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A newly-published risk model shows that buying on euphoria and selling on panic has been a successful strategy for Chinese equity markets. Rational investment Chinese style is to watch for shifts in government policy rather than changes in spreadsheet data. Liquidity is seen as the proxy signal for when Beijing turns positive/negative on equities and roll out measures to support or suppress higher prices. It shouldn’t work – but it does. Winners in China’s A-share markets buy when market sentiment is high and sell when market sentiment is low. Or, as I recommended to investors in a previous post, toss out the spreadsheet and other textbook fundamentals and go with herd psychology. It works. And now there is a study to prove it. Credit Suisse has just published a risk model for investing in Chinese stocks. And it has found that the signals for buying and selling in Chinese markets are “the opposite” of what’s expected everywhere else in the world. Chinese investors buy on euphoria and sell on panic – and the strategy has been successful on the whole, according to the Swiss banking group which has now included China in its proprietary Global Risk Appetite Index. The index, which has been around for some 20 years, measures the performance of stock markets against government bond markets based on rolling six and 12 month returns and correlates risk appetite with investment signals. The global version shows that risk is cyclical and confirms accepted market wisdom that the best time to buy is when risk appetite is low (such as during a panic) and to sell when risk appetite is high (as when the market is in euphoria). The cycles in risk appetite in most markets correlate closely with what is happening in the global economy. Extremes in risk appetite thus provide reliable countercyclical trading signals. So if you buy when the market panics and wait for the eventual rebound, you make a tidy profit. China, as always, is different. Prices don’t follow fundamentals in the way they do elsewhere in the world but are more closely linked to investor psychology, according to the report. Among the findings , as reported by the media, are: “… in China, buying the market when risk appetite was high and selling when risk appetite was low has been a successful strategy in general. This is the opposite of how our Global Risk Appetite Index has behaved.” The report gave two reasons for why the China market is different. One, the free float is much smaller than in other markets because state firms account for 45% of market valuations. Small moves in a stock can thus have a huge impact on the price. Second, the level of government intervention is high. Further distorting traditional signals is the extreme swings in risk appetite that characterize the Chinese market. Prices tend to overshoot and go off the charts before reverting to the norm – challenging standard concepts of “cheap” valuations. Nor are conventional performance metrics of much help. The fortunes of individual companies can – and have been – scuppured by government campaigns, such as Beijing’s anti-corruption drive. The Chinese corporate world is unusual in that the sins of executives are often visited on the companies they run. When a top executive falls, he typically brings down all around him, sometimes even the company itself, as I explained in a previous article, ” The Midnight Knock. ” The strategy that has produced results in China’s contrarian equity markets is to follow the herd. This means jumping in when the market is high (as the chances are that you can sell even higher) and dumping stocks when the market is low (as it is likely to go even lower). But this does not mean the Chinese stock market “behaves weirdly”. Investors in China simply follow a different set of rules, as I have argued in many previous posts. They track fundamentals but of a different sort. Chinese fundamentals have little to do with western textbook metrics and everything to do with government policy – unlike in Western markets where the term “fundamentals” has been hijacked by the financial industry to mean only spreadsheet data. In China, the very visible hand of government is always hovering – skewing market direction and distorting what would be classic signals in the free and open markets of advanced economies. The valuation that matters in China is the price-to-fear/greed ratio. And the signal for the switch from greed to fear and back is liquidity. Driving stock prices in China is liquidity . Not the economy. Not corporate earnings. Not abstract theories of reform or quality growth that is supposedly superior and sustainable for years to come. Liquidity is seen by Chinese investors as the proxy signal for when the government turns positive/negative on equity markets and will roll out measures to support/suppress higher prices. The biggest losses since the rally took off in earnest last September have all been triggered by market fears that the regulator was about to put an end to the party by pulling liquidity. Investors started turning skittish in January when the regulator tightened rules for entrusted loans which had been providing funds for stock purchases. The move was perceived as signaling a coming government squeeze on liquidity to cool the bull run in equities. The market has since been swinging between greed and fear amid conflicting interpretations of Beijing’s policy moves. Every investor in Shanghai and the rest of the country has been watching every other investor to see who might be pulling out and who might be doubling down on their bets. Confidence is a fragile commodity in a market where policy U-turns can happen overnight and with little warning. Hence, the inherent volatility in A-share prices. China’s domestic investors did not put money into the market because the textbook fundamentals looked right. On the contrary, price-to-earnings ratios were soaring, the yield advantage that stocks offer over bonds rapidly shrinking, and economic growth was at a 24-year low with corporates sagging under heavy debt burdens. What domestic punters had been betting on for the past year was a liquidity story backed by policy – the only fundamental that matters in China. The A-share markets are likely to remain range-bound in the coming weeks as investors digest the implications of Beijing’s stock rescue and decide if there is time for one more roll of the dice. This is rational investment, Chinese style. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.