Shanghai Rally: Trend or Blip?

April 2nd, 2015
in contributors

The Underdog That Outperformed All Global Stock Markets In The First Quarter: A Buy Or A Bubble?

by Trang Ho

This article was published previously at Forbes.

China reigned supreme over all stock markets worldwide in the first quarter, despite expectations for slowing economic growth and a weakening real estate market. The Shanghai Composite Index soared to its highest level since April 2008 BUT remains a far cry from its October 2007 all-time high, suggesting there's plenty more room to run. Small and mid-cap stocks are relatively overvalued, but large-caps are a bargain compared to the other developed markets.


Follow up:

A Great Wall of Worry

China's stock market climbed the proverbial wall of worry typical of bull markets. Market Vectors ChinaAMC SME-ChiNext exchange traded fund (NYSE:CNXT), an ETF of 100 small- and mid-sized companies traded on the Shenzhen Stock Exchange, rallied a whopping 50% year to date. Deutsche X-trackers Harvest CSI 500 China-A Shares Small Cap ETF (NYSE:ASHS), a basket of 500 small-caps listed on the Shanghai and Shenzhen stock exchanges, vaulted 39% the first three months of the year. They easily eclipsed the benchmark iShares MSCI Emerging Markets ETF (EEM)'s 2% return over the same period.

Click for larger image at Forbes.
Shanghai Composite Chart

Shanghai Composite Index price performance over past ten years
Courtesy of Yahoo! Finance.

China's new bull market kicked off mid-2014, driven by bargain buying and the Chinese government allowing foreigners access to the mainland stock market.

"This generated a large amount of consistent capital (inflow) that was idle in several areas around the world, earning very anemic rates of return," said Matt Lloyd, chief investment strategist at Advisors Asset Management, which oversees $16.8 billion in assets.

The flagship ETF tracking Chinese shares available to foreign investors, iShares FTSE China ETF (NYSE:FXI), saw more subdued gains of 8% in the first quarter. It ended the first quarter 64 percentage points below its 2007 apex. It's made up mostly of state-owned enterprises and financials. Morningstar's China region mutual funds category returned 6.4% versus 3% for the average world stock fund in first quarter.

China's central bank in February cut interest rates for the second time in four months to counteract a weakening real estate market and risks of deflation. The People's Bank of China also lowered requirements on bank reserves to encourage more lending. Investors are betting that China's government will undergo more economic stimulus to boost growth after it set its gross domestic product (GDP) growth target at 7% for 2015 - the slowest pace in 11 years, investment strategists say.

Nathan Yates, owner and director of research at Forward View Consulting, an investment research firm in Clintwood, Va. wrote in an email:

"Investors don't believe that the Chinese government will accept sluggish economic performance, so they're betting on market-friendly moves. If the government doesn't respond with stimulus, look for Chinese markets to underperform later in the year."

China's mainland stock market is forming a bubble fueled by margin borrowing, which doubled last year, and the shadow banking system, says Daniel Jacoby, chief investment officer at Stratos Wealth Partners with $2.2 billion in assets under management in Beachwood, Ohio.

"Investors are taking money from shadow banks and investing in equity," Jacoby said in an email. "Unlike the United States, there aren't readily available asset classes in China. Third, the Chinese government has their own version of monetary easing through, which they're buying Chinese equities too."

Economists at the Jerome Levy Forecasting Center in Mount Kisco, N.Y. believe economic data out China show it's on the verge of economic collapse. The trade surplus has doubled in the past year to a new high of nearly $1 trillion. Export growth has been lackluster amid falling commodities prices while imports have been soft. From the March 16 issue of The Levy Forecast:

"Major trade partners report weakening exports to China, and prices of commodities purchased disproportionately by China have been falling. A day of reckoning is approaching as either Chinese domestic weakness becomes too great to disguise or a deterioration in exports to the rest of the world drags China's enormous trade surplus back down."


Unlike investors in developed countries, the Chinese are mainly limited to investing in their market and have fewer options. They may have run up prices too far too fast. Small and mid-cap stocks - the most speculative and volatile - are trading at very expensive valuations compared to large caps and other emerging markets. CNXT's price-to- forward earnings ratio of 27 is more than double FXI's P/E of 11, according to Morningstar.  CNXT is trading at more than four times book value and three times sales while yielding less than 1%. FXI is trading at much cheaper valuations at a price-to-book value of 1.5 and price-to-sales ratio of 1.2 while yielding 3%. It's trading on par with EEM. EEM's P/E is 13, P/B 1.5, P/S 1.2 and yield 2.5%.

China's large caps are a bargain relative to the U.S. and other developed markets. The U.S. stock market, as tracked by SPDR S&P 500 ETF (NYSE:SPY) is changing hands at 18 times earnings, 2.6 times book value, 1.7 times sales with a 2.2% dividend. Developed foreign markets, as tracked by iShares MSCI EAFE ETF (NYSE:EFA) has a P/E of 17, P/B of 1.6, P/S of 1.1 and dividend yield of 3%.



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