Investors often worry about the high valuations of the stock market in the United States. Share values are far higher in China, well beyond what can be accepted as normal growth. The excessive exuberance in the Chinese markets will have dire consequences in both the short and long term. Signs of overvaluation are everywhere, with stocks up nearly 50% in 2015. The market is being increasingly driven by speculators, rather than on economic data. The amount of additional money and new investors pouring into the markets of China, has become completely unsustainable.
As the 2nd largest economy in the world, what happens to markets in China matters enormously. The main concern of the government for now, is the general slow down in the domestic economy. This takes priority over other issues. With reports from the manufacturing sector presenting a mixed situation, analysts are betting on even further stimulus from government authorities. Furthermore, state-backed Chinese newspapers continue to insist, that the fundamentals of the bull market in China remain sound.
The Shanghai Composite closed up for the day at 4.7% and the tech heavy Shenzhen Composite was up 5.1% on Monday, June 01. The CSI300 index which lists the largest companies in China, increased by 4.9%. It was the largest one day rise since December 2012.
This was after the dramatic losses that were incurred last week. On May 28th these two exchanges witnessed losses of 6.5% and 5.5% respectively. For the Shanghai market it ended a 7 day winning streak, with the 2nd worst trading session for 2015. For the Shenzhen, the trading results for the day saw the 3rd largest plunge in prices in 5 years. As can clearly be seen, volatility in the Chinese markets is increasing.
The Chinese manufacturing PMI (Purchasing Managers’ Index), which surveys the largest companies in the country witnessed a small increase. The statistic moved from 50.1 in April, to 50.2 in May as was expected. However, the final reading from a private survey which is formulated by HSBC/Markit which focuses instead on small and medium sized firms, saw a 3rd month of shrinkage. It did increase from 49.1% to 49.2% in the past month, but still remains below 50% the level that separates expansion from contraction. The survey also showed export orders contracting at the sharpest rate in nearly 2 years.
Yet, investors in China are following the typical pattern in a bull market. That is when there is a plunge in stocks, immediately after there is a new rush of investment to take advantage of the temporarily lower share prices. To many speculators the rout in the market last week was a good thing, because it reduced investor risks substantially, allowing for new buying opportunities.
ChiNext, a market for Chinese companies newly created, has increased in valuation 300%. An amazing amount of money is being dumped here, in a very short time. The total wealth invested is nearing 10 % of the GDP (Gross Domestic Product) of the country. Companies listed on this exchange are looking at valuations, 140 times earnings from last year. Stocks listed on the Shenzhen Composite now have an average price earnings ratio (P/E) of 64. Even more troubling is the P/E for smaller sized companies which are now averaging 80. Most global investors would view anything above a rate of 25, to be priced beyond what is prudent for consideration.
Companies that are listed both in Shanghai and Hong Kong are trading nearly 30% higher in Shanghai. Although this differentiation has existed for many years, it is now at a 4 year high. Now that Chinese money can more easily be invested in Hong Kong, it should be narrowing instead. Some firms have nearly double the valuation in the rest of China.
Millions of new brokerage accounts are being opened on a weekly basis. The problem with this situation is that many of these new customers are investing money that comprises the total savings of a individual family or is sourced from loans. Borrowing money to make an investment on the belief that the valuations of stocks will continue to increase, is creating a massive bubble in the market.
The short term results of the crash that will inevitably arrive, will be devastating for many single investors as well as for the many companies who have also entered into the frenzy. The margin financing where investors need only to fund part of the total risk in investment contributes to the problem. This practice has increased in China by 500% in the last year alone, reaching the equivalent of $325 billion USD (United States Dollar). When the market finally reverses, these customers will need to recharge their accounts with additional money. This will become increasingly difficult as investors become more reckless in their purchase of stocks, that are no where near to their true valuation.
International analysts have calculated that various forms of debt financed investment in the Chinese stock markets could be as high as 9% of market capitalization. At that level, it would be at least 5 times higher than what normally exists in the more developed economies in the West.
Although the total size of the markets in relation to the GDP of China is still only 40%, it is growing rapidly. The market capitalization as a percentage of GDP in the economically advanced parts of the world including Australia, Canada, Europe, Japan, South Korea, the United States and some additional parts of Asia and Latin America is closer to 100%.
When the crash in the Chinese markets finally arrives it will come differently to Hong Kong as compared to the mainland. Whereas in China proper there are controls that suspend trading when the market gains or falls more than 10%, in Hong Kong there are no such safeguards. The panic in the former colony will no doubt spread to the rest of China, where a decline will be managed over days or maybe weeks, if the situation gets out of hand.
The long term effects of the coming crisis in Chinese markets will have a dramatic effect not only within China, but across exchanges on a global scale. The last crash in China was in 2007. It took a number of years for Chinese share prices to recover. Many investors left the market altogether, as regulators took a more active role in controlling price and market movements.
The financial situation in China today is far more dire. The first consideration is that unlike 8 years ago, the economy of China is growing at the slower pace of around 7%, instead of more than 10%. Also the country has become far more indebted on an internal level. In 2008, the total debt of the country in relation to GDP was 150%. In 2015, this has swelled to more than 250%. China has become far too dependent on domestic borrowing during the last few years.
A crash in the equity markets would basically cut off funding for much of the corporate sector, given the wobbly system of banking in China. The financial sector is already weighed down by numerous bad loans made in the previously overheated real estate sector. This was both in housing and in the commercial segments.
Worse a crash in the markets will invite further government regulation of the exchanges, which will shut down much of the private funding of companies especially start-ups. Financial liberalization in China is likely to slow down once again. The relaxing of capital controls and rules regarding the interest rates banks can charge for loans as well as pay to depositors are the most recent examples of the growing openness.
Much of the present over speculation within the Chinese stock market, is a result of the lack of marketplace forces that would deter some of the worst excesses. To begin with, allowing Chinese investors greater access to oversea exchanges would relieve some of the upward pressure on share prices inside China. Another needed reform is allowing more shorting of stocks, which would put a greater downward pressure on stock valuations. The Chinese regulators are also very slow in listing new stocks, which if the process was accelerated it would allow investors more stocks to choose from.
At this point it is not a question of if the crash will arrive in the markets of China, but rather when? A major reversal elsewhere in Europe or the United States could well be the catalyst to bring a crisis in Chinese equities. The Chinese leadership has decided to focus on economic growth in the general economy. As a result, they are now less inclined to interfere in the stock market. Perhaps there is not a full understanding of what is at stake or maybe the authorities have already resigned themselves that there will be another major market correction, regardless of government actions.
A major crisis in the Chinese stock market could well reverberate far beyond the shores of the country. It might be the event that will finally end the bull market in the United States and short circuit the recoveries in the exchanges elsewhere. Europe and Japan are unlikely to escape the aftermath of a major meltdown in Chinese equities. The chain reaction of a market collapse in China could well dip the entire world into a financial panic, which will then soon lead to another global recession.