BT: Beware the China stock market bubble (09 May 2007)

STOCK market investors in this part of the world have traditionally relied on Wall Street's movements to determine sentiment and set market direction. Recent events, however, suggest a change may have occured. Instead of the US, it is China that currently exerts a greater influence. Twice this year, sharp drops in China triggered steep declines in global equity markets, the first even causing a wobble on Wall Street. Fortunately for equity investors everywhere, China stocks regained their footing both times and thereafter surged to new highs. This, in turn, restored investor confidence and other markets duly followed. The problem is that if there is a third plunge in five months, investors may not be so lucky.

What are the chances of this occuring? The uncomfortable answer is 'very high'. By most measures, a huge bubble is building in China that simply cannot be sustained for much longer. Consider these statistics: the 52-week gains for the Shanghai Composite Index and the Shenzhen Composite are 174 and 209 per cent respectively. This year alone, the two indices have risen by an amazing 50 and 100 per cent. Of course, large gains in a short space of time may not necessarily mean a bubble exists, especially if fundamental valuations are low. However, this is not the case - according to Bloomberg's analyst estimates. Shenzhen sells for 63 times earnings and a price/book of 5.5 while Shanghai's respective equivalent numbers are 43 and 5.6. Both sets of numbers are significantly above the levels generally considered acceptable for emerging markets and are well into bubble territory - a price-earnings ratio of 20 and price/book of just over 2 would be reasonable. Both markets have virtually no dividend yields to speak of to provide buffers in case of a crash.

Moreover, the China Daily on Monday reported that there are now more than 91 million trading accounts open with brokers in China and the ranks of investors are swelling at a staggering 200,000 per day. In a recent commentary, economist Andy Xie said students are using their tuition money to play the stock market and urged the government to introduce curbs before it is too late because a market crash could have disastrous consequences for the economy.

Underpinning this rush by a naive investing public into the market is a string of successful initial public offers - thanks mainly to generous IPO pricing - and a widespread belief that one cannot lose when investing in stocks because China's growth is robust. Rapid growth comes at a price, the most common being an overheating economy. Already there are hints that Chinese officials are concerned. The central bank has raised its deposit ratio for banks and its chief this week admitted he is worried about a possible bubble in stocks. Interest rates were raised last week, with more rate hikes expected soon. Thus far, all these attempts have failed to temper the public's appetite for risk or stocks.

The market may still be able to shrug off any resulting plunge if the authorities run out of patience and decide on a more heavy-handed approach. But given the untenable levels to which prices in China have risen, investors would do well to stay on their toes.

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