Investors in the Chinese market, domestic and foreign, are disappointed that China's new leadership appears unwilling or unable put together a growth model that breaks China out of its economic policy rut, writes MoneyShow's Jim Jubak, also of Jubak's Picks.

While US stock indexes have hit all-time high after all-time high, China’s markets have been in retreat.

After peaking on January 30, Hong Kong’s Hang Seng index has fallen by 5.4% as of March 15. The Shanghai Stock Exchange Composite index peaked on February 6, and is down 6.4% from that peak to the close on March 15.

The Shanghai index is still up considerably—16.2% from its December 3 low through the March close—but that’s a retreat from the 24.2% gain the market had recorded from the December 3 low through the February 6 high.

To understand the drop in Chinese stocks even as US stocks soar, it’s important to understand the two groups of investors and traders that—in the short to medium term—drive the prices of Chinese stocks.

The two groups don’t have a lot in common, nor do they look for the same things from China’s economy and stock markets. But both have been disappointed that trends they thought they saw in place in December and January are either in jeopardy, or else were never actually there to begin with. And that has left China’s stock markets without the support of the two groups that usually lead China’s stock prices higher.

Where China’s stock markets go from here—in the short-term—rests on whether the disappointment of these groups increases or reverses. Certainly, with turmoil in the Eurozone pushing global markets toward risk-off positions, it’s hard to see Chinese stocks getting a boost from macro trends outside of China.

Two Separate But Equally Important Groups
First, China’s domestic investors and traders. This is the key group for determining prices in Shanghai in the short term, and it has been disappointed by recent government economic and monetary politics. These investors were looking for quick action by the government to stimulate economic growth and to prop up asset prices.

This group thought it saw those policies about to drop into place in December, and so they bought Chinese stocks, especially those—such as real estate developers and securities companies—most likely to benefit from this change in government policy.

Second, overseas and institutional investors. This is the key group in determining prices in Hong Kong and Shanghai in the medium term, and it has been disappointed by government economic policy.

They had counted on measures to increase economic growth, but just as importantly, they had been looking for signs of new economic policies that had the potential to break China out of a traditional reliance on export-driven growth that looked increasingly exhausted.

Recently, though, they’ve seen signs that China isn’t willing to explore changes to its economic model, or—and this might be even worse—that China’s leaders don’t know how to put together a new growth model.

These Are Their Stories
Let me take what these two groups thought they saw in December, and the grounds for their recent disappointments.

In the late fall and early winter of 2012, China’s domestic investors thought they saw exactly the kind of policy changes they were looking for. For example, China moved to expand the number of overseas institutional investors approved to invest in China’s financial markets.

As of November 20, 64 overseas institutions had been approved to invest up to $11.9 billion in China’s markets through the Qualified Foreign Institutional Investors program. In January, the head of the China Securities Regulatory Commission said that China could increase these quotas tenfold.

On the central bank front, China’s money supply grew by 13.8% in 2012, up from 13.6% in 2011...but with inflation under control—inflation climbed at a rate of only 2.6% in 2012, down from 5.4% in 2011 and well under the government’s 4% target for the year—government economists strongly argued that growth in the money supply wasn’t too fast, and that it even had some room to speed up.

Analysts inside and outside of China finished 2012 talking about further loosening by the People’s Bank of China in 2013. Maybe not a reduction in the central bank’s benchmark interest rate, but certainly a cut or two or three in the ratio of reserves that banks were required to keep.

No wonder that the stocks of companies that would directly benefit from these policies soared. Shares of Citic Securities, China’s biggest securities company, climbed 60.6% in Shanghai from November 29 through February 1. Shares of China Vanke, one of China’s biggest real estate developers, moved up 63.1% from November 12 to January 31.

But then doubt began to surface that the government’s policy would be as hell-bent on stimulus as those early signs indicated. On March 4, Beijing told cities with higher-than-average rates of real estate appreciation to tighten lending standards and to impose a 20% tax on profits from real estate sales.

Then the January-February inflation rate came in higher than expected at 3.2%. That is close enough to the 3.5% inflation target for 2013 to raise concerns among investors that the People’s Bank would become concerned.

At the least the new inflation numbers suggested that the central bank would take a wait and see attitude toward increasing the speed of growth in the money supply, or in cutting either the reserve-ratio requirement or the benchmark interest rate.

The hopes for looser money and more stimulus that had fueled the rally that began in December weren’t exactly dashed, but they weren’t strong enough to bet on either. Domestic investors in China took profits.

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Tickers Mentioned: Tickers: PNGAY, HMIN, TCEHY