China’s Stock Market: Echoes of the 1929 Crash

Special Report from Money Morning

by Shah Gilani, Money Morning

You’ve heard the stories about the 1929 stock market crash, how investors should have figured out that, when taxi drivers and shoe-shine boys hawked stock tips, the end was near.

The lesson we’re supposed to have learned was that cheap margin – the debt that investors can use to finance stock purchases, when wielded by uneducated, blindly optimistic “plungers,” can drive stocks up and up over a cliff into an abyss.

Too bad the Chinese never got that memo.

China is now facing a 1929-style stock market crash thanks to rampant margin buying by millions of new investors who believe the market is the road to riches.

But it’s not just Chinese plungers or the Chinese economy that’s going to suffer.

A 1929-style crash in China will send shock waves around the globe and to your door.

Here’s what’s really happening and what you can do to protect yourself and even profit from the fallout…

Up, Up, and Away

There are three principal Chinese stock markets: the Shanghai Stock Exchange, where most big company “blue-chip” stocks are traded; the Shenzhen Stock Exchange, where some big and mostly middle-market company stocks are traded; and “China’s Nasdaq,” known as ChiNext, where mostly small, speculative companies trade.

Stocks on those exchanges, after running up wildly over the past 12 months, are now all selling off.

The Shanghai Composite was up over 100% in the past 52 weeks. It’s still up 83% according to optimists, who prefer not to admit it plunged 26% in the last three weeks. The Shenzhen is down almost 30% in the same few weeks after being up 150% in the past 52 weeks and up 60% just since January 1 of this year. The ChiNext is now down 40% from its June highs.

New “investors” are mostly to blame for the run-up and the sell-off as they get hit with margin calls as prices topped out and began falling.

The Perils of New Money

Millions of Chinese have been opening up brokerage accounts and taking the market plunge.

According to the China Securities Depository and Clearing Co., in the last week of April, nearly 1.7 million new brokerage accounts were opened across China. Over a two-week period earlier in April, 2.4 million new accounts were opened. On average, since the beginning of 2015, almost 170,000 brokerage accounts a week have been opened.

Most of the new accounts have been opened up by many of China’s least-educated investors.

According to data compiled by Bloomberg, there’s a big difference between “Existing Investor Households” and “New Investor Households.”

The highest level of education for 7.7% of existing investors is elementary school. A total of 5.8% of new investor households are “not literate,” and 25.1% only have an elementary school education. A total of 18% of existing investor households have a junior high school education, while 36.7% of new investor households have only a junior high school level education. High school percentages for existing households is 28.1%, while only 14.7% of new investor households finished high school. The numbers get a lot smaller all the way up the ladder for new investor households.

Are a lot of these new investors in the same category as taxi drivers and shoe-shine boys? Maybe. Although it doesn’t matter if they are farmers or factory workers, it does matter that they probably aren’t educated enough to understand how capital markets work and that stocks don’t always go up.

Leverage, Leverage, Leverage

It’s one thing to give an uneducated person a gun; it’s quite another thing to give them bullets, too.

Almost every account that’s been opened in China comes with a margin agreement and access to margin. Margin lending is big business in China, as it is here in the U.S.

But in China not all lending comes from brokerages. The shadow lending market all across China provides loans to almost anyone who has anything, even of questionable value, to put up as collateral. In the case of borrowing to buy shares of stock, borrowers put up their shares of stock as collateral for loans to buy more shares.

Shadow lenders include “trust” facilities, manufacturers with capital to lend, insurance companies, special-purpose vehicles set up by individuals, companies, brokerages, banks, local government entities, and others. There’s plenty of money to borrow in China, because the central government wants growth at any price.

Institutionally, brokerages lend on margin, with purchased shares as collateral, against their own capital.

Last week the Peoples Bank of China quadrupled the capital of the state-owned China Securities Finance Corporation (CSFC), the entity that funnels margin money to brokerages for their customers. That wasn’t to extend more margin to bleeding customers; that was to backstop the CSFC itself because its own capital had been exhausted lending to brokerages who desperately needed to pump more margin to new accounts bleeding money from falling stocks.

Plainly, when uneducated investors are allowed to leverage themselves to the hilt to chase momentum-driven shares higher and higher, they will reach the proverbial cliff.

In spite of everything Chinese authorities and regulators are doing to shore up the stock market, there’s a better than 50% chance their efforts will fail and that a devastating crash could send global markets back into a 2008-era financial crisis.

The China Crash Play

That’s where Chinese markets are now. We’ll see soon enough if the authorities’ efforts to stick their thumbs in the dam of swollen stock prices can stem a 1929-style crash.

If they can’t, U.S. investors will face the tide of retreating stock prices on our shores as contagion will spread throughout the global, interlinked economy.

Investors here need to have stop-loss orders in place to exit their positions in the event of collateral damage to our markets.

And, if you want to make money on a potential contagion crash here, short the market by buying an inverse ETF like the ProShares Short Dow30 (ETF) (NYSE Arca: DOG).

Or, take your own plunge if you see a huge sell-off coming and buy a leveraged inverse ETF like the ProShares UltraShort S&P500 (NYSE Arca: SDS).

Just don’t be under-educated and over-leveraged when it’s time to take your plunge.