Stocks in that emerging giant come in three distinct types. Knowing which is which can make a big difference in how you play them and how much you make.
If you want to figure out China's stock markets—and hence China's stocks—start by dividing investments there into three parts.
For today, forget about sectors and trying to map economic and monetary policy out of Beijing. Put fundamentals back on the shelf. Give your technical indicators a day off.
Instead, think about how investors in the markets of Shanghai, Shenzhen, and Hong Kong believe they can make money in these markets. In other words, think about where they believe profits lie in their stock markets. Then let their sense of the sources of profit opportunities drive your understanding of these markets.
Let me explain further.
Making Sense of 1.3 Billion Investors
Every day, we try to discern some kind of order in the Brownian motion of day-to-day stock volatility.
We say that oil stocks are up or down. Or that money is flowing into or out of big-cap stocks. Or that investors are seeking or abandoning the safety of consumer stocks.
But as we use this kind of logical shorthand, it's important that we remember it is just shorthand. We must also be on guard that that we don't confuse such objective qualities as "oiliness" or "big-capness" or "consumerness" with what actually drives stock prices from day to day.
It's not membership in the oil sector that moves oil stocks on any particular day, for example, but rather the ever-fluid preferences of investors for oil stocks.
The incredible volatility of stock prices is ultimately an expression of the volatile emotions and logic of hundreds of millions of investors. Thinking of that makes the project of finding some order in the stock market seem laughably naïve.
But there are patterns in investors' relationships to stocks. We express them in such cynical observations about human nature as "stocks are the only thing people want more of as they get more expensive." Or we note the ownership life cycle as a former growth stock such as Microsoft (MSFT) ages toward a value stock, losing one type of investor as it picks up another.
We know that many institutional investors can't buy stocks priced below $10 a share, and that others can't buy stocks that don't pay dividends.
All those relationships between stocks and stock investors help organize a stock market—and thus the strategies investors use to search for profits.
New Markets Follow Their Own Rules
Those relationships also exist in the world's newer financial markets, such as China and Brazil.
They're relatively unstudied in comparison with the markets in New York or London, for example, both because those emerging markets are so new and because they're unfamiliar to most of the overseas investors who have begun buying stocks in them.
We overseas investors may buy Chinese stocks, but we don't belong to those markets, and we don't—at least at this point—determine the psychological structures of those markets. Instead, those structures are largely determined by the everyday inhabitants of those markets.
I'm a student of China myself, but I think I can make three sweeping, yet still useful, generalizations about the structure of its markets.NEXT: Three-Fold Investment Advice