Equities world-wide are feeling the weight of another tough day for China’s Shanghai Composite Index, which slumped 6.7% today most since June 2008. Now, China’s equity market has dropped more than 20% from the latest highs, making this an official bear market.

The trouble started as the explosive growth of domestic lending has cooled significantly over the last few weeks. We had wondered, as recently as July in this blog (Leverage Bubble Reinflating, This Time in China), if the breakneck pace of bank lending was sustainable and if it was creating another leverage problem for the world economy. It is no surprise that the economy appeared to be booming as the state-run banks were dolling out loads of cash, but now that the lending has slowed, so too has the outlook for growth. New loan growth for August is reportedly going to be about half of what it was in July.

‘Bubble Territory’

The Shanghai Composite has slumped 23 percent to 2,667.75 since Aug. 4, more than the 20 percent drop that is the common definition of a bear market. China’s gauge is the worst performer this month among 89 benchmark indexes tracked by Bloomberg globally.

China’s economy isn’t “sustainable” and the Shanghai Composite “should be 2,000 or less,” former Morgan Stanley Asian economist Andy Xie said in a Bloomberg Television interview. He added that China’s market remains “in bubble territory.” — from Bloomberg.com

The bottom for the Chinese stock market was in late October of 2008, and from that point on indexes had just about doubled. The apparent strength in China’s economy was a major reason for the optimism that the U.S. economy had bottomed, as pundits like Jim Cramer talked about China leading the world economy out of recession. That thesis has held up thus far, and if that remains the case U.S. stocks could be headed for a correction. Of course, the two equity indexes don’t move in lockstep, but in general, Chinese stocks are a few months ahead of their American counterparts (a fair amount more volatile as well). The two economies are major trading partners and rely upon each other greatly, so to see them trade in similar fashion makes sense in our increasingly global economy.

The troubling trends in China should pressure energy and basic materials stocks most directly, but it may also have a broader impact on the psyche of U.S. investors. Right now, investors sentiment is firmly in bullish territory, but at Ockham, we have been expecting a correction for the last few weeks. There are no more major earnings reports until October to buoy the market, so macroeconomics should be the focus for investors. The developments in the Chinese stock market suggests that there is a risk of the China leading the market to the downside as well.

China Enters A Bear Market…Preview for U.S. Stocks?