That the market is in a bubble phase is obvious. Less clear is how much further stocks have to run before the inevitable burst. Remember Alan Greenspan's 1996 warning of 'irrational exuberance' - four years before the party ended?
"Reports of over 300,000 new trading accounts opening every day are testament to the 'fear of missing out' mentality."
The Chinese stock market is largely represented by two exchanges, the Shanghai and Shenzhen stock exchanges. The CSI 300 Index is representative of the top 300 companies from both of these exchanges. In 2006, the CSI 300 rose 116 percent and so far this year the index has soared by nearly 90 percent!
Apart from this nearly vertical price appreciation (see chart), one of the classic symptoms of a bubble is mass participation, and the Chinese have been jumping into the market en masse. Reports of over 300,000 new trading accounts opening every day are testament to the 'fear of missing out' mentality.
So while we accept that the Chinese stock market is a bubble waiting to burst, the important point is to focus on why and what will be the fallout after the inevitable crash?
We are not experts on China, but it is reasonably safe to say that the genesis of most bubbles is in excess liquidity. To understand where all this 'liquidity' comes from, we'll briefly look at China's emergence as an economic power.
China's economic rise has been export led. Over the years, a massive cost advantage with the rest of the world has resulted in huge inflows of foreign direct investment (FDI) as (mostly) western manufacturers build factories in China to lower their cost base. This is why most low cost, low value added products are 'made in China'.
China's cost advantage in international trade has resulted in a huge trade surplus. According to Bloomberg, China's trade surplus swelled 63 percent in April from a year earlier to US$16.9 billion (see chart below). The trade surplus for the first four months of 2007 was US$63.3 billion, an increase of 88 percent from a year earlier.
Those are some pretty big growth numbers. The current account surplus inflated 55 percent in 2006 from a year earlier to a record US$250 billion. The US is responsible for most of this surplus. In 2006, they ran a deficit of nearly US$233 billion with China and are on track to topple the record again this year.
These growing surpluses explain why China now has foreign exchange (FX) reserves of over US$1.2 trillion dollars. And this is where we get back to excess liquidity and the stock market. When the reserves of a central bank grow, this expands the country's domestic monetary base. So, expanding foreign reserves in China, brought about by a ballooning trade surplus with (predominantly) the US, serves to increase the domestic money supply.
With all these export dollars floating around the market, the notoriously thrifty Chinese would normally be happy to keep the funds in the bank. But as we are witnessing around the world, inflation is on the rise, despite what the official numbers might suggest.
In China, one can earn a paltry 3 percent on deposits. With inflation also around 3 percent, more and more savers are waking up to the fact that real interest rates are around zero. In such an environment, borrowing and investing (or rather speculating) in growth assets is the way to go.
And the results are obvious as Chinese shares are soaring. While there is some element of catch-up taking place - the Chinese market underperformed for years prior to the recent run up - current valuations are looking scary. The CSI 300 Index trades on a current price-to-earnings multiple of around 44 times! The authorities recognise there is a problem but so far, efforts to curb investors' enthusiasm have had little effect.
Firstly, the People's Bank of China (PBoC) have raised the commercial bank's reserve requirements a number of times, most recently to 11 percent on May 15, with another rise of 50 basis points (to 11.5 percent) to occur on June 5.
Increasing bank reserves as a percentage of deposits is a way to soak excess liquidity from the market. However, there is speculation that these measures will have little effect on liquidity as the bank reserves held at the PBoC are already higher than the 11 percent requirement.
In other measures, the PBoC is cautiously trying to let air out of the bubble by widening the daily trading band between the Yuan and the dollar. The central bank manages the Yuan/US dollar relationship and last week changes were made to allow greater flexibility on this front.
The real problem here is that China is still a managed economy. Both China and the US are trying to manage the rise of China for their political betterment. The result has been excess liquidity looking for a home, and the stock market is always an accommodating host.
So it seems that Chinese speculators may continue to enjoy strong gains for another week, or maybe even a few more months. Bubbles by their very nature are irrational, so there is no way of knowing when the party will end. But what does this mean for investors?
No doubt, any news of a bursting Chinese stock market will have global implications. As we saw in February, falls in China led to a very sharp global sell-off. We would not be surprised to see this happen again. News of market declines in China would make very good headlines and provide the opportunity for much scaremongering. However, we don't believe a shakeout in China will signal the beginning of a bear market.
Why?
The Chinese stock market is not necessarily a barometer of world economic growth. It is too small and too undeveloped to be truly representative of the global economy or even the domestic economy in China.
Regardless of what happens in the Chinese equity markets, its economy will continue to grow. Financial markets and economies don't always walk hand in hand. We're seeing this now in the US. With that economy headed for recession, the market there is hitting record highs. Accommodative monetary policy can work wonders for markets!
The best way to avoid any potential fallout is to stick with companies that display solid fundamental valuations, strong balance sheets and sound business models. While some calculated speculative positions are ok, these should represent a small proportion of one's total portfolio.
In summary, I believe the Chinese market is in the midst of a speculative bubble, which may still have some way to go. When the correction finally arrives, global markets will undoubtedly be impacted. However, we are unlikely to see any long lasting effects on global markets from a Chinese stock meltdown.
We are still of the opinion that the biggest risk to the global economy is the fragile US economy. The housing sector looks to have stabilised, however the effect on consumer spending (the world's consumer of last resort) is yet to be determined.
Greg Smith is the Managing Director of Fat Prophets. If you would like a further sample of their expert research please click here.
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