China's Market: May End Up Being the Biggest Equity Bubble in a Major Country

I hate to be beating a dead horse but it's worth revisiting the Chinese equity bubble once again. For anyone that ever wanted to see what a bubble is, they simply need to follow China's stock market.

Valuations in the Chinese market may have passed the NASDAQ and Nikkei peaks. As Angela Barnes of The Globe and Mail reports:

Last week, UBS Securities noted that the Shanghai composite's P/E of 68 times on trailing earnings was just 12 per cent shy of the average for the last three "bubble highs" - the 68.3 times for the Nasdaq composite, the 73.4 times for the Nikkei and the 86.9 times for the Nasdaq 100. (The Shanghai composite has risen since then, which has pushed its year-to-date advance to 121 per cent.)

I don't know what the latest numbers are but I would hazard a guess that the P/E ratio has overtaken the Nikkei. I am not sure one can trust some of the earnings from the Chinese corporations (their accounting is weak) so the P/E value may be understated. However, it is worth noting that the Nikkei and the NASDAQ also likely understated their P/Es during the peak (Nikkei because a lot of Japanese companies got into real estate speculation, with major banks carrying questionable loans; NASDAQ because a lot of tech companies had bogus earnings due to shoddy accounting).

Looking at the price-to-book value ratios, the picture is even more interesting. Shanghai's price-to-book of 7.5 times is already well above the Nikkei's high of 4.3 times. But Sakthi Siva, a UBS strategist, said in a recent report that this may be justified as Shanghai's return on equity has almost doubled from 6 per cent in 2004 to 11 per cent currently. That contrasts with the 6 to 6.5 per cent for Japan in the late 1980s.

The book value looks really expensive for the Chinese market and I don't really buy the analyst's view above. Justifying high P/BV based on high ROE is kind of questionable in my eyes. Taking on excessive debt can increase ROE, while also increasing P/BV, but any downturn in the economy and the debt, which is a double-edged sword, will swing towards you and cause financial pain. There is nothing to indicate that Chinese companies are overly leveraged but there isn't anything to say they are underleveraged either. For instance, many articles have been written about how government-owned banks loan indiscriminately to favoured clients.

Some analysts think the Chinese markets can run up for several more years:

So what might end the Chinese markets' run? Mr. Zhao thinks it could be overinvestment. He notes that the Chinese authorities are trying to encourage growth and job creation by holding down the currency and interest rates.

"This policy inevitably causes overflows of liquidity as the current account surplus balloons, capital inflows soar and household incomes rise," he said.

That in turn will likely inflate asset prices even further, driving down expected return on capital and in time, market valuations can no longer be supported by the capital returns and prices deflate. "That, however, could be one or two years away," he said.

In the end, the Chinese market will likely be the biggest bubble in any major country in the last 30 or 40 years. However, in dollar terms, the bubble isn't very large because the Chinese stock market valuation is small. I suspect the inevitable collapse will cause more political problems than economic.