Argument

A Red Bull (Market) Doesn’t Give You Wings

As China’s economic numbers get worse and worse, why does its stock market keep climbing?

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If China’s stock market had a mascot, it would be Mad magazine’s Alfred E. Neuman, famous for the line with the goofy grin: “What — me worry?” In mid-April, Beijing announced that China’s official GDP growth sank to 7.0 percent, the lowest since the global financial crisis sideswiped the country’s exports in 2009. A growing number of economists suspect the real rate is actually much lower.

But amid a deepening slowdown and rising signs of financial distress — such as the April 20 bond default by one of China’s leading property developers, Kaisa — Chinese share prices have suddenly taken off like a bottle rocket. The Shanghai Composite Index has doubled since July and has risen roughly 22 percent in the past month, to 4,200. Also, Hong Kong’s Hang Seng Index, which had lagged, shot up 16 percent in the past 30 days.

Is it a bubble? You bet. But to understand how this bubble came about and what the ramifications might be, it helps to have a bit of background.

In 2007, the Shanghai Composite Index topped 6,000 after tripling in a single year. Even though the Chinese economy was chugging along quite well at the time, many worried that prices had shot up too far, too fast, but reassured themselves that the government would not allow the market to fall. “You don’t understand,” one Chinese CEO confidently explained to me. “This is China. Maybe after the Olympics [in August 2008], but they won’t let it happen before.” Then, in October 2007 — well before the Olympics or the global financial crisis — the bottom fell out. In a sell-off as steep as its rally, like a ballistic missile falling back to Earth, the Shanghai index lost 66 percent of its value, giving back all its gains.

A lot of small-time Chinese savers got burned in that fiery crash. They saw stocks as a risky investment and, for the next six years, kept them at arm’s length. Even when Beijing injected $15 trillion in stimulus lending following the financial crisis, roughly quadrupling the money supply, most of that money avoided the stock market and flowed instead into real estate. While China experienced a massive property boom, the Shanghai index barely treaded water above 2,000. Until last summer …

Bulls argue that China’s stock market is just catching up with the country’s post-stimulus growth spurt. But the timing is ironic because China’s economy is losing altitude fast. The volume of property sales in the first quarter was down 9.2 percent compared with the year before; inventories of unsold properties increased 24 percent. Land sales — a critical factor in financing local-government debt — were down 32.4 percent. The slowdown in China’s construction boom pushed first-quarter steel output down 1.7 percent, year on year, its first decline in 20 years. Chinese exports in March fell 15 percent from a year ago, while industrial profits for the first two months of the year were down 4.2 percent from a year before.

Falling profits and rising share prices usually don’t mix. Bullish investors note that the average price-to-earnings (P/E) ratio for the Shanghai index has jumped from just 10x to 15x — close to its historical average and still well below the current 18x for the United States’ S&P 500. But Chinese banks weigh down that average because investors heavily discount them, believing (correctly) that the banks are facing a wave of unrecognized bad debt. The median P/E ratio for companies listed in Shanghai is 30x; for China’s second exchange, in Shenzhen, it’s 39x. A third of the stocks in Shanghai and half in Shenzhen have P/E ratios higher than 50x; 10 percent in Shanghai and 18 percent in Shenzhen exceed 100x. These are bubble valuations. (By comparison, fewer than one in 10 stocks in the U.S. small-cap Russell 2000 have a P/E higher than 50x, and only 4 percent have a P/E above 100x.)

These valuations have been fueled by an explosion in margin lending. Chinese securities firms have lent an estimated $264 billion to fund stock purchases, about four times as high as when the rally started in July and up 50 percent since January — when regulators announced they would crack down on such lending. The level of margin lending is now about twice as high, relative to market capitalization, as on the New York Stock Exchange. Many “shadow,” or non-bank, investment vehicles in China that were funding property projects have switched to financing stock speculation. In fact, the downturn in China’s real estate market — and its broader economy — may be helping to fuel China’s stock market rally, as Chinese savers and the Ponzi schemes that cater to them search frantically for returns.

Some hypothesize that Beijing has engineered the stampede into stocks as a way for banks and other “too big to fail” entities to paper over big losses from bad lending by issuing inflated shares. If so, it’s a high-risk strategy because any serious drop in those inflated share prices could result in margin loans being called, sending shock waves through China’s financial system. It’s also counterproductive in the long run. China’s strategy to get growth back on track involves shifting from an export- and investment-driven model to an economy that relies more on domestic consumer demand. That means shifting resources from the bloated state sector to the household sector. Conning Chinese households into buying overvalued shares to cover the state sector’s losses does the opposite.

Others argue that, by engineering a stock market rally, the Chinese government is attempting to compensate for the negative wealth effect of falling property prices in an effort to prop up consumption. That might make sense, but to succeed, the rally in share prices must be sustainable, not just a short-lived mirage. And the way to do that is by implementing real economic reforms that get growth back on track. There are no short cuts.

No one knows how long the current buying frenzy can continue. We do know, objectively, that the “smart money” is no longer driving this train. According to a recent survey, roughly 68 percent of new investors piling into China’s stock market rally have no high school diploma, compared with just under 26 percent of the prior investor base. Now their money is flowing into Hong Kong’s stock market, lifting shares long weighed down by prosaic concerns like falling earnings and rising debt.

All last week, a steady drumbeat of downbeat economic figures from China pushed share prices ever higher, as punters rationalized that Beijing would have to respond by pouring on more stimulus — ignoring Premier Li Keqiang’s repeated statements that more stimulus is not the answer. Whenever Chinese regulators hint at reining in margin lending, however, the market shudders. Many buyers say they don’t believe the rally can last, but plan to ride it out a little longer — and then get out before the crash.

The spectacular rise and fall of China’s stock market in 2007 had little impact on the global economy. Then, as now, the direct exposure of Western banks and investors to China’s share market is limited. But by upping the stakes for the world’s second-largest economy and distracting attention from the urgent task of more meaningful reform, China’s stock market mania risks doing lasting damage. Really, Alfred: Wipe that goofy grin off your face.

Photo credit: JOHANNES EISELE/AFP/Getty Images

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