Is the Chinese stock market a bubble?
Reader's Question: What causes asset price bubbles? Have Chinese stocks reached bubble levels? Can you share your perspective on the potential for a Chinese stock market crash?
The Logic of Asset Bubbles
Given the commonly accepted conclusion (with 20/20 hindsight, of course!) that the Japanese stock and real estate markets around 1990, dot-com stocks in the year 2000, and current U.S. housing market (now beginning to deflate) are all notable examples of asset price bubbles, and that at least some people are smart enough to learn from the past, it would seem logically to follow that either:
1) All market players ought to be wiser now and should behave more rationally (i.e., "arbitraging away" bubbles by selling overly rich assets and buying whatever is cheaper), so that future bubbles caused by psychological polarization and excessive asset buying do not have a chance to form, or
2) Even if not all market players have learned their lesson, at least the more alert and perceptive investors among us ought to have learned from prior bubbles and should now know when to buy and sell to profit from any bubble currently underway.
If #1 above is true, then the Chinese stock market is not a bubble, since investors are collectively "smarter" now and behave as a group to "nip any bubble in the bud," so that it never forms. Alternatively, if #2 above is true, then there's an opportunity for at least those who have learned from the past (that's both you and I, right?) to become a little richer. . . .
Before getting too carried away with theory, however, let's see if we can learn anything by looking at some actual Chinese market data.
Shanghai Premium
From the vantage point of a U.S.-based investor, the most readily accessible Chinese stocks are those that are listed on U.S. stock exchanges. Some of these companies are listed only in the U.S., like China's dominant search provider Baidu (Nasdaq: BIDU), even though their businesses are inherently Chinese. Others are listed in both the U.S. and Hong Kong, like oil giant PetroChina (NYSE: PTR), whose domestic IPO in Shanghai has been approved but not yet launched (incidentally, PetroChina is also a stock which Warren Buffett has been (for better or worse?) incrementally divesting of late). Still a smaller group of companies is triple-listed: in the U.S. as ADRs (or ADSs), in Hong Kong and also in Shanghai.
Because current Chinese government policy severely restricts both investment by domestic Chinese in markets outside of mainland China and investment by non-Chinese investors in the domestic Chinese market, the Shanghai stock market is effectively isolated from the Hong Kong and U.S. markets. Consequently, domestic pricing in Shanghai is driven by a different set of supply-demand curves, while U.S. and Hong Kong prices for a particular stock move more or less in tandem, after translation through the foreign exchange rate and ratio of shares per ADS.
Historically, the Shanghai market has traded at a premium to Hong Kong and the U.S., indicating a higher level of overall demand by domestic Chinese investors for the same stocks. This "Shanghai premium" is most evident if we focus on the handful of triple-listed stocks:
Yanzhou Coal Mining (NYSE: YZC, $101.70; Hong Kong: 1171.hk, HKD 15.32; Shanghai: 600188.ss, CNY 22.92), 50 shares per ADS
China Petroleum & Chemical Corp., "Sinopec" (NYSE: SNP, $126.81; Hong Kong: 0386.hk, HKD 9.77; Shanghai: 600028.ss, CNY 18.94), 100 shares per ADS
Huaneng Power International (NYSE: HNP, $52.48; Hong Kong: 0902.hk, HKD 9.90; Shanghai: 600011.ss, CNY 17.42), 40 shares per ADS
Guangshen Railway (NYSE: GSH, $42.30; Hong Kong: 0525.hk, HKD 6.40; Shanghai: 601333.ss, CNY 9.93), 50 shares per ADS
China Life Insurance (NYSE: LFC, $95.97; Hong Kong: 2628.hk, HKD 48.35; Shanghai: 601628.ss, CNY 62.41), 15 shares per ADS
Aluminum Corp. of China, "Chalco" (NYSE: ACH, $76.85; Hong Kong: 2600.hk, HKD 23.10; Shanghai: 601600.ss, CNY 47.75), 25 shares per ADS
(Prices shown above are closing prices on October 5, 2007 for New York and Hong Kong, and September 28, 2007 for Shanghai due to holidays last week. Exchange rates: 7.76 HKD/USD, 7.51 CNY/USD.)
