&l;p&g;&l;img class=&q;dam-image getty size-large wp-image-578019252&q; src=&q;https://specials-images.forbesimg.com/dam/imageserve/578019252/960×0.jpg?fit=scale&q; data-height=&q;621&q; data-width=&q;960&q;&g; Hong Kong China traffic Kowloon Woosung Street with signs overhanging street. (Photo by: Education Images/UIG via Getty Images)
&l;strong&g;China&a;rsquo;s mainland stock markets are not like those in open economies. The Shenzhen and Shanghai stock exchanges miserably fail to capture China&a;rsquo;s spectacular growth. No, investors would rather not go near a market with sloppy regulations and too much government interference.&l;/strong&g;
Ages, the world waited for this moment. In 2018 the MSCI, the world&a;rsquo;s leading index provider will include shares from mainland China in its index.
That&a;rsquo;s a pretty big thing, because whatever the MSCI does influence trillions of dollars of stock market trading. MSCI-controlled indexes are the main point of reference for fund managers and investors to compose exchange traded funds (ETFs). That includes MSCI Emerging Markets ETFs.
But isn&a;rsquo;t this a gross miscalculation on the MSCI&a;rsquo;s part? China&a;rsquo;s mainland stock markets are detached from its economy. That means they don&a;rsquo;t mirror the economy&a;rsquo;s performance like a normal stock market does. Too many shares of mainland China could become a heavy burden on the MSCI&a;rsquo;s index &a;shy;- and on your portfolio.
&l;strong&g;Chinese stocks don&a;rsquo;t reflect economic performance&l;/strong&g;
Stock markets in free market economies, like in the U.S, are a reliable indicator of economic performance.
In an economy on the rise, companies make a profit, which will result in rising stock values.&a;nbsp; But closed planned economies like China&a;rsquo;s don&a;rsquo;t work like that. Their economic performance has little to no impact on the value of their stock market.
This becomes apparent when you look at the graph below. China&a;rsquo;s real GDP rises steadily, but the absolute value of Shanghai Composite (SHCOMP) Index, tracking the performance China&a;rsquo;s stock market, has hardly changed since 1998.
&l;a href=&q;https://blogs-images.forbes.com/peterpham/files/2018/02/Picture1-8.png&q; target=&q;_blank&q;&g;&l;img class=&q;size-full wp-image-1105&q; src=&q;http://blogs-images.forbes.com/peterpham/files/2018/02/Picture1-8.jpg?width=960&q; alt=&q;&q; data-height=&q;518&q; data-width=&q;924&q;&g;&l;/a&g; SHCOMP Index vs. China Real GDP
It&a;rsquo;s obvious that Shanghai&a;rsquo;s index and the country&a;rsquo;s economic growth are completely separated. And it seems regional growth has not effect on it either.
In the graph below, you can find a comparison between the SHCOMP and the MSCI Emerging Mark Index Asia&a;rsquo;s annual returns percentages. The MSCI follows large and midcap shares across 9 emerging Asian countries. Both indices&a;rsquo; numbers seem completely mismatched.
&l;a href=&q;https://blogs-images.forbes.com/peterpham/files/2018/02/Picture2-8.png&q; target=&q;_blank&q;&g;&l;img class=&q;size-full wp-image-1104&q; src=&q;http://blogs-images.forbes.com/peterpham/files/2018/02/Picture2-8.jpg?width=960&q; alt=&q;&q; data-height=&q;470&q; data-width=&q;910&q;&g;&l;/a&g; Annual Performance
Obviously, China&a;rsquo;s stock market performance is not driven by economic growth, nor corporate earnings. The performance of China&a;rsquo;s stock markets is at the mercy of regulators and small investors instead.
&l;strong&g;A world of bendable rules&l;/strong&g;
In China, bogus credit reports of listed companies are no exception and trading regulations are not applied, causing insider trading to run wild. This lack of control makes it hard to know what a listed company is actually worth.
As a result, speculation takes over from valuation on mainland China&a;rsquo;s stock market.
&l;strong&g;Retail investors play the stock market like a casino&l;/strong&g;
Investors in Chinese mainland markets are from a different breed than those investing in other markets. This causes the SHCOMP Index prices to become incredibly erratic.
Retail traders hold about 80 percent of Chinese equities. They have a total of 112 million accounts in Shanghai and 142 million in Shenzhen. Retail traders collectively tend to buy and sell based on speculations and hearsay, as opposed to institutional investors who base themselves on fundamentals.
As retail investors account for more than 80 percent of the SHCOMP Index, the index&a;rsquo;s price is extremely unstable. If the price were to increase, everyone will jump on the train and buy. If the price would go down, everyone would head for the exit at the same time trying to sell.
If the index price in developed markets would increase or decrease by 5 percent, chaos would reign. But if that happens to the SHCOMP Index, no one would even turn their head.
The deep flaws of China&a;rsquo;s stock market can be traced back to its creation.
&l;strong&g;The CCP&a;rsquo;s unruly sugar daddy&l;/strong&g;
The mainland stock markets were created with the sole purpose of giving state-owned enterprises (SOEs) a boost, not to open up the market to the public. The Chinese Communist Party found itself a sugar daddy loaded with foreign money in the stock market, which can be exploited to revitalize SOEs burdened with debt. The Party (fruitlessly) tries to control this uncontrollable source of capital
On mainland stock markets, the Chinese government unsurprisingly controls 30 percent of the shares. That comes down to 468 listed SOEs that gained access to foreign cash thanks to the government.
As long as the government backs them up, Chinese companies have the opportunity to list on mainland stock markets. It doesn&a;rsquo;t matter if they&a;rsquo;re competitive or not. In China, profitability takes a back seat to politics.
As opposed to developed markets that are driven by the subtle mechanism of supply and demand, markets on mainland China are strictly controlled by the government.
The Chinese government has a wide array of both direct and indirect means to try and force the market in a certain direction.
For example, in 2016 the government wanted to put a stop to short-selling and the futures market. So it prohibited large shareholders to sell and demanded US$250 billion be injected into the market.
Evidently, foreign investors, particularly institutional investors, are not keen to enter a stock market heavily manipulated by politicians.
China has no open market.
This will keep the stock market in an underdeveloped state and makes it damn near impossible to predict its true value.
Chinese stock markets are therefore not the way to exploit the country&a;rsquo;s economic growth. China&a;rsquo;s massive banking sector offers much more interesting investment opportunities.
Next time, we&a;rsquo;ll tell you how to take optimal advantage of China&a;rsquo;s markets to achieve true wealth.&l;/p&g;