable maturation process that all capital markets undergo over time.

Further, Chinese A-shares – meaning those traded on mainland exchanges – are largely blocked from foreign investors. That means Chinese investors can bid them up to their hearts’ content almost in complete isolation and without the institutional selling that would otherwise balance that out.

Things are so bad that investing has quite literally become a spectator sport, with tens of thousands of brokerage houses in cities all over China providing theater-like seating so customers can chart the rise and fall of their investments.

I’ve been to more than a few of them over the years and you’d be hard pressed not to think you were in Vegas at the craps tables because of the way emotions flow through the crowd.

This picture, for example, shows a brokerage house in Beijing on a good day. All the red you see actually means that the Chinese markets were having a great day. The few green lines are actually stocks headed lower. (In China, red is up and green is down.)

lecture (1)

Sources: EPA,

Here in the U.S. roughly 70% of trading volume is generated by institutions. That gives our markets a pronounced stability that most investors either take for granted or have never thought about before. Further, U.S. markets are open to millions of participants around the world, resulting in a constant stream of buying and selling rather than unidirectional, manic buying or selling.

And finally, many Chinese bears are concerned that money will flee China and suck the lifeblood out of the world’s global growth engine. This isn’t really the big deal they make it out to be either.

According to the World Bank, only 7% of Chinese households have invested in Chinese markets, allocating an average of 9% of their wealth, according to Beijing. Either way, that implies that more than 90% of Chinese households haven’t invested in their country’s stock market… yet. To use a very American stock market expression, there’s still plenty of money on the sidelines.

In reality, money leaving China would be great for one simple reason – because the vast majority of it would head straight for the most sophisticated and stable stock market on the planet, which is ours.

China’s Markets Aren’t China’s Economy

Pundits tend to wrongly equate the direction of a country’s markets with the trajectory of its GDP. That’s a loose correlation at best because the former is a financial instrument while the latter is an economic one. Even if growth has slowed from 7% to merely 4%, that’s not the disaster everybody thinks, especially when you consider how central banks in Europe, the United States, and Japan have spent trillions and have very little to show for their efforts.

The real risk here is something nobody’s talking about – that Beijing uses current market conditions as an excuse to slam down on the economic reforms that have gotten it this far.

If you think things have been wild now, imagine what happens if Beijing actually cuts off trade and reverts to Soviet-style communism rather than the capitalist version they’ve adopted.

So how do you build an investment strategy to prepare for this threat?

No doubt the situation in China is serious, but it’s all about psychology, not economic reality. That means you probably want to confine investments in China to very small slivers of your portfolio, just as you would any speculative investment.

Investing because of China is another matter entirely. That’s because China is the world’s last true growth market. It will remain volatile, but as such, also filled with opportunity.

Your best bets will be Western companies traded on Western exchanges tapped into the huge wealth creation. It’s not for nothing, for example, that Apple Inc. (NasdaqGS:AAPL) is focused on China. The same is true for The Coca-Cola Co. (NYSE:KO), Starbucks Corp. (NasdaqGS:SBUX), and Ford Motor Co. (NYSE:F). Even Molson Coors Brewing Co. (NYSE:TAP) announced a joint venture in China.

Of course, resource companies like BHP Billiton Ltd. (NYSE:BHP) and Freeport-McMoRan Inc. (NYSE:FCX) work, too. They’re major commodities players that will tap into the underlying production that quite literally makes China go. They’ve both been beaten down severely as China’s growth rate has slowed and Westerners have predictably panicked; yet, they’re ideally positioned to surge on an inevitable rebound for vital raw materials.

In closing, the real risk to China is one nobody’s talking about, at least not that I’m aware of.

So sit back and enjoy the entertainment as others squabble over what every squiggle in China’s markets may or may not mean. The louder the Chinese doomsayers become, the more likely they are to be wrong yet again.

Growth there may slow, but it won’t grind to a halt barring a complete policy reversal from Beijing… and that’s something 1.367 billion consumers will make sure never happens.

Until next time,


37 Responses to The Real Threat from China’s Stock Market Crash

  1. Douglas Holbert says:

    Are the banks involved.

    • Keith says:

      Hello Douglas and thanks for asking.

      Chinese banks are involved but not like they are here. Let me explain.

      Many Chinese banks offer something called a “Wealth Management Product” or WMP for short. They’re marketed to individuals and supposed to be invested in very conservative risk-averse securities like a money market fund would be here.

      However, WMPs are also invested in very risky instruments made up of bundled assets that – you guessed it – are sold in “tranches” carrying varied risk levels. That means Chinese investors who think they are buying low-risk products are really being sold highly leveraged instruments that resemble the collateralized debt obligations or CDO’s that sent our markets off a cliff in 2007.

