While world headlines focus on Greece, a far bigger market is gyrating wildly: China.
At the start of this week, China formally entered bear territory when its Shanghai Composite Index dropped 20% from its highs over a period of three days. But, as always with Chinese markets, assessing what it means is not straightforward.
Firstly, China is still a star performer by any normal metric. It has doubled over the last 12 months. At today's close it was down 22% from its peak in the middle of June, but it remains one of the best performers in the world both over the last quarter and the last year.
Secondly, valuations were very high, and this had been coming for a while. The Shanghai Stock Exchange says its average P/E ratio is 20.93 times, though the median P/E is far higher, and has been as high as 65 times, reflecting the fact that the average is brought down by relatively low valuations for China's banks (which in turn reflects concerns about their unrecognized bad loans). There are rumours that foreign institutions have been shorting the market, finding it ripe for a correction, though the China Financial Futures Exchange today issued a statement denying that this had been taking place (one cannot normally short stocks in China, but it can effectively take place by using index futures).
Third, when confronted by a correction, China often takes action to halt it, and this has happened again over the last week. It has announced plans to allow the state pension fund to invest in stocks and it has lowered the stamp duty charged on share purchases, which should encourage more buying. Whether this is a wise move is another question. Additionally, the central bank cut interest rates at the weekend for the fourth time in seven months.
But, fourth, a market like this is always going to be volatile. Take Tuesday: the index first dropped by 5%, then rallied, and ended up closing 5.5% up, before losing the whole lot again on Wednesday - and that's after precipitous falls last week (7.4% on Friday, for example). For every state measure to prop up the market, there is a concern that too many people have got themselves into debt in order to fund their share purchases over the last year. If they have to sell in order to meet margin calls, or just pay back loans, then that will send markets spiralling.
The FT today cites the following data on margin lending in China: "Official margin lending through securities brokerages peaked at Rmb2.3tn ($371bn) on June 19, up from just Rmb403bn a year earlier. Goldman Sachs estimates such lending equals 12 per cent of the free-float market capitalisation of margin-eligible stocks, and 3.5 per cent of gross domestic product, 'both of which are easily the highest in the history of global equity markets'."
And on top of that, grey market margin lending adds a great deal more to the figure.
One gets a sense of shifting sentiment from the data provider Red Pulse and its China ETF Monitor. It says that of the best-performing ETFs in China in the week to June 23, nine were bear market products, and the best - the Direxion Daily FTSE China Bear 3x Shares - is, as the name suggests, three times leveraged. And that was before the biggest falls. Many investors in China leap in and out of products on a sometimes daily basis, seeking an edge and an opportunity, and if enough people follow this lead into bear products, it will more or less guarantee that the market will fall.
In such an environment, the underlying fundamentals are something of an afterthought, but they're not great either: China is slowing down, problems in Europe affect exports, and manufacturing indices on the mainland seem to be weakening. There may be worse to come for the markets.
Chris Wright is the author of No More Worlds to Conquer, published by HarperCollins
