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China stocks crash into bear territory as margin calls bite

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Hope lasted for about eight minutes in China’s stock markets Monday.

Hope from tens of millions of small investors that the country’s policy makers would stave off a traditional bear market. Hope from investors who have taken out record loans over the past year to fling at the stock market.

Over the weekend, policy makers enacted a two-punch response to the country’s stock market’s 7.4% dive on Friday, that left it down 19% in just the two weeks since June 12. The central bank cut the one-year lending rate by 0.25 percentage point to 4.85% and reduced some banks’ reserve-requirement ratio in what analysts said was the first time China’s policy makers had cut both rates in the same day since Oct. 2008, when the entire world economy looked on the edge of collapse. It was the fourth interest rate cut in eight months.

And on Monday, Shanghai stocks opened up slightly—reflecting the government’s desired effect. The Shanghai index rose almost 100 points to 4,276 in the first few minutes of trading. Analysts agreed that the central bank was telling investors it didn’t want to see panic selling following a manic 150% rise in Chinese stocks over the last year, which started when the country’s state-owned press began touting stocks to the country’s small investors.

But eight minutes after the open, around 9:38 a.m., the sellers took over and Chinese markets later slipped into traditional bear market territory (a 20% decline from peaks) for the first time since 2010.

Today’s continued fall wasn’t unexpected. Steven Sun, HSBC’s head of Hong Kong and China equity research, said the reduction in margin financing is behind the rout in stocks, as leveraged traders furiously try to cut their exposure.

“Margin financing was the primary market driver on the way up, and it will be a key driver on the way down as well,” he wrote today.

Margin loans allow investors to bet a multiple of their own capital. That juices returns as stocks rise but exacerbates losses on the way down, as brokerage will generally liquidate their clients’ positions if they don’t add more ‘margin’ to cover losses on their account.

Sun said the volume of margin loans outstanding had declined by 6%, or $23 billion, over the past five trading days after peaking on June 18.

Not only are Chinese traders stretched, so are stock valuations. The CSI 300 Information Technology Index, a mix of high-tech names similar to the Nasdaq, trades around 75 times earnings, or a 75 P/E ratio; the Nasdaq is trading for about 3o times earnings.

Jonathan Anderson, an influential emerging markets analyst at Emerging Advisors Group, told clients Sunday night he was avoiding Chinese stocks amid the selloff. “The 20% correction in the China equity market is our signal to leave. Wish us luck,” he wrote. He said by his count, during China’s last equity bubble 2005-07 there wasn’t a decline of more than 13% as stocks rose. When the market finally fell more than 20% in November 2007, it marked the end of the bull market and stocks fell more thereafter.

Perhaps the overleveraged traders buying overvalued stocks in a potentially overvalued market are the ones who need the most luck now.