China’s Stock Bubble - Is the nation’s $7.7 trillion equity market a bubble waiting to burst?

Even as its economy slows, China’s stocks have been posting some astonishing gains.

Chinese stocks are soaring even while its property market and economy tank.

On April 24, the Shanghai Stock Exchange composite index closed at 4,393 points, up nearly 36 percent for 2015 but a staggering 123 percent over the past year. Its domestic counterpart, the Shenzhen Stock Exchange’s composite index, finished at 2,256, up nearly 60 percent this year but a 120 percent increase over the past year.

Combined trading on China’s two main bourses has reached nearly $200 billion on several daily sessions this year – around four times the total value of daily trading on the New York Stock Exchange during the first two months of 2015.

The outperformance of China’s major bourses is readily seen in comparison with other major Asian exchanges. Other the past year, Japan’s Nikkei 225 index has risen a relatively modest 41 percent, Hong Kong’s Hang Seng index is up 31 percent and both Singapore and South Korea’s benchmark indices have gained just 11 percent.

China’s stock surge has been partly facilitated by the central government, which has cut trading fees and had state-run media publish articles encouraging stock investing.

“In our summer last year we started seeing in the Chinese media almost educational pieces encouraging mainland investors to get back into the sharemarket,” Catherine Yeung, a Hong-Kong based investment director at Fidelity Worldwide Investment, told the Sydney Morning Herald.

Beijing also recently introduced a measure allowing investors to operate up to 20 separate accounts, compared to just one previously. Following the move, a record 3.3 million equities trading accounts were opened in just one week, with nearly 200 million mainland trading accounts currently used by an estimated 100 million investors.

On a larger scale, a major factor has been the introduction in October 2014 of the Hong Kong-Shanghai Connect scheme, which has allowed foreign investors to trade Shanghai-listed A-class stocks via the Hong Kong bourse. The move has helped Hong Kong’s market triple daily turnover, from around HK$87 billion to HK$231 billion.

“The government is indeed encouraging stock investment,” Zeng Xianzhao, an analyst at Everbright Securities, told Bloomberg News. “They need the market to be vibrant to encourage foreign funds into the country.”

With economic growth recently falling to its slowest pace since 2009 amid an “acute oversupply of property,” China’s central bank has been injecting more monetary stimulus to prop up the economy. On April 19, the central bank’s reserve requirement ratio was cut by 100 basis points, injecting around 1.2 trillion yuan into the market to boost lending.

Critics have pointed to the low educational level of new investors as an example of the fervor. According to Bloomberg, the number of new investors with a high school degree or less now accounts for more than half, compared to 26 percent of existing investors.

“I don’t know much about the stockmarket, but my friends have made a fortune recently and they can give me some advice so I must seize the chance,” a Chinese investor called “Mrs Wu” told the Australian.

“I have been worried about some of the risks, but my friends have told me that the bull market is going to stay in place for a few more months, so hopefully I can make some money. One of the hot topics between my friends lately has been whether they should sell their houses to buy stock or should we be using money that we make in the market to buy houses.”

Bulls, Bears Balanced

Is China’s stockmarket now in bubble territory? In the U.S. options market, demand has recently surged for contracts that protect investors against losses, as well as those that profit from more gains, according to Bloomberg News.

“There is still a lot of conflict in the investment community with regard to the legitimacy of the rally,” said Mark Luschini, chief investment strategist in Philadelphia at Janney Capital Management LLC. “Is it purely speculation and therefore vulnerable to get smashed, is there a disconnect between the rally in the equity market and what appears to be soft growth in China?”

In an indication that authorities are becoming worried, the China Securities Regulatory Commission (CSRC) has launched a campaign targeting stockmarket manipulation and insider trading, with CSRC chairman Xiao Gang recently warning of stockmarket risks. Regulators have also taken action to slow margin lending, which has surged to account for around 15 percent of Shanghai’s daily turnover.

Despite the boom, stocks on the Shanghai bourse are currently trading at 18 times estimated earnings for 2015 – around the same level as the U.S. S&P 500 index, but below the 28 times of the U.S. Russell 2000 index.

“On an absolute basis, the valuations of these markets are not expensive, nor are they if you benchmark their P/Es [price/earnings ratios] against the U.S., Japan, Australia, or even Europe,” Joseph Lai, who manages Platinum Investment Management’s Asia Fund, told the Sydney Morning Herald.

China’s recent boom follows the markets’ lackluster performance from 2011 to 2014, when they “essentially stagnated” as investors chased property instead.

“If economic reforms can continue to progress towards a more equitable and ecologically sound outcome, and the country can allocate capital better, then I think the market today is very cheap,” Lai added.

According to AMP Capital’s Patrick Ho, further gains will be spurred by Shanghai’s potential inclusion in the MSCI Emerging Markets index, which would spark greater buying by institutional investors such as pension funds.

“If progress with Stock Connect is made quickly enough, the Shanghai Composite could potentially be included for the first time as early as this year, which would prompt a massive influx of passive funds,” Ho was quoted as saying in the Australian Financial Review.

However, analysts at Bank of America Merrill Lynch recently cut their rating on the China bourse from “overweight” to “neutral,” urging investors to take profits.

“China’s real interest rates remain too high, the currency is too expensive, fiscal policy is tight, and debt deflation is taking hold,” the analysts said.

“We are now concerned that the scale of monetary/fiscal easing required in China is so large, and so radically different from where policymakers’ assessments are, that an overweight [rating] is no longer tenable.”

A famous Wall Street saying warns: “When even the shoeshine boy [or taxi driver] is giving stock tips, it’s time to sell.” According to Beijing media, “even the cleaning lady” has now opened an account to trade shares.

Chinese investors do not have far to look when seeing the consequences of an overinflated stockmarket. On December 29, 1989, Japan’s Nikkei reached its all-time high of 38,916, with even “cautious predictions” from analysts expecting it to end 1990 above 45,000. Having expanded sixfold during the 1980s, the Nikkei tumbled all the way back down to 7,054 in 2009, only recently regaining a level nearly half its 1989 peak.

For now though, both Beijing and China’s millions of new stock investors will be hoping that their boom proves far longer lasting. The Diplomat