Cityscape of Shanghai © Andy Brandl, Flickr, Getty Images

While U.S. stock indexes have hit all-time high after all-time high, China's markets have been in retreat. After peaking Jan. 30, Hong Kong's Hang Seng index has fallen by 5.4% as of March 15. The Shanghai Stock Exchange Composite index peaked on Feb. 6. It was down 6.4% from that peak to the close on March 15. The Shanghai index is still up considerably -- 16.2% -- from its Dec. 3, 2012, low through the March close, but that's a retreat from the 24.2% gain the market had recorded from the December low through the February high.

To understand the drop in Chinese stocks even as U.S. 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 December and January are either in jeopardy or else were never there to begin with. And that has left China's stock markets without the support of the two groups that usually lead them 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.

The view from inside

The first group is made up of 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 these investors bought Chinese stocks, especially those -- such as real estate developers and securities companies -- most likely to benefit from this change in government policy.

The second group consists of overseas and institutional investors. This is the key group for determining prices in Hong Kong and Shanghai in the medium term, and it has been disappointed by government economic policy. These investors had counted on measures to increase economic growth but, equally important, they had been looking for signs of new economic policies that had the potential to break China out of its traditional reliance on export-driven growth, which 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.

Jim Jubak

Jim Jubak

Let me take a look at 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 its financial markets. As of Nov. 20 of last year, 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 10-fold.

An open spigot

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 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 by 60.6% in Shanghai from Nov. 29, 2012, through Feb. 1, 2013. Shares of China Vanke, one of China's biggest real estate developers, moved up 63.1% from Nov. 12 to Jan. 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 was 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.

At the same time, overseas investors were starting to wonder if China's new leadership was up to the task of breaking China out of its economic policy rut. The consensus among economists outside China is that the country has moved beyond its old policy of export-driven growth. The fuel for that huge leap forward -- a massive army of cheap migrant labor created when workers moved from rural areas to the cities -- was starting to run short. Wages were rising in the traditional coastal areas where exporting companies were located. Companies cut labor costs by moving production to inland areas that had missed out on the earlier phases of the boom. But this was clearly a stopgap measure. China needed to move up the value chain as cheaper labor in countries such as Vietnam and Bangladesh took Chinese jobs. And China needed to rebalance its economy so that more growth came from Chinese companies producing goods and services for Chinese customers.

What international investors want to see

Initially, the trends here were encouraging to overseas investors. Indeed, at the end of 2012, it looked like they might get the best of both worlds. Chinese export growth soared to a seven-month high in December, hitting a 14.1% annual rate after growth of just 2.9% in November. And the new leaders of China looked to be building on domestically oriented policies in the new Five-Year Plan that had promised double-digit annual increases in the minimum wage, increased government contributions to pension plans and higher health care spending outside China's major cities.

Shares of domestically oriented growth stocks, which had lagged behind real estate and financial stocks, began to move up, too --although more slowly in overseas-influenced Hong Kong than real estate and financial stocks were advancing in a Shanghai market dominated by Chinese traders and investors. Hengan International (1044.HK), a maker of baby diapers, advanced 21.2% from Dec. 14 through March 8. Shares of insurance company Ping An (PNGAY), which trades as 2318.HK in Hong Kong, moved up 22.9% from Dec. 4 through Feb. 1.

But then, just as in the Shanghai market but for different reasons, optimism began to fade. The government fell back on the policies of the past that had worked so well to stimulate the economy in the aftermath of the global financial crisis. Announcement followed announcement of new (or at least it seemed to be new) spending on rail lines, airports and subways. Infrastructure spending, it seemed, was once more the policy of the day.

But what of the new initiatives to rebalance the economy? The rhetoric was there, certainly, as, for example, new president Xi Jinping told delegates at the closing session of the National People's Congress on Saturday that economic benefits must be shared more equally in China. And in his closing address at the congress, new premier Li Keqiang promised to crack down on corruption and clean up pollution. Li's speech came while China was still in the midst of an effort to pull dead pigs -- 12,000 so far -- from the waters of the Huangpu River, which supplies drinking water for Shanghai.

But overseas, investors and economists are increasingly wondering if China can actually implement policies that will rebalance the economy, reduce pollution, tame corruption and remove the heavy hand of the state from crucial industries.

Typical of these worries is the call from Zhang Zhiwei, the chief China economist for Japan's Nomura Holdings, for a second-half slowdown in China's economic growth. The days when China could turn in 8% or 9% growth without target-busting inflation are over, he told Bloomberg last week. The Chinese economy has matured, he notes, and the speed limit is now more like 7%. Anything above that -- like the 7.9% rate of growth of the gross domestic product recorded in the fourth quarter of 2012 -- will start inflation on an upward track again.

Add to these doubts worries over whether that the central government has the means -- whatever the will -- to contain official corruption or to control pollution from companies with government connections -- and you've got doubts among overseas investors that are serious enough to put a check on the rally that began Dec. 4.

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