China Bubble: The Price-to-Whatever Ratio Stock Market

I have been repeatedly saying here that the Chinese government has purposely been inflating a stock market bubble as part of their public information campaign to project that economic conditions have been hunky dory, and that for skeptics, “there’s been nothing to see here, so move along”

The spurt  in Chinese stocks has initially been fueled by the PBOC’s targeted easing in June 2014 and subsequently the IPO price controls in August 2014 where the latter sparked a retail based mania.

Combined with these has been varied accounts of easing via rate cuts, increasing accounts of  liquidity injections, snowballing bailouts and the force feeding of credit into state owned companies. The Chinese government even introduced the HK-China Shanghai connect last November.

Charts from FT Alphaville

The result of these accrued policy actions has been to spur a nearly vertical takeoff in her stock markets as retail participants and the shadow banking sector go on a wild party!

The Chinese government initially attempted to contain their self created mania by a crackdown on margin trades early this year. But with her stock markets responding violently, apparently the government seemed to have realized that  for political goals, accommodation of the bubble has been better than prevention.

You see the Chinese government has been reversing its previously announced market reform through political centralization. Such actions has been justified in the name of 'anti-corruption' which in reality has been about persecution of the opposition in order for the incumbent to consolidate power amidst growing economic and financial stress, as well as, intensifying strains in the domestic political environment.

Nevertheless, even mainstream media seems to have noticed now  of the fantastically absurd degree of proportions the bubble in China’s stock market has reached.

This “Time is Different” rational and the stampede into the stock market by retail investors.

From Bloomberg: (bold mine)

The 40-year-old strategist, who turned bullish just as the steepest four-month surge in seven years began last September, is among a growing number of forecasters who say traditional measures of value have little sway in a market where individual investors drive 80 percent of volumes and the biggest companies are run by the state. As long as China’s government maintains its support for the rally and keeps borrowing costs low, they say money will flow into shares and drive prices higher.

Investors in the $6.3 trillion market are showing few signs of fatigue after the Shanghai Composite Index jumped 77 percent over the past year, the biggest gain among major global equity gauges tracked by Bloomberg. The Shanghai measure rose 0.6 percent at the close on Thursday, versus a 0.9 percent drop in the MSCI Asia Pacific Index.

Mainland traders opened a record number of new accounts to buy yuan-denominated A shares in the week to March 20, while the value of equities purchased with borrowed money rose to an all-time high on Tuesday. The Shanghai Composite climbed for 10 consecutive days through March 24, the longest winning streak since 1992, as daily turnover on mainland bourses surged to an unprecedented 1.4 trillion yuan ($225 billion).

The Chinese government sees rising stocks as alternative instruments to credit…

China needs a strong stock market to make it easier for companies to lure equity financing and invest in projects that drive economic expansion, said Kelvin Wong, a Hong Kong-based analyst at Bank Julius Baer & Co., which has about $304 billion under management. The country has relied on credit growth to spur the economy for the past five years, sending total debt to more than twice the nation’s gross domestic product.

So inflate a bubble to generate funds for corporate operations, and most importantly, for debt servicing. This is what the late economist Hyman Minsky calls as Ponzi finance. And considering that China's debt may have already reached its peak levels thus the next step has been to ignite asset inflation via stock market boom.

 

Chinese stocks has reached outrageous valuations…

The Shanghai Composite’s median price-to-earnings ratio, which is less influenced by the nation’s biggest banks than a market-capitalization weighted average, has climbed to 44. That level has been breached just twice during the past decade, in late stages of rallies in 2007, when it climbed as high as 66, and early 2010, when the peak was 47. The Standard & Poor’s 500 Index has a median ratio of about 20, data compiled by Bloomberg show.

The Shanghai index’s earnings yield, or profits as a percentage of the price, has shrunk to 5.6 percent, the lowest since May 2011 versus the nation’s highest-rated 10-year corporate debt, which has a 4.8 percent yield. Chinese companies with dual listings are 34 percent more expensive on the mainland versus Hong Kong, the widest gap since October 2011, according to the Hang Seng China AH Premium Index.

