China's stock markets .... just one big bubble ?

Friday 29th May 2015

 China's stock markets .... just one big bubble ?

"A goring concern" , The Economist, p.67

  and

"China stocks in dramatic plunge", The Financial Times , p.15

It was quite a day in China yesterday, what with the Shanghai stock market down 6.5% and the tech-heavy Shenzen Composite Index down 5.5%. Over a 12-month period, these markets have more than doubled and nearly tripled respectively, and one could have been forgiven for wondering if yesterday's action signified the start of a major reversal. As it happens, the markets are holding steady today but that won't calm the nerves of those that argue that Chinese stocks are looking more and more like a bubble waiting to burst. Or are we just due a controlled correction to an overbought market ?

Well, from this angle it certainly looks like a bubble. If you accept that many in more mature markets would baulk at buying a share with a prices-to-earnings ratio (PE) of more than say 25, consider that the median Shanghai share has a PE of 75. What are we to think of the ChiNext, the exchange for start-ups that is considered China's equivalent of the NASDAQ ? It is currently valued at 140 times last year's earnings. Nearly 85% of listed companies have higher valuations than they did at the height of the last China stock bubble in 2007. As China's growing middle class rush to climb on board the gravy train, 8 million new brokerage accounts have been opened in the first quarter of 2015 alone. All this at a time when China's growth is slowing, remember.

Okay..... enough, enough. But should it prove to be a bubble that bursts how bad will it be ? Short term, bloody but manageable, according to the Economist. For sure, investors would get badly mauled given the leveraged nature of their investments (margin financing etc) that wasn't even permitted at the time of the last crash. The rush to sell in order to repay loans will only exaggerate losses, with inevitable knock-on effects for the economy.  But retail sales data has been sluggish despite the market rally , and therefore may be less affected by any fall that would normally be the case. Besides, we should remember that free-float capitalisation of the stock market is only about 40% of GDP , compared to over 100% in most rich nations. China should be able to cope.

The longer term effects might present deeper concerns. If the aftermath of the 2007 bubble is anything to go by, investors are likely to run shy of the market for the near future. This means corporates will find it tough to issue equity, and will instead be once again forced to seek funding from banks. This is the main reason why China's debt levels have risen to an eye-watering 250% of GDP. China needs to see these levels sharply lower, and a price crash will only make them worse.