      Compounding the problem is the fact that WMP investing falls outside the margin requirements applied by the Chinese regulators. That means millions of investors were able to pile in well above the legally permissible 2-1 leverage using virtually the identical structure and off balance sheet loophole our big banks did to trade trillions in derivatives yet maintain the perception of having everything under control

      All this is simply coming back to earth.

      Best regards and thanks for being part of the Total Wealth Family, Keith 🙂

  2. Gunny says:

    Hi Keith,
    What should one do about Chinese stocks sold on the U.S. Stock Exchange (ie. BABA, KWEB, etc) -hold or sell?

    • Keith says:

      Hello Gunny.

      That depends on your risk tolerance and perspective. Of all the Chinese stocks traded here, the one I am least worried about is BABA. That’s because I think it’s totally under-recognized for what it will become and how it will challenge western Internet dominance when the time comes.

      Best regards and thanks for being part of the Total Wealth Family, Keith 🙂

    • Stan says:

      I am disposing of my BABA because the Chinese market has turned my investment into a gamble and you know that the a player nearly always loose in gambling.

      • Patricia Krenik says:

        Every investment is a gamble. Every Guru in finance gives his own best guess and promotes it strenuously. We are always warned that any investment is risky. The market is somewhat manipulated, so it is hard to find a good stock that will reliably make gains. I’ve noticed that when a new, break through stock is advertised many people join and for a time it rises. I suspect that at the rise the promoters get out before it falls again. Even Bitcoin has that problem, it goes up, people sell and take a profit. So I don’t see that China’s market is any more of a gamble than ours.

  3. Jm McKenzie says:

    I think this is a very good review. People don’t see the crowd mentality. It is all over Wall Street.
    It is all over China. It is “Everyday Delusions and Madness of the Crowd” which contributes to over-reaction in the market.
    That mentality is not known for producing rational decisions. Who doesn’t like to get rich quickly? Ironically the Chinese investors sometimes do not follow the Confucian adage of extolling “moderation in all things.”

    • Keith says:

      Thanks for the kind words, Jm.

      I think you’ve got a good take on things. My experience in China corresponds with your observations – there’s definitely a manic streak when it comes to money. Unfortunately, that works both ways which is what the Chinese seem to be figuring out at the moment.

      Best regards and thanks for being part of the Total Wealth Family, Keith 🙂

  4. c. l. smith says:

    Appreciated the China history lesson and your positive comments…….it’s been a tough ride so far in the market but iI believe in the old saying”Stick and Stay it’s bound to PAY” Hope it pays off!!!!!!!!!


  5. Paul says:

    Keith what are the ramifications if the IMF gives China the reserve currency status later this month? That should help the Chinese stock markets and their currency, right? Wouldn’t it also hurt our markets by the dollar taking a slow painful decline?

    How would you play this?

    • Keith says:

      Hello Paul.

      Thanks for asking. There are some nuances here that I don’t think the mainstream media has latched on to. The Chinese Yuan is already the 3rd of 4th most liquid currency in the world so there’s a good case to be made that much of this is already factored into exchange rates. I beleive the frustration, certainly in the West anyway, is that China has established the Yuan by going outside the primary trading pairs: USD, YEN, Euro and Pound.

      Conventional thinking is that this will weaken the dollar. No doubt that’s true if it were a two way street. However, thanks to the constant money printing now undertaken by central banks around the world, I think this is offset by the need for safety. That’s why the dollar, for example, has gotten stronger, not weaker since the Financial Crisis began.

      I’m actually doing some more research on this at the moment and will present more detailed findings later this year along with a few recommendations you may find helpful.

      Best regards and thanks for being part of the Total Wealth Family, Keith 🙂

  6. COL DONALD MACK, MBA, US Army Special Ops says:

    Aloha Keith: Spoken analytically just like my right hand man Professor Steve “Fitz,” Ph.D., when we were training our allies in the Asia-Pacific region in the 1980s – early 90s. Yes, as I mentioned before, his last name was identical to yours.
    New topic: India although close in population to China needs a colossal amount of infrastructure work before they can be a top emerging market country; China has air and water pollution but India has those too plus a lack of water pipelines, sewage system, poor roads plus tiny sanitation garbage collection system. On the other hand, our neighbor, Brazil, has all of the above problems of both countries, although some topics are not as severe, but the corruption, law & order, and diseases problems spoil that large soccer talented country.

    • Keith says:

      Mahalo Colonel!

      You raise some great points, as usual. I view the countries as a continuum of discontinuity if that makes sense. That means you can invest almost according to some sort of chaos index highlighting industrial, commercial and consumer maturity…or lack thereof.

      That gives me a great idea for an upcoming column…

      Best regards and thanks for being part of the Total Wealth Family, Keith 🙂

  7. fallingman says:

    How big was Russia’s bond market in ’98 when the Russian default caused Long Term Capital to fail, nearly collapsing the US financial system?

