Research Affiliates: The China Syndrome: Lessons From The A-Shares Bubble

September 21, 2015

Waving The Flag

Most global pension funds and other state-controlled pools of capital invest heavily in their domestic stock market. This is true, although to a lesser extent, for the Chinese market. After a meaningful price collapse, it is completely reasonable for a government fund to invest in quality companies that have become cheap. This, of course, presumes that the pools of capital are managed by experienced professionals who invest solely with the objective of earning high returns under acceptable risks. Insofar as the government buying activity suggests favorable investment opportunities, this activity can additionally provide a signaling benefit.

But economists have long cautioned against making "signaling to the market" the primary objective. Attempts to fool the market generally fail and sometimes backfire. Chinese A-shares had an aggregate market capitalization of USD12.5 trillion when the Shanghai Composite reached 5,200. The nearly 40% decline from that peak represented a loss of USD5 trillion. Additionally, each day roughly USD150 billion of stock shares were sold and bought. A few tens of billions of dollars in government buying is simply unlikely to move market prices in a meaningful and lasting way.

Ultimately, investors will form an opinion regarding the government's competence in stock market intervention. Market participants will either come to believe that the government is a savvy investor that steps in to buy equity shares when prices are cheap, or they will conclude that the government is a bad investor, too quick to jump in after the initial decline—when prices are still expensive—in an attempt to appease retail investors. If the former, investors will tend to synchronize with government buying, and if the latter, government buying may accelerate liquidation from institutional investors.

In Closing

Stock markets, even the most efficient and well-functioning ones, are volatile, producing daily short-term winners and losers. This noisy short-term fluctuation can often distract from the important long-term function of the equity market, helping good businesses and good entrepreneurs acquire capital to provide better products and services. Bubbles or irrational bull markets are an indication that the equity market is failing at its job—bad businesses and perhaps bad people are being funded instead.

The more the market is dominated by the irrational exuberance of naïve speculators, the more and the longer prices will deviate from rational valuations. The consequences of a low-quality equity market are severe; that's why some economists have endorsed regulation and even intervention. However, regulation and intervention can only work when policymakers are at least as adept and knowledgeable as market participants, including investment professionals, and when regulators are not in thrall to the industry and populist pressures.


  1. It's a joke with a point. Beyond the cognitive bias of overconfidence, to which even experts are prone, the illusion of superior skill reveals among less accomplished individuals a fundamental inability to appraise their own performance. Kruger and Dunning (1999, p. 1132) find that "those with limited knowledge in a domain suffer a dual burden: Not only do they reach mistaken conclusions and make regrettable errors, but their incompetence robs them of the ability to realize it."
  2. In addition to tempting people who considered themselves honorable to cut corners, manic markets entice outright criminals to take advantage of trusting investors. In his classic history of the 1929 crash, John Kenneth Galbraith (1997, p. 133) observed that the "bezzle"—his name for the "inventory of undiscovered embezzlement"—varies with the business cycle: as-yet undetected fraud increases in good times and shrinks as swindles come to light in depressions. "In the late twenties," he wrote, "the bezzle grew apace."
  3. Peter Schuck argues that governmental initiatives fail because of internalities that are symptomatic of disharmony between a program's publicly stated goals and the private goals of its administrators. Levy and Peart (2015) discuss Schuck's insights from their perspective as economists.


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