Why Market Timing Makes Sense In China:Re-Examining Local Investor Behavior

Abstract

In October 2000, when, during a televised interview, the renowned economist and long-standing capital markets advocate Wu Jinglian called the Chinese A-share market a “casino,” the public outcry was immediate. The early responses focused on the need for improved market regulation and transparency, but a few prominent market participants and academics highlighted a more fundamental problem: A-share investors’ stubborn reliance on market timing strategies to generate return. The persistence of this latter issue is why today—despite nearly 15 years of regulatory development and investor education—the gambling metaphor still finds traction. For overseas investors, this type of speculative investor behavior only reinforces the already robust investment case for China’s capital markets. The success of China’s f irst wave of reforms has bolstered confidence that the positive trends in consumer spending, urbanization, and productivity will ultimately be ref lected in higher share prices. Financial liberalization will introduce new f lows into the markets and support higher valuations. Further, according to J.P. Morgan Asset Management [2014], current valuations are still attractive: the market’s average price/forward earnings ratio in the third quarter of 2004 was less than 10x, and the 10-year average of a composite valuation metric evaluating price versus forward earnings, book value, historical cashf low, and historical dividends, respectively, was close to one standard deviation behind the long-term global market average. China’s interbank f ixed income market is still in a relatively nascent stage, but recent long maturity corporate issuance, newly introduced regulation to improve credit risk transparency, and the development of new securitized bonds—including the planned launch of mortage-backed securities—offer foreign investors the opportunity to benef it from unprecedented structural reforms. Recent efforts to liberalize interest rates have already had a positive impact on f ixed income market liquidity, and China’s current policy real yield remains among the highest in the world. Despite this positive long-term outlook for China’s capital markets, overseas investors would benefit from a close examination of domestic speculative investment behavior, particularly in China’s A-share market. Market timing—in simple practice, predicting the outperformance of stocks relative to bonds—is still a vexing topic in financial market theory. In the absence of persistent, superior forecasting skill, market timing is considered irrational behavior. Further, devising a method to assess this forecasting skill is fraught with difficulty and contingent on a number of impractical assumptions. Yet neither these impediments nor the long-term poor performance of onshore market timing strategies have deterred China A-share investors. In China, at least, this activity, albeit “irrational,” clearly must have some rationale. The seminal work by Merton [1981] on evaluating asset manager total performance proves relevant here. Merton argues that a pure market timing strategy can be regarded as a long position in a zero-cost European call option on the market portfolio, with a strike price that aligns to the drift path of the risk-free rate. This analogy Why Market Timing Makes Sense In China: Re-Examining Local Investor Behavior