The graph below shows in percentage terms how the Shanghai premium for these stocks has varied over time, beginning with Yangzhou Coal Mining in 1999 and joined by the other companies as they later became triple-listed, the most recent being Chalco with its Shanghai listing in the middle of this year. Notice how the Shanghai premium contracted from the 200%-400% range in 1999-2000 to zero, on this scale, at the end of 2005. Then, beginning in 2006, the premium resurfaced, gradually building in conjunction with the outperformance of the Shanghai market, to the 50%-100% range where it sits today.
Taking a broad-brushed approach to highlight general trends, we can see from the graph below that over the past eight years the New York-listed, per-ADS share values of these companies have consistently marched higher, with some price acceleration over the past year or two. There is, of course, plenty of variation among the particular stocks, but the basic trend is as stated--up.
Examination of the Shanghai-listed per-share values of the stocks, on the other hand, presents a different picture, as shown below. From 1999 through 2005, these stocks in the Shanghai market traded sideways, followed by a quick ascent beginning in 2006. The flatness of Shanghai prices while New York and Hong Kong prices steadily rose during 1999 to 2005 corresponds to the falloff in the Shanghai premium during this time period. The relative outperformance of the Shanghai market from 2006 coincides with the reappearance of the premium over the past two years.
Which Market Is Right?
Now, with two strikingly different indications of value--the higher one in Shanghai and the lesser one in Hong Kong and the U.S.--being the source of the Shanghai premium, it would seem that both markets can't be right. Either the Chinese on the mainland are, relatively speaking, paying too much for these stocks, or investors outside of China are not yet paying enough. A common explanation of the situation, based on pent-up domestic Chinese demand chasing too little domestic supply of shares, attributes the valuation "error" to the restricted Chinese investor, suggesting that Shanghai pricing is more overvalued than Hong Kong and U.S. pricing is undervalued.
Over the years ahead, as the Chinese government fully opens the gates and allows unrestricted two-way capital flow in and out of China's stock market, the Shanghai premium must vanish, since it will then presumably be possible for traders to arbitrage small pricing differences between markets. In the meantime, there is an opportunity, albeit risky, for investors outside of China to go long Hong Kong- and New York-listed shares, based on the expectation of continued upward price pressure through increasing demand from mainland Chinese investors for cheaper offshore shares as Chinese financial policy liberalizes.
How to Play the Bubble, If There Is One
To resume our bubble discussion: If the Chinese market is not a bubble (scenario #1 above) and the future GDP and earnings growth implied by current price levels actually does materialize, then anyone long needn't worry so much, since the market is behaving rationally and Chinese stock prices should not collapse, despite their recent run-up. On the other hand, if the Chinese market is a bubble (scenario #2), then, although it is extremely difficult to know when the bubble will burst, investors in Hong Kong- and New York-listed shares can find some degree of comfort in the upward price pressure from the Shanghai premium. In this regard, the New York-listed ADS shares of Chalco and Sinopec, with Shanghai premiums currently around 100%, offer a larger "cushion of safety" than the other four companies, all of which are trading at significantly smaller, though still very sizeable, Shanghai premiums.
(Disclosure: Among the stocks mentioned in this article, the author has been and remains long at the time of this writing shares in the following companies: Baidu, Chalco and Sinopec.)
The Logic of Asset Bubbles
Given the commonly accepted conclusion (with 20/20 hindsight, of course!) that the Japanese stock and real estate markets around 1990, dot-com stocks in the year 2000, and current U.S. housing market (now beginning to deflate) are all notable examples of asset price bubbles, and that at least some people are smart enough to learn from the past, it would seem logically to follow that either:
1) All market players ought to be wiser now and should behave more rationally (i.e., "arbitraging away" bubbles by selling overly rich assets and buying whatever is cheaper), so that future bubbles caused by psychological polarization and excessive asset buying do not have a chance to form, or
2) Even if not all market players have learned their lesson, at least the more alert and perceptive investors among us ought to have learned from prior bubbles and should now know when to buy and sell to profit from any bubble currently underway.
