Bulls & Bears: China’s Stock Market

shanghai-61900_1920

 

The analysis below is designed to help you decide if you should expect China’s stock market to continue to fall and if you should expect a fall in the market to have a large impact on the global economy:

 

If you are BULLISH ON CHINA’S STOCK MARKET, then you …

Intervention will win: Believe in the ability of government intervention to sustain a market, particularly when a government does everything in its power, from directly buying stocks to suspending trading in the majority of stocks

Long-term growth: Believe that the rise in the market over the last year is supported by China’s long-term growth, not just leverage and liquidity.

Adjusted expectations: Have adjusted your expectations, figuring that, when a market advances by 100% or more, if it then has a 30% correction, that’s no big deal.

Confused and conflicted: Either work directly for the Chinese government or are as excited by your unicorn collection as you are the Chinese stock market.

 

If you are BEARISH ON CHINA’S STOCK MARKET, then you might think that…

Margin will fall: Any market whose rise coincides with a 500% rise in margin buying is bound to fall hard and fast.

Valuation too high: A median price earnings ratio in excess of 50 is unsustainable for any market, regardless of the long-term economic potential

Intervention can’t win forever: While government intervention can slow the fall of a market, ultimately the market will find its own floor.

Immature markets can’t be trusted: An immature market built on the speculation of retail investors (who own 85% of China’s stocks) is likely to have irrational volatility marked by fast rises and fast falls.

 

If you think CHINA’S STOCK MARKET WILL HAVE A LARGE IMPACT on its economy and/or the global economy, then you are likely focused on the fact that…

History: Historically, market collapses have coincided with economic recessions, i.e., the Great Depression, Japan in the 1990’s, the Great Recession, etc.

Huge trading partner: China is a huge trading partner with most of the rest of the world, including the US, and many companies, like Apple and GM, derive a substantial part of their profits from China.

Wealth Effect: After absorbing stock market losses consumers in China will be able to spend less which will slow the economy further (known as the “wealth effect”).

 

If you think CHINA’S STOCK MARKET WILL HAVE A MINIMAL IMPACT on its economy and/or the global economy, then you are likely focused on the fact that…

Not integrated into global markets: China’s market is immature and highly restricted, which results in foreigners owning only 2% of Chinese stocks which means China’s market is not very integrated into the global capital markets

Not correlated with real economy: China’s market is immature and highly restricted which means it is driven more by liquidity and speculative sentiment than company or economic fundamentals which is why, from 2001-2005, though economic growth in China was very strong, the market actually declined by roughly 40% and the period 2010-2013 also saw strong growth but weak market performance which demonstrates that, in China, the market and economic performance are not closely correlated.

Market-to-GDP not high: While the valuation of the market of many developed countries is more than 100% of annual GDP, China’s total market value is less than 50% of GDP, plus the Chinese have a very high savings rate, both of which suggest that the “wealth effect” of a market drop in China will not be very large.

Consumer not leader in China yet: While retail spending has been one of the bright spots in China’s slowing economy this year, it still comprises a relatively small portion of the Chinese economy so any slowing of retail spending will have a fairly muted impact.

China still primarily a supplier: China’s role as a market and source of profits is growing, but not large yet.  It is still primarily a supplier to the world, not a customer, so the ripple effects of a China slowdown will not be terribly strong.

 

OUR TAKE

Leveraged market is sure to fall, but economic fallout limited (unless Beijing makes policy mistakes)

 If more people in the world were good at predicting market and economic collapses, then we would have fewer of them, and we certainly wouldn’t have had a global financial meltdown just a few years ago.  So we don’t hold ourselves out as great and precise prognosticators.  We do think that the decisive factors in the Chinese market are the explosion in leverage (margin buying) that occurred on the way up and the extremely high PE valuations.  Any market built on such conditions will surely fall.  How far is hard to say, but continued rise looks very difficult and unstable.  As to the economic fall-out, the short term impact looks to be minimal.  But China has greater economic challenges.  It is in the midst of a transition from an export and investment led economy growing at 8-10% per year to a more consumer-oriented economy that will likely grow at 5-7% per year.  This transition is made more challenging by the fact that China has racked up huge debts over the past five years trying to “stimulate” its economy (debt to GDP has increased from roughly 120% to more than 250%).  If China uses the stock market correction as a reason to pile on even more debt and liquidity into an already overly indebted economy, then it will make its larger challenges even worse which will not help in the medium to long-term.