China – buy when there's blood on the streets, or avoid trying to catch a falling knife?

The second adage seems more appropriate. JP Morgan last week noted the median Chinese stock had tripled in value in the year prior to June’s peak.

The median return among the 185 top performers was 410 per cent. True, they have since been brutalised, falling by an average of 57 per cent in just three weeks. However, stocks remain wildly overpriced; of the top 30 biggest gainers over the previous year, just seven trade on a price-earnings multiple of 100 or less.

Chinese stocks are driven by sentiment rather than valuation, so there will be some furious rallies, as was seen last Wednesday, when Shanghai enjoyed its biggest one-day gain since March 2009.

Still, further pain looks likely.

A Merrill Lynch note last week examined the duration and magnitude of the initial drop from the high in eight other historic crashes – the Dow Jones in 1929, gold in 1980, the Nikkei in 1990, Russia in 1998, the Nasdaq in 2000, Saudi in 2006, China in 2008, and oil in 2008.

The average initial decline was 51 per cent and lasted 90 days. The smallest drop was 37 per cent; the shortest drop lasted 41 days. China has fallen by 32 per cent in just 17 trading days, indicating the bloodletting is not over.

Short-sellers and confidence

Everything would be fine if, as the People’s Daily reported, silly Chinese investors would just remember that “rainbows always appear after rain”.

Indeed they do. “Confidence is more precious than gold”, headlined the same newspaper. “That’s what Chinese investors need at this moment; confidence, not panic.”

That message echoed the China Securities Regulatory Commission, which lamented "panic emotion" and "irrational selling".

This irrational lack of confidence may have been caused by short-sellers.

State news agency Xinhua reported police and regulators were investigating “vicious” and “malicious” short-selling as well as “clues of illegal manipulation across markets”. Ignoring the fact short interest in China is at its lowest level in a year, Xinhua said it was clear authorities would “punch back” with a “big fist”.

Does all this talk about crooked short-sellers and the need for confidence sound familiar? Yep – Ireland in 2008.

State actions may backfire

China’s government is not the first to try its hand at market manipulation. Western policymakers routinely bash short-sellers while central bankers have been forcing equity prices higher via quantitative easing programmes over the last number of years.

Nevertheless, China “does seem to be raising the bar in terms of intervention techniques”, to quote Deutsche Bank’s Jim Reed, whether it be banning major shareholders and directors from selling stock for six months; forcing fund managers to spend 500,000 yuan (€73,000) of their own money buying stock; freezing trading in more than half of listed companies; suspending initial public offerings (IPOs); or allowing ordinary investors to literally bet the house on stocks by allowing them to pledge their home as collateral to brokers.

This may yet support prices in the short term, but the long-term effects will damage China.

MSCI, the world’s largest indexing firm, last month rejected calls for Chinese stocks to be included in its emerging market indices. Instead of introducing the reforms sought by MSCI, China has introduced new trading restrictions that will worry international fund managers.

What future restrictions might be introduced? Will global investors be allowed to sell what they want, when they want? Less trustworthy markets get punished with lower valuation multiples – hardly what Beijing wants.

Concern, but no panic so far

With Chinese and Greek woes dominating market headlines, one might have expected gold to get a bid.

Instead, gold last week hit its lowest level since March, prompting many to ask if the yellow metal has lost its perceived safe haven status.

Perhaps. Gold has been a lousy investment for years now, falling from its 2011 high of $1,920 to $1,160 last week.

The fact a US rate hike is expected later this year has further dampened gold’s appeal.

Still, it’s not just gold – there has been no great appetite for other traditional safe havens such as the Swiss franc, the yen and silver. In Europe, there has been no rush into German bonds, nor any great exit from peripheral bonds.

In other words, there is concern over China and Greece, but no panic.

That may change, but for now investors are betting against any contagion effect.