If #1 above is true, then the Chinese stock market is not a bubble, since investors are collectively "smarter" now and behave as a group to "nip any bubble in the bud," so that it never forms. Alternatively, if #2 above is true, then there's an opportunity for at least those who have learned from the past (that's both you and I, right?) to become a little richer. . . .
Before getting too carried away with theory, however, let's see if we can learn anything by looking at some actual Chinese market data.
Shanghai Premium
From the vantage point of a U.S.-based investor, the most readily accessible Chinese stocks are those that are listed on U.S. stock exchanges. Some of these companies are listed only in the U.S., like China's dominant search provider Baidu (Nasdaq: BIDU), even though their businesses are inherently Chinese. Others are listed in both the U.S. and Hong Kong, like oil giant PetroChina (NYSE: PTR), whose domestic IPO in Shanghai has been approved but not yet launched (incidentally, PetroChina is also a stock which Warren Buffett has been (for better or worse?) incrementally divesting of late). Still a smaller group of companies is triple-listed: in the U.S. as ADRs (or ADSs), in Hong Kong and also in Shanghai.
Because current Chinese government policy severely restricts both investment by domestic Chinese in markets outside of mainland China and investment by non-Chinese investors in the domestic Chinese market, the Shanghai stock market is effectively isolated from the Hong Kong and U.S. markets. Consequently, domestic pricing in Shanghai is driven by a different set of supply-demand curves, while U.S. and Hong Kong prices for a particular stock move more or less in tandem, after translation through the foreign exchange rate and ratio of shares per ADS.
Historically, the Shanghai market has traded at a premium to Hong Kong and the U.S., indicating a higher level of overall demand by domestic Chinese investors for the same stocks. This "Shanghai premium" is most evident if we focus on the handful of triple-listed stocks:
(Prices shown above are closing prices on October 5, 2007 for New York and Hong Kong, and September 28, 2007 for Shanghai due to holidays last week. Exchange rates: 7.76 HKD/USD, 7.51 CNY/USD.)
The graph below shows in percentage terms how the Shanghai premium for these stocks has varied over time, beginning with Yangzhou Coal Mining in 1999 and joined by the other companies as they later became triple-listed, the most recent being Chalco with its Shanghai listing in the middle of this year. Notice how the Shanghai premium contracted from the 200%-400% range in 1999-2000 to zero, on this scale, at the end of 2005. Then, beginning in 2006, the premium resurfaced, gradually building in conjunction with the outperformance of the Shanghai market, to the 50%-100% range where it sits today.
Taking a broad-brushed approach to highlight general trends, we can see from the graph below that over the past eight years the New York-listed, per-ADS share values of these companies have consistently marched higher, with some price acceleration over the past year or two. There is, of course, plenty of variation among the particular stocks, but the basic trend is as stated--up.
Examination of the Shanghai-listed per-share values of the stocks, on the other hand, presents a different picture, as shown below. From 1999 through 2005, these stocks in the Shanghai market traded sideways, followed by a quick ascent beginning in 2006. The flatness of Shanghai prices while New York and Hong Kong prices steadily rose during 1999 to 2005 corresponds to the falloff in the Shanghai premium during this time period. The relative outperformance of the Shanghai market from 2006 coincides with the reappearance of the premium over the past two years.
Which Market Is Right?
Now, with two strikingly different indications of value--the higher one in Shanghai and the lesser one in Hong Kong and the U.S.--being the source of the Shanghai premium, it would seem that both markets can't be right. Either the Chinese on the mainland are, relatively speaking, paying too much for these stocks, or investors outside of China are not yet paying enough. A common explanation of the situation, based on pent-up domestic Chinese demand chasing too little domestic supply of shares, attributes the valuation "error" to the restricted Chinese investor, suggesting that Shanghai pricing is more overvalued than Hong Kong and U.S. pricing is undervalued.
Over the years ahead, as the Chinese government fully opens the gates and allows unrestricted two-way capital flow in and out of China's stock market, the Shanghai premium must vanish, since it will then presumably be possible for traders to arbitrage small pricing differences between markets. In the meantime, there is an opportunity, albeit risky, for investors outside of China to go long Hong Kong- and New York-listed shares, based on the expectation of continued upward price pressure through increasing demand from mainland Chinese investors for cheaper offshore shares as Chinese financial policy liberalizes.