    How big was Thailand’s currency market in 1997?

    If you think the size of a market has a directly proportionate influence on trading, you don’t understand complex systems or contagion risk.

  8. Khem says:

    How safe is the Vanguard Natural Resource Bond to 2020 dividend payout?

    • Keith says:

      Hi Khem.

      Vanguard hedges extensively and, unless that’s changed, there’s some stability that competitors don’t enjoy when it comes to dividend security. However, the whole enchilada depends on a fine balance between investing for growth and large distributions. I want to see how they’ll handle 2016 when the extensive hedging in 2015 runs out. Then we’ll have a better idea running into 2020.

      Best regards and thanks for being part of the Total Wealth Family, Keith 🙂

  9. Helmut says:

    Everybody knows that the China’s Economy is manipulated,why then does not EVERYBODY know that almost all in the U.S.A. is manipulated,especially when it comes to MONEY.

    • Keith says:

      Very well put and straight to the point. Well done Helmut!

      The irony is, indeed, stunning.

      Best regards and thanks for being part of the Total Wealth Family, Keith 🙂

    • ron goddard says:

      well done helmut…spot on!! why indeed? its a world wide malady ..going on for 5,331 years..:-) or so. the banksters of the world, politicians and religious leaders have stuffed things up for a long, long time. don’t wait for things to change real soon. depression? maybe..there is so much confusion today about almost everything….we mushrooms just survive on darkness and b.s. lol…..cheers for now. oh 1984 +31 =2015…..if you are a christian….thats cryptic i know..but think a little..

  10. Greg says:

    As an Aussie investor who picked the boom in october and the bust – and saw how it worked – and a watched of cnbc every day i would make 4 points

    1) the run up on china a shares to 3100 on Shanghai comp was valuation based – it brought a shares to H share values

    2) the A share market wen 3600 to 3100 from Dec 17 to March 14 – coincidign precisely with a 3 month ban on margin lending by china’s 3 largest brokerage firms – so everything above 3100 ont he shangai comp you can regard as froth

    3) massive racism/xenophphobi evident in US commentary – the number of times I;ve seen Us commentators talk about china stocks being out of step with china’s economy – yet they seem to forget 2009-11 was the best time to buy US stocks – while the economy was still cotnracting – is frankly disgusting – and intellectually disingenuous

    4) the chinese to this point have shown the same self-centred, material possession focused behaviours as US popultation – so given similar economic behaviours – at 3 times plus the population – their stocks are significantly more attactive in terms of potential earnings growth. something im yet to see a single pundit recognise.

    • Keith says:

      G’Day Greg and thanks for writing.

      That’s a very well laid out and logical argument you make. Not to many people make the linkage between the margin ban and market activity which is, of course, a real feather in your cap.

      I share your opinion, particularly when it comes to point #4. The Chinese have had the world’s largest GDP for 18 out of the last 20 centuries. They will again simply because of the numbers involved.

      Best regards and thanks for being part of the Total Wealth Family, Keith 🙂

  11. Esko says:

    It’s all about perception vs reality. Even if the Chinese market has no real impact on the US market, it’s people’s perceptions (sentiment) that can move markets. The important question to ask is can you trust the Chinese data ?

    • Keith says:

      Howdy Esko.

      That’s the trillion Yuan question…trust. Personally, I don’t trust a single bit of government data no matter which government publishes it. Instead, I look to CEOs who are motivated by growth. They may have their own set of problems not the least of which is greed, but I think they’re far more capable of tapping into growth the government apparatchiks.

      Best regards and thanks for being part of the Total Wealth Family, Keith 🙂

  12. Doc Nichols says:

    Appreciate your efforts to add some insight into China’s markets. The subject of manipulated equities in that country leaves one thinking that our domestic investment products might be tainted but relatively honest. I for one would proffer a far more skeptical view, and I’ll tell you my experience just a few weeks ago as just one illustration..
    I purchased a 100 share position in Select Sector Health Care ETF (trade symbol XLV) in early March this year for $71.52 a share with a 7% trailing stop. This well performing
    fund was moving with only small variations in price and managed to reach $77.40 mid-July. So far, all good. Then we have the 8/24/15 flash crash and from a close the prior Friday, Aug. 21, with a price near $71 – that ETF open in the initial minutes of that ugly Monday down 21% at $56.63. One has to ask, how the hell does an ETF get pushed down
    so violently while markets are closed over a week-end Talk about getting “Ice Picket”.
    That ETF recovered immediately that same day to the $68 range and never trended much lower than the open price before moving up more days later. Talk about taking all the stop order out in one sweep and then buying the markets back into profits…..this isn’t a market, it’s a rigged casino. I took an $1,100 hit with this seeming safe ETF because the life sucking equity decent didn’t produce a sell until around $60. Your thoughts would be greatly appreciated.

