China: China Braces For A Bubble

Although he is 63 years old, Beijing retiree Du Shuzhan is not afraid to try something new. He has just discovered the stock market. A few weeks ago, he deposited $1,500 in his first share-trading account, and on a January afternoon he visited a local broker to buy shares of seven Chinese companies. “All my friends started to invest in the stock market last year,” Du says. “My wife and I decided to join the trend.” He admits that when it comes to deciding which stocks to buy, he lacks expertise. “I don’t know much about it. I just picked the ones with low prices.” But he figures he will do fine. “With all the money in the market, I don’t see how it could go down.”

Neither could Dutch tulip-bulb speculators in the mid-1600s nor American day traders in the dotcom boom of the late 1990s nor even Chinese investors in the early 2000s. The history of investing demonstrates that there is no faith stronger than that of newbies plunging into a molten market. And that certainly describes China today. Emboldened by last year’s 130% rise in the Shanghai Composite Index–which made Shanghai one of the best-performing exchanges in the world–first-time punters like Du have been storming into Chinese stocks, ending the market’s five-year slump and in recent weeks pushing daily trading volume to new records. They are ignoring the stop signs raised by market experts and government officials, who warn that a correction might be coming.

Last year 2.4 million investors began trading stocks through the Shanghai exchange, a 250% increase in new accounts. That’s an average of about 7,000 a day, a flood of fresh blood from san hu (as the Chinese call small investors) that is making seasoned traders nervous. “When you see shop assistants and taxi drivers racing out to borrow money to buy stocks, you’ve got trouble,” says commodities guru Jim Rogers. “That’s the market sucking in a whole lot of neophytes priming to get slaughtered.”

Plenty of stock analysts and fund managers disagree, arguing that prices are simply keeping pace with China’s remarkable economic rise and that accounting reform and better supervision have made Chinese companies more attractive. The country’s GDP grew 10.7% last year, the highest rate since 1995. But the alarm is being sounded by Beijing officials, who are worried there could be another Chinese market meltdown like the one in 2001 that soured the public on stocks for years. On Dec. 30, Cheng Siwei, a vice chairman of the National People’s Congress, cautioned investors against “blind optimism” in the country’s relatively underdeveloped capital markets. China Central Television, the government TV network, last week aired a show warning citizens not to put up their homes as collateral for loans to buy stock. Authorities are doing more than jawbone. Bank lending for stock purchases was banned last month, and regulators temporarily halted the sale of new mutual funds.

Beijing may have good reason to apply the brakes. In frothy markets, investors tend to form unrealistic expectations. They buy into an ill-founded theme, whether it’s about future demand for tulip bulbs or, in this case, the notion that China’s economic growth is boundless. David Webb, an independent investor based in Hong Kong, says that this is what’s happening with many China stocks. “Once you get past the hubbub, the fundamentals behind these prices just aren’t there,” he notes.

Take the nation’s largest life-insurance company, China Life, which trades in Shanghai, Hong Kong and New York City. On Jan. 31, its shares had a price-earnings ratio of around 70 (a stock’s P/E ratio shows the amount investors are paying for each dollar of per-share earnings). That’s a richer multiple than investors are shelling out for fast-growing Google.

Nor are high prices confined to a few Chinese stocks. Webb estimates that the average P/E for “A” shares (stocks available to mainland investors on China’s Shanghai and Shenzhen bourses) is 34; the current P/E for U.S. stocks in the S&P 500 Index is 18. Want more proof? A report by investment bank JPMorgan notes that of 37 Chinese companies listed jointly in Shanghai and Hong Kong, eight trade on the mainland at valuations at least double those quoted in Hong Kong. “The risk-reward picture is unhealthy at the moment,” says Frank Gong, JPMorgan’s chief economist for China. “The market has undoubtedly moved ahead of itself.”

Not surprisingly, comparisons are being drawn between China’s stock boom and the U.S. dotcom bubble. Certainly there are similarities, such as a frenzy for initial public stock offerings. As investor demand for Chinese stocks has increased, so has the list of mainland companies eager to cash in on the mania by going public. In 2006, Chinese firms raised more than $53 billion in the Hong Kong and Shanghai markets through IPOs and secondary share offerings, up from $24 billion the year before. Among them was the largest IPO in history, November’s $22 billion listing in Hong Kong and Shanghai by the Industrial & Commercial Bank of China (ICBC). Despite the fact that Chinese banks are known for their lack of transparency and weak management, ICBC was a wild success. In Hong Kong, its share price at one point soared 70% above its initial offering price of 39¢. That pushed the bank’s market cap so high that for a while it was valued as the second largest financial institution in the world, behind Citigroup.

The appetite for China stocks has encouraged other big corporations to tap the market. Analysts say they expect China Mobile, the world’s largest mobile-phone company, to issue additional shares this year. Ping An Insurance, China’s second largest life insurer, and oil-and-gas conglomerate PetroChina are also expected to issue more shares. There is no way all can be winners, says Nicholas Yeo, a fund manager for Aberdeen Asset Management. “One of these large IPOs last year would have been impressive,” Yeo says. “But can they keep pulling them off? Probably not.”

A market correction is not inevitable, says Peter Alexander, chief analyst for Z-Ben Advisors, a Shanghai investment consultancy. He argues that Chinese companies are stronger and more efficient than they were a few years ago. “It’s dangerous to bet against China,” he says. Also, if China Life and banks that fueled last year’s blockbuster IPOs are excluded from the picture, Shanghai stocks trade at prices comparable to those of Asian firms listed on other regional bourses. In fact, some of China’s smaller manufacturing and textile companies are still relatively undervalued. “Judging from history, the stock market doesn’t bust when the buying is concentrated on blue-chip names,” says Lan Xue, head of China research for Citigroup. “It’s when the buying goes into the second line, third line, fourth line [companies]–the speedy names–this is what would get me more worried.” Xue predicts that the bull market will continue for at least one to two years.

That’s what China’s new investors think too. Punters who gathered to swap stocks and stories at the Beijing branch of the China Galaxy Securities brokerage house on Jan. 29 weren’t letting a small drop in the market that day dampen their spirits. “I guess the fluctuation will go on for a while, maybe another month or so,” says Jiang Yulan, a trading aficionado, “but in a long term, the price will be going up by the end of this year.”

So confident are the assembled san hu that they don’t regard their activity as serious business. They use wan, Chinese for “play,” to describe it. If the market tanks, the san hu won’t be the first to discover that investing is not a game.

DON’T LOOK DOWN [This article contains charts. Please see hardcopy of magazine.]

The Chinese market has soared over the past six months, but overpriced shares could end the winning streak

Hang Seng China Enterprises Index Jan. 30 9,771.66

Shanghai Composite Index Jan 30 2,930.562

Source: Yahoo! Finance