How to Play the Bubble, If There Is One
To resume our bubble discussion: If the Chinese market is not a bubble (scenario #1 above) and the future GDP and earnings growth implied by current price levels actually does materialize, then anyone long needn't worry so much, since the market is behaving rationally and Chinese stock prices should not collapse, despite their recent run-up. On the other hand, if the Chinese market is a bubble (scenario #2), then, although it is extremely difficult to know when the bubble will burst, investors in Hong Kong- and New York-listed shares can find some degree of comfort in the upward price pressure from the Shanghai premium. In this regard, the New York-listed ADS shares of Chalco and Sinopec, with Shanghai premiums currently around 100%, offer a larger "cushion of safety" than the other four companies, all of which are trading at significantly smaller, though still very sizeable, Shanghai premiums.
(Disclosure: Among the stocks mentioned in this article, the author has been and remains long at the time of this writing shares in the following companies: Baidu, Chalco and Sinopec.)
posted by Lloyd Sakazaki at 10:37 PM
13 Comments:
I stumbled upon your site today and found your analysis to be quite insightful, now my question to you is What to do about BIDU? Obviously it plummeted today, how long do you give this guy to try and regain some of those losses?
Mark Mobius recently in Bloomberg is saying they are employing this similar arbitrage strategy. I think you raised an interesting point, shall we participate if we can find value in these stocks?
Of six examples you have given, Chalco and Sinopec appear to be undervalued in relations to growth. Aluminum Corp. of China “Chalco” PER 24, China Petroleum & Chemical Corp. “Sinopec” PER 18 while earning growth exceeding 20% from 2002 to 2006.
However, Huaneng Power International, Yanzhou Coal Mining, Guangshen Railway and China Life Insurance growth are less spectacular. Huaneng, Yanzhou and Guangshen growth are between 4 to 8%. China Life Insurance, from a loss in 2002 turned in excellence results, EPS growth from 2003 to 2006 was 27%. But paying for PER in the range of 19 to 66 times?
Take China Life for an example, if the market went burst, the investing community begins to value the stock more rationally at $ 2.70/share based on PER 27(27% growth assumption) on EPS $ 0.10, the stock would lose 56% in value. Question: how long will it take to recoup the principal based on 25% earning growth? Roughly 5 years. If the same amount of money(1,000 shares @ $ 6.20/share) invested in other stock, the opportunity cost(of CAGR 10% for 5 years) workout roughly around ($ 9,985 - $ 6,200) $3,785. Assuming the price premium gap narrows to 0 and price of China Life does not go up further in Shanghai market, the reward is $ 1,912. Is this risk-reward worthwhile?
Assets price bubble starts with liquidity ends with liquidity. The assets typically inflated by a group of stocks. When the bubble burst, lower valuation stocks will take a similar beating as well. If one does not have an exit strategy or stomach temporary losses, be prudent. It is always more fun to buy when you see bloods on the streets.
13 October 2007
Good post! Here's PINR's commentary on the prospect of the bubble popping. They seem to take the same view - that China will keep its market up while gradually opening it up.
As long as Warren Buffet is selling his stocks in China (although the company he had shares of, PetroChina has now reached a very high level of capitalization), probably it’s not really smart to invest there? Or only invest in small amounts and for a short term, just to win on the momentum.
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In the short run it may be a bubble. However, as the Chinese economy continues to grow, they have a lot of people willing to work hard and live a better life.
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Everyone here is talking about marketing and money. PINR's topic about bubbling is here.
I have a web site where I research stock under five dollars. I have many years of experience with these type of stocks I would like to comment about china's stock market being a bubble. I do not believe that china's stock market is a bubble.
The correction in the chinese stock market appears to have run its course.
I've found this very interesting and has a good stuff for the readers and designers. I would be glad to recommend the post for its quality content. Nice post.
the most readily accessible Chinese stocks are those that are listed on U.S. stock exchanges. thanks for share this post.
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