Blowing bubbles in China as stocks soar

Chinese investors have gone crazy for stocks this year. The tech-heavy ChiNext index has risen by some 150 per cent since January. The Shenzhen stock market, where many of the country's small-cap names are listed, has more than doubled. The Shanghai stock market, where many of China's large state-owned enterprises can be found, is up almost 60 per cent in 2015, and by 150 per cent over the last 12 months.

Almost every stock is soaring. All but four of the 1,684 stocks listed on the Shenzhen market have risen this year. Almost 90 per cent of Shenzhen stocks have seen share price rises of at least 50 per cent; roughly two-thirds have more than doubled; more than 100 names have soared by more than 500 per cent.

Demand for new listings has been especially intense.

One company, online video stock Beijing Baofeng Technology, saw its stock enjoy a 40-fold rise in its first six weeks of trading, a gain that chief executive Feng Xin partly attributed to the government's pro-innovation outlook.

“If investors hear the government is promoting the internet as a concept, they will be influenced when they see a product [like ours] they have been using all this while,” he said.

As explanations go, it's far from satisfactory, but the madness is not limited to technology companies. Hong Kong-listed umbrella maker Jicheng Umbrella Holdings is up more than 1,800 per cent since its market debut in February. On average, new listings have gained around 500 per cent in 2015.

Consequently, valuations often look, well, bonkers. The average Shenzhen stock trades on 66 times earnings – a veritable bargain, perhaps, compared to the average ChiNext stock, which trades on 137 times earnings.

Shanghai’s index is dominated by banks, which means the overall index trades on less than 17 times estimated earnings. However, the median Shanghai stock trades on more than 70 times earnings, according to Hong Kong-based research firm Gavekal.

Rookie investors

The enormous stock gains have catalysed an explosion in interest amongst rookie investors. More than two-thirds of new investors, a recent study found, had left school by the age of 15, while more than 30 per cent had not gone beyond elementary school. Household wealth among new investors is roughly half that of existing investors.

Some 33 million people have opened new trading since January, roughly as many as had opened accounts over the previous four years combined. A record 4.4 million new accounts were opened in the last week of May. Many are borrowing money to buy stocks, with a fivefold increase in margin trading occurring over the last year.

The Chinese market, valued at almost $10 trillion, is now almost twice as large as the Japanese market, and is dwarfed only by the $25 trillion US market. In terms of turnover, China is already the top dog; last month combined trading volumes on the Shanghai and Shenzhen exchanges were more than 10 times higher than that seen on the New York Stock Exchange.

Notably, the market gains have come against a backdrop of a slowing Chinese economy. The government projects GDP growth of 7 per cent this year, the weakest expansion since 1990, and many commentators suspect the real number is much lower again.

Government cheerleading

This hasn’t stopped the Chinese government from acting as a market cheerleader. It has been urging the case for equities through the state-run media over the last year, with market tumbles almost invariably followed by official reassurances. Trading fees have been reduced. A 17-year ban that restricted investors from owning more than one trading account was lifted in April; now people can hold up to 20 accounts with different brokers.

The People’s Bank of China has also encouraged equity inflows, cutting interest rates on three occasions over the last six months, and further cuts are expected. Additionally, it has cut banks’ required reserve ratios, freeing up money for new lending.

For the government the wealth effect created by a soaring stock market has been especially welcome against a backdrop of a sluggish property market. It also allows indebted and lossmaking state-owned enterprises, as well as the state-owned banks who have been encouraged to lend to them, to get out of jail. A buoyant stock market allows them to raise cash more easily, swapping their debt for equity.

Foreign investors

Until now, this recapitalisation has been largely financed by domestic investors, but China hopes that foreign investors will increasingly take their place.

Until recently, it was all but impossible for international investors to buy stocks in mainland China. However, that changed late last year with the opening of the Shanghai-Hong Kong Stock Connect, which allows foreign fund managers limited access to yuan-denominated A-share stocks. Further liberalisation is planned, with the Shenzhen stock exchange expected to be connected to Hong Kong later this year.

Major index providers have noted developments, and domestic Chinese stocks are likely to increasingly feature in emerging market (EM) benchmarks in the future. The FTSE Group recently announced that it is to introduce EM indices that will include exposure to Chinese A-shares. Earlier this month Vanguard followed suit. MSCI, the world's largest indexing firm, announced last week that it was holding off for now on adding A-shares to its EM benchmark, but that China remains on review for possible inclusion in 2015.

Concerns

It all means international investors will be forced to take an increased interest in a Chinese market that is not exactly renowned for its corporate governance standards.

Carson Block

of Muddy Waters, a short selling firm famous for having exposed scandals at Chinese companies, describes the Chinese market as the “largest pump-and-dump in history”.

Some might see that as hyperbole, but fears regarding serious wrongdoing are not confined to short sellers, and there is concern that investors in international index funds are about to become more exposed to some of China’s more ethically challenged corporations.

International investors are also about to become more exposed to a market that has long been prone to bubbles and crashes. Many worry that the current rally is eerily similar to the bull market that saw stocks quadruple in value between 2005 and 2007. That bubble ended badly, stocks going on to lose 72 per cent of their value. They bumped along the bottom between 2009 and 2014, before again taking off in manic fashion late last year.

It may all "end in tears again", Credit Suisse warned recently, adding: "There will be a massive correction of these stocks. Avoid this space!!!"

That is echoed by high-profile bond manager Bill Gross, who describes the Shenzhen market as "the short of a lifetime".

A crash may come, but when? “At some point,” says Credit Suisse. “Not just yet,” says Gross. In other words, no one knows. Bubbles can become inflated to degrees that no one anticipated, so China’s stocks may well continue to soar, especially while they have such strong government backing.

However, a rally characterised by soaring umbrella stocks and routine triple-digit percentage gains is surely not a sustainable one. With the Chinese market increasingly opening up to western money managers, the eventual fallout will not be confined to domestic investors.