What the Chinese Stock Market Crash Can Teach You

By some accounts, China's stock market has been in freefall. In less than a month, the Shanghai Stock Exchange Composite Index -- the Chinese equivalent of America's S&P 500 stock index -- saw a 30% drop in value.

Media reports have ranged from indifference to breathless comparisons with the great stock market crash of 1929, followed by dire predictions for you and yours. Most recently, Chinese stocks have recovered some lost ground. So why all the bother?

The following chart clearly shows that, despite the huge drop, the Chinese market is still a lot higher than it was a year ago. Some speculate that this may be a bubble bursting -- and if it is bursting, they wonder if things are yet to get worse.

Source: Stock Charts.

The picture looked even worse for the high-tech exchange index (somewhat equivalent to the Nasdaq here):

Source: Stock Charts.

A trillion here, a trillion thereSipping your favorite overpriced hot beverage, you may look at a chart like this and wonder, "How significant is this really?"

The general consensus is that roughly $3.5 trillion in paper wealth evaporated with the downstroke of a chart. To paraphrase a quote attributed to the late Sen. Everett Dirksen: "A trillion here, a trillion there -- pretty soon it adds up to real money."*

To put that number in perspective, it is more than 10 times the entire gross domestic product of Greece, the other nation currently hogging the headlines.

So could a shock wave of this magnitude cripple China?

Why China's situation is differentIt's easy for us to look at China and think this crash would affect it like an American stock market crash affects us. That would be a mistake, and here's why.

China's financial industry has a different focus. In America, roughly 50% of the population owns stocks, either individually or through mutual funds, retirement plans, and pension funds. By comparison, that number in China is less than 10%. Most people there build wealth through real estate and old-fashioned savings accounts because the financial industry (mutual funds, managed retirement plans, etc.) isn't that well developed.
China is a state-run economy. The biggest banks, factories, and businesses are owned by the government, not individuals. To a much larger degree than we here can imagine, events there are dictated (sometimes unintentionally) by the government. In this case, the Chinese authorities launched a concerted effort in the second half of 2014 to encourage individuals to invest in the stock market.
China curbed real estate growth. Chinese real estate prices reached a level a few years ago which concerned authorities, causing them to implement measures to curb real estate price growth. In response, real estate sales have slowed, new construction has dropped off sharply, and banks have become increasingly cautious about lending to developers and homebuyers. Housing prices fell in June for the second month in a row, two surveys showed earlier this month. Individual investors were ripe for other investment opportunities.

When they saw their government's push to invest in stocks, that was all many needed to jump into the market. Once the market took off, margin-buying (going into debt to buy stocks) followed, turning the growth into a bubble -- and we all know what happens to bubbles.

Will China's market crash affect us?If that thought crossed your mind as you blew the steam off your cuppa, you are not alone. The biggest reason for saying "no" is the Chinese government's restriction on foreign stock ownership, with the result that less than 2% of the stock market is owned by foreigners. That means the carnage is restricted to Chinese individuals (who own more than 80% of all Chinese stocks).

Lost in all the drama about the stock market crash is that it still plays a surprisingly small role in the Chinese economy. The free-float value of Chinese markets -- the amount available for trading -- is just about a third of GDP, compared with more than 100% in developed economies. Less than 15% of household financial assets are invested in the stock market, compared to around 50% in the USA. Consequently, soaring shares did little to boost consumption, and crashing prices will do little to hurt it.

The larger questionHowever, the larger question is: Will the Chinese-stock market drop merely be a prelude to a recession in its economy, which will then infect ours? The answer to that question may be less reassuring.

The fact is that, for a few years already, the Chinese economy is no longer driven by exports made cheap by low wages and a low currency. Wages have risen in recent years along with the currency. Not surprisingly, exports ceased to be the main engine driving the Chinese economy. That has led to a drop in Chinese purchases of commodities, which in turn has depressed prices and sales for other countries that produce those commodities.

To compensate for weakening exports, the Chinese government embarked on a massive program of developing infrastructure, funded by debt. The question in some minds now has become: Are China's stocks the canary in its coal mine of debt?

As one Washington Post reporter mused: "The rest of the world can handle a Chinese stock market crash, but not a Chinese housing crash." And it's too early to tell how far the dominoes in China will fall.

What can you do if ... ?As you put down your empty cup of something and get ready for your day, you might ask yourself: If the worst-case scenario happens and, for one reason or another, the Chinese-stock market meltdown makes its way to our neck of the woods, what can I do?

1. Don't sell. The worst thing to do when the stock market crashes (like it does every seven to 10 years) is to sell. The market moves in cycles, and in the past it has always recovered. Selling low is the worst thing to do. Strangely, it is also the most popular course of action.

The wise thing is to simply hold what you already have. Chances are the markets will come back (and better) long before you need the money for retirement or whatever.

2. Keep on keeping on. If you are like most people, you make a living from a job. In turn, that means you invest monthly, whether through an employer-based retirement plan or on your own. Put another way: You are buying -- and will be buying -- for many years to come.

When the stock market crashes, that means (as Warren Buffett loves to remind everyone) that "everything is on sale." Emotionally, you may feel afraid to buy because times feel so uncertain, but logically, the best time to buy is when prices are low. Therefore, that is also the best time to keep doing exactly what you have been doing -- making those monthly buys.

3. Keep the long view. It's true that nobody knows the future; but when you see a pattern as old as dirt, you also don't ignore it. The economy (including the stock market, real estate, and commodities that you can invest in like gold and silver) has moved in an up-and-down cycle as long as humanity has tracked it. No two cycles have been the same, except for one thing -- there is always a "down," which is always followed by an "up."

Another test of willsEven if the Chinese stock market crash is only an event we observe from afar, we can use those observations to help us develop the will to stay the course with our own investments when the time comes. By most people's reckoning, the U.S. has been on an upcycle for several years now. We may debate its attributes and its duration, but one thing is indisputable: When the next change happens, it will be downward. Whether that downdraft will be caused by China, Greece, or even Puerto Rico (the headline hogger on deck) probably doesn't matter all that much.

What is important is to expect a crash or recession of sorts in the not-too-distant future -- and to be practiced at staying the course. Knowing that ahead of time takes away the surprise and the emotional anguish. It allows us to keep on track to getting rich slowly. The trick, of course, is holding on to the job that provides that monthly income ... but that's another story.

(*For the nitpickers, Senator Dirksen didn't really say that, but when it was attributed to him, he thought it was such a good quote, he apparently saw no reason to correct anybody.)

This article originally appeared at Get Rich Slowly.

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