Futures Now

The (sad) truth about China's rally and crash: Stocks are too frothy

Into the futures: China's day of reckoning?
Into the futures: China's day of reckoning?

Chinese stocks have fallen dramatically over the past four weeks, a slow-motion crash that has stoked concern about the Chinese economy and the potential for financial contagion.

Yet a look under the hood of the Chinese rally shows that the move can be explained in the context of two far more basic forces: The time-honored principles of valuation and of gravity.

A comparison of the Shenzhen A Shares Index to the index's price-to-earnings ratio (the most commonly used measure of valuation) shows that the two charts are one and the same.

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That is, Chinese stocks have soared on soaring valuations, with the index at one point trading at more than 40 times next year's expected earnings. That made it more than twice as expensive as the S&P 500 in terms of valuation.

Between the market's cheerleading and overt manipulation of price action by the Chinese government—and the herd mentality that swiftly rising prices naturally generates—the doubling of Chinese stocks in the first six and a half months of the year is fairly easy to explain.

Still, that doesn't mean the move had anything to do with economic reality.

Robert Shiller, in his popular tome "Irrational Exuberance", defines a speculative bubble as "a situation in which temporarily high prices are sustained largely by investors' enthusiasm rather than by consistent estimation of real value." As the above chart shows, that's clearly the best way to explain the Chinese rally.

That is to say, the Chinese government hasn't magically found a way to make stocks rise forever, without those companies also having to go through the process of actually making more money. This may be the easiest way to explain why the speedy rally is now being followed by an only-slightly-speedier decline.

Three charts explaining China's strange stock market

That may makes some of the moves that have come alongside the Chinese plunge a bit mysterious. For instance, copper has been suffering a dramatic decline, as has the Australian dollar.

Normally, a strong relationship between the Chinese stock market and each of those assets would make sense. After all, China is a huge consumer of copper, and Australia is heavily levered to the Chinese economy. Yet that is a characteristic it does not share with the Chinese stock market, at least in the short term.

It would appear, then, that some investors are confusing financial movement with economic reality. Put differently, some are listening a bit too closely to their trading algorithms—which likely tell them to sell Australian dollars and copper whenever Chinese equities slide.

"So much is just model-driven that everyone is doing less and less thinking for themselves," commented Brian Stutland of Equity Armor Investments. "It's just algorithmic 'if-then' statements driving the market."

At least in this case, those models may be on to something, as the Chinese economy is clearly in some distress. Growth is clearly slowing, as China's second-quarter gross domestic product (GDP) number will likely show Wednesday.

If the numbers impress, however, investors shouldn't expect the market to turn around and march higher. That dynamic would undercut the powerful force that's undergirded the Chinese rally of early 2015: The madness of crowds.

Clarification: An earlier version contained a typo that misstated the length of time China's market has been in decline.

—By CNBC's Alex Rosenberg.

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