If economic forecasts only exist to make astrologers seem respectable, the stock market forecasts only exist to make economic predictions seem respectable. As Chinese stock markets have spent the past year or so on a rampage that would make any Party chiefs child proud, I have done my absolute best to avoid writing about it. I only decided to write about it, with a few follow up posts, because I think there are numerous poor stories and interpretations about what is happening. My focus here will be on providing data and detail that I don’t think is being recognized.
The first question is whether or not there is a bubble in the Chinese stock market. Most people, and very understandably, argue there is clearly a bubble. While I generally agree with this view point, the reality is much more nuanced than that.
One of the most enduring lessons I have ever learned about China is from the Yasheng Huang book Capitalism with Chinese Characteristics that probably more than anywhere else, details matter if you want to understand what is happening. In our case, people who argue there is a bubble point to astronomical PE ratios while those who have bravely argued there isn’t a bubble point to while somewhat high much more reasonable PE ratios.
Here is the misunderstanding: the Chinese stock market is bifurcated. In geek speak, we would say that there is a bimodal distribution with one part of the market doing one thing and the other part of the market doing something completely different. Since 2010, the average Shanghai PE has been 15.4 while the Shenzhen board has clocked a significantly higher 30.7. More recently, while Shenzhen has been on a tear with the average PE topping 60, the Shanghai market only in May topped 20. In fact, it wasn’t even until March that the Shanghai board topped 18.
While I believe the 20 PE is overvalued for other reasons, I think you would have a difficult time making a solid argument that the Shanghai market is radically over valued in a bubble driven mania. In fact, if you believe that official growth numbers, even with slowing growth, let’s assume 7% GDP growth, a PE of 20 probably is not entirely unreasonable speaking in generalities for major red chips. Conversely since 2010, the Shenzhen board has averaged a PE of 31 and broke that barrier in November last year. Even as late as February it was trading at a PE of 39. In the past few months however, this number has exploded and recently hit 61 with a median PE much higher.
When you look beneath the headlines at individual stocks, you see very similar patterns of firms and how the market is pricing them. In Shanghai, such major red chips as Agricultural Bank, Bank of China, and ICBC have PE’s of 7-8. The bulk of Chinese industry from banks, securities, car companies, steel, real estate, power, and airports all of which are very large and state favorites, all have very reasonable though in my estimation somewhat high valuation. These valuations are even more reasonable if you believe the expected path of growth and earnings. The firms with astronomical PE ratios, regardless of whether they are listed in Shanghai or Shenzhen, tilt much more heavily to different industries that I would strongly suspect, though I don’t specifically have data on this topic, to be private or near private firms. Pharmaceuticals, hi-tech, new energy, and of course my favorite clothing firm Metersbonwe.
Though I have no specific data on this, given the space that many of the firms occupy in Chinese industry with low valuations, I would strongly suspect that the amount of GDP and corporate profits linked to firms with lower PE is a grossly disproportionate share relative to firms with above median PE.
All of this analysis matters for a couple of reasons. First, the headline grabbing numbers of astronomical PE’s are probably distorting the picture a little of what is really happening. Second, the headline number run ups are not from firms who are responsible for most of Chinese GDP. Third, any fall in the stock market in the absence of related economic events, will probably have a more muted impact on the major firms and broader economic activity. Fourth, given all the additional risk factors, not just basic PE analysis, investors are probably assuming a lot more risk than they believe investing in these types of firms with high valuations. Fifth, there is probably more muted financial and economic risk from a stock market decline, but significant political risk if investors feel cheated.
I believe major Chinese firms are currently overvalued but more due to earnings quality and future economic risks. If you believe future growth prospects and earnings quality, there is a strong case to make that the major firms are not overvalued or not enormously overvalued. There seems to be a much stronger case that smaller and private firms are significantly overvalued though I believe any decline would have a more muted impact on the Chinese economy in the absence of other events.
Here is some PE data on markets and individual firms and I will be presenting some other data refuting other misconceptions about high share prices later this week.