    • Keith says:

      Hi Doc.

      Yikes! Thanks for sharing. Unfortunately, that’s a more common experience than many are prepared to beleive. You are not alone.

      When markets crater volatility rises. That, in turn, means spreads widen and liquidity evaporates. When that happens, the adaptive true range associated with many stocks goes right out the window.

      I suspect based on what you described you got hit by two things…single day volatility that snapped your otherwise tight stop and ruthless traders who simply took out stops before reversing.

      The simplest ways around that are: put options, a wider and deeper trailing stop, and or limit orders that would otherwise prevent you from getting gamed.

      I’ll put a more detailed discussion in an upcoming column so thanks, in advance, for the idea!

      Best regards and thanks for being part of the Total Wealth Family, Keith 🙂

  13. fallingman says:

    What’s a matter kids? Can’t handle challenging questions? Can’t entertain any disagreement with the chatterings of his highness?

    • Keith says:

      Dear Fallingman,

      One of the things that makes Total Wealth such a great place to be is that there are varied comments and opinions from everyone involved including me. More importantly, there is a spirit of camaraderie, dialogue and respect that allows us to intelligently discuss the issues in each column even if we respectfully disagree from time to time.

      To that end, that’s why your posting today surprises me. You’ve made some terrific observations in the past that are clearly well thought out so the sniping seems out of character with the intelligent nature of your prior commentary.

      If there’s something specific about this article that you don’t agree with or some commentary you’d like to add, please do so rather than simply throwing churlish remarks over the stern using an anonymous email moniker. That way every member of the Total Wealth Family can potentially learn from what you have to say – just as I will.

      With best regards and thanks for being a part of the Total Wealth Family, Keith 🙂

      • fallingman says:

        Okay, calmly, calmly. I’ve sent my comment in somewhat different messages THREE &$@^$#! times and your system either didn’t capture it after saying the comment was awaiting moderation or it censored it. The only thing that got through was the comment above.

        And anytime you want me to use my name, no problem. It’s T.P. Waldenfels.

        • Keith Fitz-Gerald says:

          Dear Mr. Waldenfels,

          I had a hunch that something was going on. Your message simply didn’t fit the intelligent thought in your prior commentary.

          Unfortunately, the Internet is an imperfect world and not every comments gets to us. I’ll be looking into it with my team and appreciate the heads up.

          In the meantime, thanks for sticking with me, for helping make Total Wealth a great place to be, and for the time you take to comment. Together we are all stronger!

          Best regards and thanks for being a member of the Total Wealth Family, Keith 🙂

  14. yngso says:

    Too many in the US and UK are constantly predicting – based on what exactly? – the downfall of not just China, but Europe and Russia too. After monster growth in China for decades it isn’t strange that there are some imbalances that need to be strightened out. The Chinese govt is still learning how to relate to this type of situation, but there’s no change in their long term plans.
    China isn’t going “Soviet” again, because the Chinese and Vietnamese have been smart enough to allow private wealth, unlike miserable North Korea, Cuba and Venezuela. Taking that away would be disastrous, destroying the foundation of successful Commie govts.
    Investing in the emerging world is incredibly exciting, and China is a very important part of that…

  15. Larry Hutchins says:

    what difference is there between BBL and BHP????

  16. Dave Moore says:

    Keith, That was a great breakdown on China and its small effect on the world level. I am more concerned with the next IMF meeting and what is coming in October? Will China get SDR rights? What will that mean for our stock market and where is a safe haven?


    Dave Moore

  17. RJ says:

    We understand the role of China’s Wealth Management Product, the leverage, and that it is “coming back to earth”. We also understand the reigning in of the brokerage accounts by the regime.

    With that said, we are left with general volatility, the bidding of securities to “nose bleed” levels, and the normal corrections to sanity.

    But did I miss something?

    Less than 10% of China’s population is invested in the national market, and most don’t have a high school education.

    How in hell do they pick their investments?

    Should we make a correlation that if another 10% pile in, that national market volatility would commensurately (or disproportionately) increase?

    Just where are they getting the money if prices are so high?

    Does the expanding Chinese middle class have less than a high school education?

    If the long-term ride is favorable, why would they want to invest here, unless we have QE 4 and Dow 25,000?

    Whew…what a ride this will be…

  18. Dom Brunone says:

    Hello Keith – I think I understand the Chinese pretty well, having worked with them for three decades. Among their other fine qualities, they are inveterate gamblers. So when I hear that their stock market is leveraged 5:1 at historically high price levels, I find that easy to believe. I am not terribly worried, as you point out, about the Chinese economy. What I am worried about is that a normal slowdown there will precipitate margin calls that force them to dump even sound companied like the S&P500, causing a waterfall decline in US markets. Your thoughts?

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