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July 1, 2015

Don't Count China Out Just Yet

With the Shanghai Composite index up 130% in the past year and China’s economy slowing, most commentators are calling for a bursting of what they see as the Chinese stock market bubble—the “biggest since the dot-com boom” as the Washington Post called it.

But that may be a myopic view. Looked at over the long-term, the market run-up looks largely justified, and considering the strong cash flow, there’s little to stop it from continuing. While we shouldn’t devote too much of our portfolio to such a volatile market, our holding of the Guggenheim China Small-cap ETF (NYSE: HAO) not only allows us to ride this bull market, but may also benefit from China’s capital markets opening.

A recent Washington Post story on the Shanghai market had some fun examples of excess. In one case, a Chinese real estate company had changed its name to “P2P Financial Services” without bothering to develop a peer-to-peer lending business, but semantic difference causes its stock to jump 10%. The Post story also points out that Chinese stock markets have risen enough in the last year to create $6.5 trillion of value, about 70% of China’s 2013 GDP and 40% of the New York Stock Exchange’s value.

But long-term, the Shanghai market doesn’t look too overvalued. The market is 22% below its all-time high, reached in 2007. It’s 6.5 times its level of 20 years ago, at the beginning of July 1995, which sounds like a lot until you remember that Chinese GDP in 2014 was 10.2 times its level in 1995 in renminbi terms, or 14.5 times its 1995 level in dollar terms. So since 1995 the Chinese stock market has risen 37% to 55% less than nominal GDP. For comparison, the U.S. stock market, which is standing at 4.5 times its early 1995 level, has risen more than twice as much as nominal GDP since 1995.

You also have to remember that the Chinese saving rate is much higher than that of Americans (and are of course four times as many Chinese as Americans). Chinese households save more than 20% of GDP, about $2 trillion in 2015. By comparison U.S. household savings, at 5.5% of GDP, are less than $1 trillion. As Chinese savers have re-oriented from housing to the stock market, it’s not surprising they’ve caused a boom.

Then there’s the question of Shanghai versus Hong Kong prices for the same shares. HAO invests primarily in Hong Kong listed shares, because it follows the Alpha Shares China Small Cap index, which only uses shares that can be bought from outside China. However, Hong Kong prices for Chinese shares are far below Shanghai prices, and the two markets are slowly converging as the Chinese government’s restrictions on domestic investors are removed, step by step.

So even though the average P/E ratio in the Shanghai market is 22.7 times, higher than the Standard and Poor’s 500’s 20.6 times, the average P/E ratio in HAO is much lower, at only about 13 times earnings.

Yes, the Shanghai market may be in a bubble. But so was the U.S. market from 1995 to 2000, and if you’d sold out in late 1996, when Fed chairman Alan Greenspan decried the market’s “irrational exuberance” you’d have felt pretty silly – the Dow Jones index was at about 6,400 on that day with another 70% to go until its 2000 peak. Since the Shanghai market only began levitating a year ago, is still short of its 2007 high, and is not excessively valued on a long-term view, I’d say there is considerably further for it to go. And with HAO’s holdings modestly valued, and Hong Kong/Shanghai price arbitrage favoring it, I’d say HAO’s risk-reward outlook at least in the short to medium term, looks distinctly biased towards reward.

But still, don’t bet the farm!

Courtesy Martin Hutchinson for Investing Daily (More from Investing Daily Here

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters. © EconMatters All Rights Reserved | Facebook | Twitter | Free Email | Kindle

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