China's Market Rout In Perspective

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But that was chump change compared to the 396% run from June 2005 to October 2007. Even the most recent run-up is a story of triple digits.

The next run up will be, too.

Keep the following in mind and chances are you'll do just fine…

First, China's stock markets are not the economy. It's important to remember that one is a capital instrument, while the other is a driver. So don't immediately assume that the economy will fail just because the markets are getting trashed. There have been plenty of cases throughout history where markets fell yet growth continued.

Second, China's middle class of 600 million people will no more return to the financial equivalent of a consumer Stone Age than we would… even if the markets there come totally unglued as opposed to partly unglued like they are now. The genie is out of the bottle and hundreds of millions of communist Chinese want the high quality of life that comes with capitalist success, so they're going to do what every society in history has done before them… buy… everything.

Third, China's economy is still growing at 6.5% to 7% a year. To that end, Premier Li Keqiang noted Wednesday that the country is still on track when it comes to meeting its projections. So what if the numbers are cooked. Everybody knows that, just like they know the recovery our politicians are peddling is a pile of you-know-what.

It's the proportions that matter. China's still way ahead of the West, even after trillions of dollars have been spent here in a well-intentioned but totally misguided stimulus. That's why you want to stay focused on the upside and the profits that come with it. Anything else is a waste of time and a risk you don't need.

Fourth, despite the perception that global markets are inextricably linked, in reality China's markets are still largely isolated from global capital. That means the real risk here is not China's markets cratering but China's leaders using the rout as an excuse to curtail economic reforms that have propelled that nation to where it stands today as the second-largest economy on earth.

Fifth, a strong correction is great for Chinese equities because it bleeds out the excess that's crept in. That's the way markets work in a normal, growing country… any normal, growing country.

If anything, I'd be more worried if we didn't see a correction like this every now and then. Nothing goes up forever, including China.

Why, then, is all this happening?

Most Western analysts have it wrong. They're blaming everything from corruption to insider trading, ghost cities, and more, because it's convenient and sounds logical.

Chinese investors, who are a naturally suspicious lot anyway, are also pointing fingers. I'm hearing reports that Morgan Stanley (NYSE:MS) and other "evil" Western influences are supposedly at work there profiteering in Chinese markets much the way billionaire trader George Soros did when he "broke" the Bank of England in 1992 and made billions doing so.

In reality, something far simpler is at work.

Every Chinese company has to submit to a semi-annual listing that forces it to disclose what it owns and how it came to possess what it has. That means, just like their Western money manager counterparts, they engage in the process of "window dressing" intended to please regulators and investors alike.

Chinese money managers are simply dumping holdings related to the excess margin they've got on the books. And that's what initially took the legs out from under the latest Chinese rally.

Now, emotion has taken over. We've talked many times about how dangerous this is , so there shouldn't be any surprise here.

Hundreds of millions of inexperienced Chinese investors, many of whom have never owned securities before and who have never experienced anything other than rising markets, are panicking. Effectively, they've all hit the sell button at once.

That compounds the problem because routs like China's are not really the result of too much selling like most people think. Prices really drop hard and fast when there's not enough buying.

The other thing to consider is Chinese markets got this way by taking a similar path to our own. Chinese regulators there did in 2010 what regulators here did years before, loosening requirements that used to prevent buying stocks on borrowed money.

At the same time, Chinese investors did what their American and European counterparts did leading into 2007-2008 and found very creative ways around the system to engage in speculative trading.

For example, many Chinese banks offer something called a "Wealth Management Product" or WMP for short. They're marketed to individuals and supposed to be invested in very conservative risk-averse securities like a money market fund would be here.

However, WMPs are also invested in very risky instruments made up of bundled assets that – you guessed it – are sold in "tranches" carrying varied risk levels. That means Chinese investors who think they are buying low-risk products are really being sold highly leveraged instruments that resemble the collateralized debt obligations or CDO's that sent our markets off a cliff in 2007.

Compounding the problem is the fact that WMP investing falls outside the margin requirements applied by the Chinese regulators. That means millions of investors were able to pile in well above the legally permissible 2-1 leverage using virtually the identical structure and off balance sheet loophole our big banks did to trade trillions in derivatives yet maintain the perception of having everything under control.

I wish I knew how to say "déjà vu" in Chinese… no doubt it applies.

Anyway, the bottom line here is that the Chinese market correction is as long overdue as it is logical, especially when you understand the reasons behind it.

It will continue until excess leverage is either priced out of the system or stocks are "sold" down to where value takes over and margin does not apply.

You'll know you've reached that point when you see magazine articles talking about "the end of Chinese stock investing" or hear stories about Chinese investors who are "swearing off the evils of Western-style trading forever."

And you'll know it's time to put money to work there again, because I'll tell you.

Written By: Keith Fitz-Gerald