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Is the Worst Over for China Stocks?

By Jim Trippon

The Shanghai Composite Index hit a low for 2010 on Tuesday, giving the doubters new reason to dismiss Chinese stocks. As we have discussed before, China’s A shares are suffering from a serious case of nerves about the prospect of economic tightening from Beijing.

In fact, Beijing has already raised bank reserve ratios several times this year, introduced a host of measures to dampen property speculation and instructed banks to reduce the flow of loans without shutting off the spigot completely.

But news that China’s property prices rose by a record 12.8 percent year-over-year in April sparked new investor fears on the mainland. An uptick in inflation to 2.8 percent from the previous month’s 2.4% also sparked worries that a long-awaited interest rate rise was inevitable.

Here’s the key point. A Chinese interest rate rise is inevitable. So is another increase in the bank reserve ratio. Everyone in the investment community expects further tightening in bank lending and mortgage rules to squeeze the air out of the property bubble. And when ‘everyone’ expects an economic event, it is almost certainly priced into the market.

Very few news reports and even fewer readers make the essential distinction between the Shanghai Composite Index and the China ADR Index. They behave very differently. The Shanghai Index reflects the highly volatile fears and expectations of mainland China investors. It is sometimes seriously overvalued and sometimes undervalued as fears increase. The China ADR Index is far less volatile because, unlike China, trends are driven largely by professional investors who are focused on more realistically on valuation.