Cracks in the Fortune Cookie

China's pretty much leading the global economic recovery, so why is the Shanghai Stock Exchange technically in bear market territory? History shows a booming Chinese economy doesn't always translate to booming market returns.

The Chinese economy's superstar status (it's currently the third largest in the world) and fervent drive toward modernization makes it tempting to think its stock markets are as developed as its economic peers. But the still-young exchanges sometimes march to the beat of a different drum—namely, the state's—perhaps explaining why dramatic market movements haven't always reflected economic fundamentals.

Elsewhere (i.e., freer, developed markets), stock prices are largely determined by supply and demand. In China, both can be distorted. China opened its present-day, mainland stock exchanges—the Shanghai Stock Exchange and Shenzhen Stock Exchange—in December 1990, but until a couple years ago, the majority of Chinese shares were non-tradable and controlled by the state (with a small percentage of "A-shares" publicly available to Chinese investors). Strong demand for the limited A-shares pushed prices to staggering heights (the Shanghai Composite rose 129% in 1991 and 166% in 1992*)—likely even higher than the strong economic fundamentals warranted. After all, the index subsequently contracted in 1994 and 1995, despite continued robust economic growth.

Since releasing these state-owned shares to the market, and with the re-opening of the IPO market in 2006, mainland Chinese stock and trading volumes soared. Despite these market reforms, state-induced supply and demand distortions remain. The state still constrains stock supply to some degree: Companies wishing to list shares on mainland exchanges must meet a stringent set of criteria and conditions set by China's State Council Securities Management Department.

Demand also suffers from manipulation. China's closed capital account and the underdeveloped Chinese bond market force most Chinese investors into hard assets (real estate or gold), cash, or domestic stocks. In such a restricted scenario, it's easy to see why demand for stocks may be pushed higher than fundamentals warrant. But eager investors can't just throw money at any stock—the state's tight grip on capital inflows and outflows has resulted in a segmented market, with four types of Chinese shares currently available:

• A-shares: Shares of Chinese companies listed on the primary mainland Chinese stock exchanges. These shares are only available to domestic Chinese investors.
• B-shares: Shares of Chinese companies listed on the primary mainland Chinese stock exchanges. These shares were originally only available to foreign investors but are now also available to mainland residents.
• H-shares: Shares of Chinese companies listed on the Hong Kong Stock Exchange. Since Hong Kong has (ostensibly) autonomy under Chinese rule, these shares are not subject to Chinese restrictions.
• S-shares: Shares of Chinese companies listed on Singapore's stock exchange.

Investors generally invest in A-shares and H-shares. Many Chinese companies list both A-shares and H-shares to tap domestic and foreign demand. But because Chinese investors can only invest in A-shares, a company's A-share price is consistently higher than its H-share price—sometimes 100% more—due to high demand relative to lesser available supply to meet it. Demand can also be distorted at the IPO level. Recently, to rein in excessive liquidity, China limited the number of licenses given to institutional investors wishing to invest in IPOs in the offline bidding process. The institutional offline bids typically set the IPO's price range.

This isn't to say the emperor has no clothes. The Chinese stock market and economy are among the fastest growing in the world—and will likely remain so for some time, helped in part by aggressive stimulus efforts. More than $1 trillion in new loans were already extended this year, manufacturing employment is the highest in 25 months, and prospects for Chinese companies look quite good.

However, investors interested in investing in Chinese stocks must be wary of the potential disconnect between economic fundamentals and market returns, lest they trip over cracks in the fortune cookie.

 *Source: Global Financial Data