Shanghai Daily Article by Owen Caterer, Austen Morris Associates Senior Associates
– September 2007
What does a bubble look like?
(Commentary on the Shanghai Stock Market and what is happening with investments)
There has been a lot of speculation in China and around the world as to whether the high rates of growth in the Chinese market are a bubble or not. This is an important question that affects many, probably millions, of investors here in Shanghai. The market has been growing at seemingly continuous high rates of growth such as 130% in 2006 and around 85% so far this year.
But high growth by itself doesn’t necessarily mean it is a bubble. In fact since 2003 China is not even the best performing market in the world. Brazil, Russia and India have all outperformed China over this time-period and with the exception of India, these markets often don’t have the words “bubble” used in describing their growth.
But what do bubble’s look like? They don’t come with captions or big bold neon lettering. In fact all bubbles are debatable. The need to be, because to become a bubble in the first place, convincing arguments need to exist for the big growth in stock. So what are the arguments exist in China.
One argument is “it will rise until the Olympics”, which has been said to me by investing Chinese more than 400 times this year without a blush is probably the easiest. This reason I take to mean is that the government, all seeing, all powerful will ensure they make gains until after the Olympics to ensure social order.
I don’t buy it for a couple of reasons. Firstly the government although able to change policies on a whim is still not able to control the markets. Don’t believe me? Then what about the huge stock market flat spot in China from 2000-mid 2005? Do you think the government wanted a rising market during that period to try and fix some of the problems of bankrupt stock brokers? Of course they did. But it didn’t happen, because you can’t yet legislate for good sentiment. Legislation can easily be drafted kill good sentiment if you are willing to be brutal enough, but that is a different matter. Policies to influence sentiment for the better are far more difficult to draft.
At the moment, the government’s policy of choice to give the market a boost when it looks uncertain is its ability to approve funds quickly, thus adding more “money” or investors into the mix. The real beauty is that the sentiment change is stronger than the effect of adding the new money. This works fine when the pressure on the new money plumbing system is strong. But what happens if the government turns the tap on allowing more money in, but overseas funds decide not activate their investments because of poor performance by market or if there are no overseas funds left seeking approval to invest?
Which leads me to the most common reason cited for continuing to invest in the Chinese market. The huge wall of money from average investors. As an argument goes its not a bad argument either. It is true that people are lining up to put money in the market, just walk into any bank to see the evidence. It is also that there is still a huge amount of money still held in bank accounts. Survey’s have shown that still 45% of urban residents keep their primary assets on bank deposit. This might be hard to believe at times, but in my role in adviser individual investors, I think the figure is broadly true. A surprising number of even very wealthy Chinese individuals keep completely out of the Chinese stock market preferring the safety of bank accounts.
So the arguments of market boosters basically run that, the party is going to get bigger because of that big group of people outside who haven’t yet joined the party. But what if the non-party goers outside are committed non-drinking Mormons (or other non-drinking religion of choice)? Many of the people outside won’t join the party, no matter how great it looks.
But there is still a lot of very willing money to join the market. True, at the moment. Or another way of stretching my analogy would be someone saying, “This party is great!! Its huge, you should buy a brewery.” Market sentiment whilst strong now, can turn at a moments notice. It’s not the basis of a long, medium or even short-ish investment as a turn in market sentiment can make even a market expert look like a fool.
But what about profits? Aren’t they soaring? Yes apparently they are. According to press reports average profit growth of 71% the first six months of this year. Very strong results, there is no question. Where is this money coming from? Well according to analyst Edmund Huang, “Profits from core operations at 900 listed Chinese companies increased 35% during the first six months, while non-operational income rose to 31% compared to 13% for all of 2006.” In short-hand, this means about half of current profit increase comes from companies investing in other companies, on the stock exchange, so is a once off. This “profit” will disappear as soon as the market stops rising, which doesn’t even mention the negative impact on profit and financial statements if the market happened to fall putting share purchased for speculation underwater. This has real potential to compound any market losses. To their credit, the Chinese government recognizes the dangers of this but the horse has already bolted, so to speak. There is plenty of catching up to do.
Further stretching this it doesn’t include companies whose core operations is investment whose profit should have boomed alongside the stock-market. Taking out their influence shows that probably recurring profit growth in the high 20s doesn’t justify a market that is up over 80% this year.
But aren’t we buying at a cheap price? Isn’t the long term opportunity in China just incredible? Again like all of the best misleading statements, there is a grain of truth in this. Of course the long-term opportunity in China is mouth-wateringly huge. Business empires will be built in the next 10-20 years, again there is no question. It’s a huge developing market where change is happening overnight often in unpredictable ways.
This unpredictable change however has another name. It’s called risk. There was a time when emerging markets (basically not America or Europe), were priced at a discount since they had a higher risk. Higher risk of sudden changes, of regulations changed that suddenly make a stable cash cow of a business either marginally profitably or completely un-profitable, of normal emerging market changes where one company substantially outmaneuvers another. To overcome this risk investors would usually ensure that the pe ratio (the ratio of market price to the earnings of the company) were usually around 10 to 12, which is below the 17 that is the rough average for developed countries.
Contrast this with a market average in China now in excess of 50 for historical earning and you can see that valuations for the market have risen very high. As “The Economist” helpfully pointed out recently, it isn’t the highest price a market has ever existed. The Nasdaq in 2000 and the Nikkei in 1989 both reached levels of around 100 times earnings. This means two things. The market run in China could run further to even crazier levels before it turns south.
It also isn’t a sign of comfort that the Shanghai market is being mentioned in the same breath as two of the biggest bubbles in finance history. The Shanghai market has already gone past the level reached by the Dow Jones in 2000 and the Great Crash of 1929 levels of market wide PE ratios of the high 40s. These “lower levels” didn’t stop those markets falling 45% and 90% respectively. So if the market is highly valued, and is being driven higher by investor enthusiasm, and supercharged profits made by speculating companies, why do investors continue to support the market? Two reasons.
Until very recently mainland Chinese had a very limited (if almost no) ability to invest outside their home market. The government has recognized this and has started opening the market, so this reason is declining already.
The second reason is fear of being left out. But those same investors who fear missing out, usually don’t, particularly when a market fall comes around.
Shanghai Daily Article by Owen Caterer, Austen Morris Associates Senior AssociatesShanghai Daily Article by Owen Caterer, Austen Morris Associates Senior Associates https://austenmorris.com/wp-content/uploads/2014/08/DSC_3983-2.jpg 1200 798 AMA Team https://secure.gravatar.com/avatar/4ad9c580ca7195a1d4f6c40c38a18a15?s=96&d=mm&r=g
Shanghai Daily Article by Owen Caterer, Austen Morris Associates Senior Associates