The article ends with a quote from John Maynard Keynes excerpted by a bullish analyst

There is nothing so disastrous as the pursuit of a rational investment policy in an irrational world.

It's all about a tsunami of liquidity and excessive leverage says the BNP

The Zero Hedge quotes BNP (italics, bold and underline original)

Against all odds, the best performing asset class on the planet over the last nine months or so has been Chinese equities…

...it’s not the economy (as we’ve been saying for months)...

What underlies these extraordinary gains? It is certainly not economic fundamentals. Led by the accelerating real estate slump (China: It’s Only Just Begun), China’s GDP growth has steadily slowed with reported 2014 GDP growth of 7.4% the slowest in almost twenty years. A range of ‘hard’ economic indicators such as electricity production and rail cargo volumes suggest even slower growth. Our preferred ‘real, real’ GDP estimate flags that output growth could have been as low as c.4½% in 2014 (China: Fit as a Fiddle). While the usual data fog around the Lunar New Year partially clouds analysis, high frequency indicators that generate early estimates of GDP growth suggest that the growth has continued to slide in 2015Q1…

...it must be liquidity….

By definition therefore equities’ stellar performance has been a function of liquidity driven multiple expansion. The P/E ratios for the Shanghai and Shenzhen markets have roughly doubled since August to c.19x and c.44x respectively. While still a long way short of the incredible highs of 70-80x reached during the 2006-2007 bubble, multiples are now rapidly approaching their post-GFC highs. One obvious source of fresh liquidity which could have powered equities’ bull-run is from the long-delayed introduction of the Hong Kong Shanghai ‘stock connect’ last November. The scheme, formerly known as ‘the through train’, allows two trading between the Shanghai A-share market and the Hang Seng. Two-way flows however have been relatively meagre. An initial aggregate quota of RMB300bn was set for northbound flows into Shanghai. So far only about a cumulative RMB125bn has flowed north, leaving RMB175bn of the aggregate quota unfilled. And northbound buy orders have in turn typically only accounted for around ¾% of the Shanghai market’s daily turnover…

...and it comes from a predictable place, leverage…

Far from a surge in external liquidity, an increasingly self-feeding domestic frenzy fuelled by leverage appears to be the key driver….Margin purchases have been running well ahead of redemptions ensuring that the outstanding stock of margin debt has ballooned by over RMB1 trillion since August; equivalent to more than 1% of GDP…

...and castles built on quicksand (i.e. margin debt) will likely collapse…

Margin purchases are now accounting for almost 20% of equities daily turnover which itself has soared to wholly unprecedented levels in another sign of self-feeding speculative frenzy. What happens next is clearly an ‘unknown-unknown’. By definition detached from fundamentals, speculative bubbles are inherently re-enforcing in the short-term and frequently last longer than expected. The longer they continue, however, the larger the eventual bursting. 

Well such ridiculous valuation levels hasn’t been isolated to Chinese stocks, the Philippines has been plagued by almost the same degree of outlandishness. For instance, the Philippine property index has PER valuations of 35.7 based on LTM 3Q 2014 reported earnings based on yesterday prices. 

So the same Price-to-Whatever Ratio afflicts the Philippines.

While bullish analysts may quote that “there is nothing so disastrous as the pursuit of a rational investment policy in an irrational world” in order to justify the utter disregard of risks to chase momentum or prices, unfortunately listening to such advise comes with a Damocles sword. 

That's because the same ‘illustrious’ economist also warned,

A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.

So while 'the market can remain irrational longer than one can remain solvent', such that bullish analysts will line up their pockets with money from confirming on the biases of the hapless and gullible lemmings, when the disaster comes, the same people will hide under the skirt of crowd and get themselves absolved by claiming ignorance. How nice.