Bull in a China shock

“No warning can save people determined to grow suddenly rich.”

– Lord Overstone.

History, wrote John W. Campbell Jr., doesn’t always repeat itself. Sometimes it just screams, “Why don’t you listen to me ?” and lets fly with a big stick. The definitive new millennium bubble, namely the Nasdaq Composite Index, peaked on the 10th of March 2000, at a level of 5,132. Within two years that same index would be trading at just above 1,000. $5 trillion in market value ended up going to money heaven.

History’s big stick is flying again. The Shanghai Composite Index peaked on the 12th of June, at the rather eerily similar level of 5,166. As things stand it has lost a quarter of its value and over $2 trillion in the space of two weeks. The April 10th edition of the Financial Times carried a helpful anecdotal warning within an article entitled ‘China investors: stock market fever’. It contained the following classic:

“Li Shengnan, a 33-year-old sales associate for a consumer goods company in Shanghai, called a friend last week seeking investment advice. Ms Li wanted to know whether to take out a mortgage on her apartment and use the funds to invest in China’s red-hot equity market.

“I never played the market before, but since March it seems like all my friends and co-workers are all getting rich, so I got excited,” she said.

Recent investors in the Chinese market are getting excited, but not in a good way. The Wall Street Journal reports that the 10 worst performing funds of the past month are ‘structured’ funds – i.e. they’re leveraged index trackers. The three worst performers, all run by fund managers with less than a year’s experience, fell by an average of 77% during the month.

This being China, bull markets aren’t allowed to die without a fight, and the authorities are pulling out all the stops. The People’s Bank of China has already cut interest rates and eased reserve requirements. The China Securities Regulatory Commission has relaxed collateral rules on margin loans. Not to be outdone, the Asset Management Association of China has issued a statement titled ‘Beautiful sunlight always comes after wind and rain’.

Such belief in the institutionalised defence of the market rather poignantly recalls JK Galbraith’s spirited account of ‘The Great Crash 1929’:

“The papers agreed, and this was also the informed view on Wall Street, that the worst was over. And it was predicted that on the following day the market would begin to receive organised support. Weakness, should it appear, would be tolerated no longer.

“Never was there a phrase with more magic than “organised support”. Almost immediately it was on every tongue and in every news story about the market. Organised support meant that powerful people would organise to keep prices of stock at a reasonable level.. With so many people wanting to avoid a further fall, a further fall would clearly be avoided.”

There are many ways of losing money in the markets, but the belief by retail investors that the authorities will always look after retail investors is probably the most certain. And retail investors account for between 80% and 90% of trading in Chinese stocks. (The month of May saw more than 14 million trading accounts opened.) A large constituency of neophyte investors is now in the process of appreciating that financial markets can go in a direction other than up.

And there are, fundamentally, only two real ways of making money in the markets, and they are mutually exclusive. One is to follow price momentum. This is typically a shorter term trading strategy, or what one might refer to technically as speculation. The other is to buy high quality assets at less than their inherent worth. This is a longer term approach which one might refer to technically as value investing.

The Chinese stock markets are a gigantic playground for momentum traders, but are something of a desert for value investors. A recent research paper (‘The real value of China’s stock market’ by Jennifer Carpenter and Robert Whitelaw of New York University and Fangzhou Lu of MIT) puts it as follows:

“Though it has become the second largest in the world, with a market capitalisation of $6 trillion at the end of 2014, China’s stock market is still a sideshow in a financial system dominated by a massive state-controlled banking system. After a rocky first decade from 1990 to 2000, China’s stock market earned a reputation as a casino manipulated by speculators and insiders.”

So it is progress of sorts that it is now a casino manipulated by the State.

Happily for foreign investors, what China’s stock markets lack by way of corporate governance they also lack by way of foreign sponsorship; Capital Economics reckon that foreign investors account for just 1.5% of Chinese shares. The pain of this collapse will be felt almost entirely at home. And since stock returns in China display very low correlation with those of other large economies, there is no reason to presume that this latest China crisis will embark on an international tour.

Chinese stock markets may amount to ‘here be dragons’ land, but it would be unfair to tar all of Asia with the same brush. Two markets that look especially attractive to us are Japan and Vietnam. Almost half of the Japanese stock market trades on a price / book ratio of less than 1. (Only 15% of the US stock market trades at a comparable multiple.) Vietnam, separately, looks set to benefit from the removal of limits on the foreign ownership of listed businesses. As UBS point out, Vietnam’s market cap-to-GDP ratio is the lowest in Asia, at only 30%. Having been the worst performing market in Asia for the last five years, Vietnam has the potential to be one of the best over the next five years. If jitters in Chinese markets happen to make other Asian investments cheaper in the short run, that clearly makes them even more compelling.

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