Guests drink champagne as they wait for the start of a fashion show held at the Ming Dynasty City Wall Relics Park in Beijing. REUTERS/Kim Kyung-Hoon To say Chinese stocks have endured a volatile period in recent months is perhaps the financial market understatement of the year. Up until June 12 they were on an unbelievable tear, rising more than 150% in just 12 months on the back of new account openings, cheerleading from the government and, as a consequence of both, increased margin debt used to purchase stocks. It all seemed too good to be true.

Then, almost as quickly as they went up, stocks started to fall. One day after the next, it seemed that the benchmark Shanghai Composite was suffering another multi-percentage decline. As the losses mounted, so too did the number of investors who were losing on their trades, particularly those who leveraged up using debt to facilitate their share purchases. Many investors – particularly those with limited experience in markets and little education – were learning the hard way that leverage in the stock market can magnify both gains and losses.

Between June 12 to August 26, the Shanghai Composite lost 45% from peak to trough. Many other smaller indices, brimming with small cap stocks, suffered declines of an even greater magnitude. It was a bloodbath, especially for leveraged investors.

After an unprecedented volley of measures to stop the markets losses from the government – including banning some investors from selling, forcing some state-backed bodies to buy, postponing IPO listings, limiting the ability to short sell and even arresting those who were deemed to have sold “maliciously” – the government eventually got its way.

The market began to recover.

Slowly but surely, it began to move higher. Almost by stealth, the extreme losses quickly turned to massive gains. From its August 26 nadir, the benchmark Shanghai Composite index rallied 26% over just 45 trading sessions.

It’s been a breathtaking rally, and one that has been built upon familiar shaky foundations – margin debt.

Yes, despite some horror stories about investors losing a bucketload of money on the back of margin calls, investors, yet again, a levering up in anticipation of further market gains.

As the chart below shows, supplied by Macquarie Bank’s equity research team of Matthew Smith, Steve Zeng and Patrick Dai, outstanding margin debt over stocks is yet again increasing after the massive unwind seen during the September quarter this year.

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“Brokerage margin positions in China managed a comeback in October, rising by RMB124 billion, or 14% MoM,” the trio wrote in a research note released last week.

“The increase pales in comparison to the huge sequential increases of March-June, but they are nonetheless remarkable considering they come on the heels of the 3Q15 crash, when margin positions fell 60% from a RMB2.3 trillion mid-June peak to just RMB900 billion at end- September.

Looking at the chart of the Shanghai Composite over the same time period, it is clear that the movements in the index are eerily similar to those seen in outstanding margin debt levels.

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With margin debt and stocks pushing higher in unison, the question many are now asking is whether the trend can continue. While they admit that anticipating future stock market movements based on margin positioning is “truly a mug’s game”, Smith, Zeng and Dai believe that the answer is yes.

“We should know by now that trying to anticipate results on margin flows is truly a mug’s game. However, we’re still playing,” the trio wrote.

“Our sense – based on a relatively positive view on China’s macro, the historical tendency for an end-of-year rally, and good old-fashioned (but often wrong) gut feel – is that markets are likely to continue heading higher into year-end and the trend is likely to also be reflected in margin positions which we now think will push higher too.”

While Macquarie are optimistic on the short-term outlook for stocks, whether the gains can continue beyond that timeframe is questionable. As this chart from the bank outlines below, margin debt as a percentage of the free float market capitalization currently sits at 5.6%, a still-elevated level even with the recent correction in both outstanding margin debt and the overall stock market.

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It’s remains a highly-speculative, highly-leveraged market, and one that is dominated by short term thinking from investors. Throw in PE ratios that sit at incredibly elevated levels and deteriorating economic fundamentals and it’s clear that while momentum looks strong, the fundamentals underpinning the rally are not.

As Michael Every, head of financial markets research at Rabobank in Hong Kong, told Bloomberg last month, while fundamentals can be ignored for considerable periods of time, they always win out in the end.

“It’s greed and short-term memory loss,” Every told Bloomberg. “The fundamentals stink, and they always win out in the end. Equities are still over-priced everywhere.”

Chinese stocks resume trade at 12.30pm AEDT. On Friday the benchmark Shanghai Composite index closed at 3,590.03, a gain of near 2%.