Global stock markets tumbled Tuesday, due in part to a sharp fall in China’s stocks, the sharpest correction in five years. In a day that saw a 2.4 percent gain at one point, the Shanghai Composite Index closed down 5.4 percent, led by financials and energy. The Hang Seng China Enterprises Index of Chinese stocks listed in Hong Kong fell 4.6 percent.

The correction should not have been a surprise. The Shanghai market had advanced by almost a quarter over the past three weeks and is still up 35 percent for the year. The daily turnover on the Shanghai and Shenzhen exchanges combined had reached five times the average level as Chinese retail investors, who dominate the Mainland markets, became more optimistic about the prospects for further monetary stimulus to the economy. Valuations relative to projected earnings had reached the highest level since July 2011. The market had gotten ahead of underlying fundamentals, and the potential for a correction was great.

The trigger for the market drawback was a tightening of collateral rules for equity margin and repo operations, a move that drains liquidity from the market. Some $76 billion of outstanding debt with a credit rating of AA- or below can no longer be used as collateral. The move is intended to promote a more transparent municipal bond market. This is a welcome step for the development of China’s financial markets and does not appear to us to signal a change in the People’s Bank of China’s monetary policy. We note that the PBOC did not engage in any open-market operations during the day.

Another factor that may have contributed to the market’s correction was the expectation that the authorities will reduce the economic growth target for 2015 to 7 percent, down from this year’s 7.3 percent, perhaps as early as this coming week. This adjustment corresponds well with our projections for China next year and does not alter our continued bullish view of the Chinese market going forward. The decline in oil prices, which is depressing the markets of oil-exporting countries and energy company stocks globally, should be a significant plus for oil-importing countries like China. Tuesday’s correction, which may have a little further to go, should remove some of the frothiness from a market in which investors have gotten somewhat ahead of themselves. Rather than being a signal to exit the Chinese market, the correction could provide an opportunity for investors to enter or add to positions.

The ideas and opinions expressed in this blog are those of the author, and they should not be perceived as investment advice or as any other kind of advice.

The preceding is an abridged commentary by Cumberland Advisors and has been reposted with permission. Cumberland Advisors commentaries are available at http://www.cumber.com/commentary_archive.aspx. 

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