The recent boom in the Chinese stock market has a lot in common with the Internet explosion in the 1990s. Like the Internet, China’s emergence has changed the way much of the world does business. And just like the dotcom days, it seems like any stock from China has been a no-lose investment during the past few years. Meanwhile, experienced investors have stood by shaking their heads, as the Chinese market continued to soar by defying all conventional measures of value.
But as John Maynard Keynes observed, a market can remain irrational longer than you can stay solvent. There have been a number of times it looked like the Chinese bubble was about to burst. Recall that in late February of this year, the index dropped by 9% in a single day to send global markets into a tizzy. But the market subsequently not only rebounded, but also shot up to even greater heights.
As with all financial manias, the collapse of the Chinese stock market is not a question of "if" but of "when". With the Chinese index up sevenfold during the past five years, and valuations stretching into P/Es of 60 or more, the Chinese stock market has little to do with fundamentals. Although many liken it to a casino, a better analogy is a game of musical chairs. The object is to make sure you get a seat before the music stops.
The Chinese Stock Bubble: A Textbook Case
The Chinese stock market mania is a textbook case of a financial bubble. Place the chart of NASDAQ over the chart of the Chinese index, and it is hard to tell the two markets apart. A more apt analogy, however, is the case of Japan. At the end of the 1980s, Japanese banks and telecommunications companies headed the list of the most valuable companies. Today, the same list is led by Chinese banking, insurance, telecoms and airlines. China now accounts for four of the world’s top 10 companies — China Life, China Mobile, China Petroleum and Industrial and Commercial Bank of China (ICBC). In July, China’s largest bank, the Industrial and Commercial Bank, overtook Citigroup for the title of the world’s largest bank, as measured by market capitalization. With all of Citigroup’s subprime woes, ICBC’s market cap is more than twice Citigroup’s $152 billion. China Life, the world’s largest life insurer by market value, is worth more than any of the largest North American insurers. China Mobile is the largest telecommunications company in the world with a $330 billion market capitalization. U.S. champ AT&T weighs in at $220 billion. Air China is worth more than any of its larger and more respected Asian rivals.
Every bull market has its iconic moment — the colorful story that signals the top of the market. For the Japanese, the moment was when in the late 1980s, all of the land under the Royal Palace in Tokyo was worth more than all of the land in California — or Canada. China’s moment may have been the listing of PetroChina on the Shanghai stock exchange on Nov. 5. By the end of the first day of trading in Shanghai, PetroChina’s market cap exceeded $1 trillion — more than that of Exxon Mobil and General Electric combined, the second and third-biggest companies in the world. This, despite the fact that PetroChina’s earnings stood at about half of Exxon Mobil’s. PetroChina’s valuation also pushed China’s stock market into the third spot among global markets to surpass the U.K.’s FTSE and only trail the United States and Japan. Put another way, the value of this single Chinese oil producer alone was almost as big as the entire Russian stock market — and more than the annual GDP of economic rival India. Despite this, Chinese investors were clamoring for shares of PetroChina just weeks after U.S. billionaire Warren Buffett sold his stake in the company.
The Chinese Stock Bubble: Has the Market Peaked?
Almost as soon as these mind-numbing statistics came to light, panic replaced euphoria among the Chinese retail investors virtually overnight. A month ago, Chinese retail investors brushed aside any suggestion that U.S. markets could impact equity values in China. Many U.S. investors also believed that the government would do nothing to damage confidence in stocks before Beijing hosts the 2008 Olympics next summer. Don’t you believe it. Although the Chinese government’s five interest rate hikes this year have done little to slow the market momentum, in recent weeks, regulators ordered commercial banks to freeze lending activities through the end of the year. And on Nov. 15, the Chinese government issued a report warning that a U.S. recession could be "devastating" to China’s manufacturing sector. These developments — combined with the impact of global jitters to which Chinese investors thought they were immune — is already making tens of thousands of Chinese day traders call it quits.
And the impact of the collapse of China’s stock market could be a lot worse than previously thought. Merrill Lynch estimates that Chinese retail investors — up to 150 million people — have sunk 22% of their capital into the stock market. Say the stock market drops by half (it’s already down about 20%) and Chinese urban households will lose about 20% of their overall net worth. That makes the impact of the housing collapse on net worth in the United States look like a rounding error. Pundits estimate that a 50% decline in the stock market might lop 1-1.5% off China’s double-digit percentage GDP-growth rate.
Today’s conventional wisdom has it that China is somehow different from Japan, the Internet, or any other financial bubble. But the recent correction in the markets reminds us yet again that China is no different from the other speculative bubbles that preceded it. It’s also worth recalling that international investment doyen John Templeton called the words’ "this time it’s different" the "four most dangerous words in investment." Templeton also made his quickest fortune shorting the biggest names in the Internet in 1999. I wonder whether he is doing the same with China.