China’s markets are unpredictable but mechanical

CHINA FINANCIAL - In Brief 08 Jul 2015 by Michael Pettis

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China’s Spinal Tap stock market is a volatility machine whose every knob has been turned to eleven. Value investors lack the tools they need to project or value cashflow, and so cannot play their stabilizing role no matter what policy enticements are implemented. Policy interventions undermine the regulatory stability that value investors crave, and because the many interventions include attempts to suppress the disruptive impact of shocks, a powerful and poorly-understood consequence is, paradoxically, to magnify the impact of especially large disruptive shocks. With already high expected volatility mechanically jacked up by perhaps the highest margin levels ever recorded, and by the popularity of the investment “strategy” of riding what everyone knows to be a bubble (and of course bailing out just before it bursts), and the events since Friday should be easy to understand, if no less depressing. If I had to bet I’d bet that a desperate Beijing will wheel out enough firepower eventually to stabilize the markets, but as I describe in my 2001 book, The Volatility Machine, many years of one-way price movement (the 2007-08 stock market disaster being among the few widely-shared exceptions), has left China with the typical developing-country national balance sheet and financial system in which automatic stabilizers are rare and sharply self-reinforcing mechanisms common. It is important to understand just how mechanical the market collapse has been. By “mechanical” I don’t mean, unfortunately, that if you’re smart enough you can figure out where it is going. You can, however, figure out what might matter and how different outcomes will affect the economy. You should also u...