When I wrote this, the Chinese stock market was down about 6 per cent for the day and more than 30 per cent since its peak less than a month ago. To us, that may sound like a routine day - such a decline has happened several times in the history of our markets.
However - and there's no other way to put it - the Chinese government and regulators seem to be in the danger of losing their mental balance over this market crash. Investors are panicking, and official actions are adding to the panic. The latest is that the regulator has ordered all substantial shareholders (anyone with more than 5 per cent in a stock) to not sell any stock for six months. They have been asked to maintain their positions in order to 'prevent instability' in the market.
As things stand, reports say that more than a thousand of the 2,800 companies listed in Shanghai have had their trading suspended. Apparently, this was done at their own request. That sounds like a strange thing but Chinese markets have some strange rules. Since prices started crashing, regulators have virtually banned IPOs to try and prevent money flowing out of existing stocks, and they've allowed retail investors to directly put up real estate as margin for trading. They also forced major brokerages to create a 'stability fund' of about twenty billion dollars out of their own assets.
To anyone with an iota of sense, it's crystal clear that these are disastrous actions. It's likely that they will lead to some temporary upticks, but sooner or later, reality will assert itself. And China's reality is that there are a huge number of grossly overvalued small-cap stocks in which the middle class has placed highly leveraged gambles. These stocks will basically disappear whenever the market is allowed to function normally. The government seems to fear the repercussions if newly minted middle-class investors lose a large proportion of their savings.
The China story shows that our equity markets are much better regulated. However, let's not be too happy. The central problem that China is facing exists in India too - that of individual small investors speculating like crazy in dodgy stocks whenever markets get too high.
The big difference is that in India, there is a way for the small investor to reap the rewards of equity without getting exposed to the froth, and that's equity mutual funds. China has a pretty underdeveloped mutual-fund market, while India has a highly developed one.
In the context of market bubbles and crashes, there's a big service that mutual funds give to retail customers, one which is rarely appreciated. This service is the avoidance of rubbish stocks. If you have a portfolio that consists of any type of equity funds, then you will never have more than a negligible exposure to stocks that are just froth. Companies will be real businesses that won't disappear. One or two might, but diversification takes care that you won't be staring at the kind of disaster that the Chinese retail investors are facing.
Simply look at the basic numbers. There are 80 large-cap stocks, 201 mid-cap stocks and 2,529 stocks that are listed on the BSE. If we aggregate the portfolio of all Indian funds that invest in equity, then we will find all 80 large- cap stocks, 199 out of 201 mid-cap ones and only 518 out of the 2,529 small-cap ones. This avoidance of risky stocks is always forgotten by retail investors when markets boom.
It's a basic precept of investing that before you start choosing good investments, you have to learn to avoid the bad ones.
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