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Volatility in China’s market may be inevitable correction

Recent declines follow big run-up

A stock investor checks his phone under Chinese writing that translates as “stock market has risk” at a brokerage house in Shanghai on Monday.Johannes Eisele/AFP/Getty Images

NEW YORK — While the eyes of the world have been on the crisis in Greece, China, a country with 123 times the population, has faced financial troubles of its own. A free fall in the Chinese stock market could threaten the prosperity of the world’s second-largest economy and have long-term effects of its own.

But the numbers suggest China’s stock market collapse — it’s down 26 percent in four weeks — may be less a shocking turn of events and more an inevitable correction in a market that featured many of the classic signs of a financial bubble.

Stock investing has become a middle-class pastime in China, and it’s clear the Chinese government is nervous about a continued market rout wiping out its citizens’ wealth and stoking discord. The government has pulled out a series of policy measures to try to avert the collapse: interest rate cuts, using government pension funds to prop up the market, announcing plans to investigate those betting on a market drop.

The data, though, suggest the market declines thus far aren’t as outlandish as the Chinese government seems to think. After years of rising gradually, the Shanghai composite index began an upward tear in late 2014, soaring 151 percent from the start of July last year to the June 8 high.

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It’s easy to frame market data in a way that sounds either scary or benign, depending on your inclination. “The Chinese stock market has dropped 26 percent in a month” is scary. “The Chinese stock market is up 83 percent over the last year” sounds great. Both are true.

In that sense, the people who have lost money in the last month are those who plowed money into Chinese stocks just in the last few months. Anyone who has been invested for more than a few months is doing just fine, so far at least.

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If you look at a slightly longer time horizon, the kind of volatility in Chinese stocks witnessed over the last year isn’t that uncommon. The 2010 to 2013 period was more aberration than trend in the steady, consistent rise in prices.

Consider the Shanghai composite over the last decade, indexed to its June 2005 level and compared to an index of all global stocks. The Chinese market experienced much larger swings during its 2007 boom, 2008 bust, and 2009-10 resurgence than the rest of the world. And those swings were larger in percentage terms than the recent volatility. Big swings in the Chinese stock market may be damaging for Chinese savers, but they don’t necessarily ripple across the global economy the way problems in United States mortgage securities did in 2008 or European debt did in 2011.

Why so much volatility? The Chinese stock market is less well developed than those in countries with more advanced financial markets. Many of the strongest Chinese companies list their shares in Hong Kong or New York, with those listing within China more likely to have questionable business models, accounting, and corporate governance.

That has helped fuel wild swings. That is no salve for the pain of investors who have lost their savings in the recent market drop, but does support the idea they had reason to know the kind of risk they were taking on.

But what about fundamentals? Are Chinese stocks falling toward a fair price relative to their earnings and growth rates or overshooting with further to fall?

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Just a year ago, Chinese stocks looked relatively reasonably priced, with a price-to-earnings ratio of around 10, meaning an investor paid the equivalent of about $10 for a share of stock that offered $1 per share in annual earnings. At the same time last summer, an investor in American stocks had to pay more like $17 for a share that produced $1 in income.

But the sharp rise in Chinese share prices starting in late 2014 took place without an accompanying rise in earnings. In other words, the shares weren’t worth more because the companies being traded were becoming wildly more popular. The shares rose because investors were willing to pay more for the same return.

By early June, the price-earnings ratio of the Shanghai composite index had soared to nearly 26.

There is a case that Chinese stocks deserve a rich valuation. If you expect that the companies whose shares you are buying will become much more profitable over time it might make sense to pay $19 or $26 for a dollar of earnings. That dollar, after all, might soon be two, and then four.

But the last year has seen a rise in Chinese share prices that seems to be driven more by investor psychology than anything fundamental. It is hard to see how the prices as of a month ago are justified, and easy to see why the sell-off of the last month would occur.

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That, in turn, implies Chinese officials are fighting an uphill battle in their policy moves to try to stop the correction. The question now for China — and hence for the world economy — is how much farther the Chinese market has to fall, and, regardless of whether the drop is justified, how much pain it will cause.