‘Shoe-shine boys are tipping stocks again’ – this time in China

Chinese stocks are in a “bull run of epic proportions”, says The Economist. Despite a nasty stumble last week, which saw the Shanghai Composite index plunge by 6.5% in one day, the market is still up by 135% in 12 months, and 40% this year. The market in Shenzhen, skewed towards technology companies, has doubled since January.

ChiNext, an index for start-ups, is up by more than 150%. The Chinese market “has often been called a casino”, with share prices “bearing little connection with economic reality”, but the gap between stock prices and the fundamentals “has reached new extremes”.

Growth in the first quarter fell to 7%, a six-year low. Yet signs of irrational exuberance in the equity market abound. Valuations range from expensive to bonkers. The Shanghai Composite is on a price/earnings ratio (p/e) of 24, which seems merely pricey, but the picture is skewed by the weak performance of the heavyweight banking sector.

The median stock in Shanghai is on a p/e of 75. Around half the stocks in Shenzhen have reached p/es of more than 50, while the average p/e on ChiNext is 100. A sauna-manufacturer and a pet-food company have hit p/es of 220 and 285 respectively.

Retail investors pile in to Chinese stocks

Money has poured into stocks as retail investors have raced to open accounts. Most stockmarkets are dominated by institutions, but in China retail investors account for 90% of daily turnover.Almost eight million accounts were opened in the first quarter of 2015 alone.

As people have piled in, turnover has rocketed. On some days this year, trading volumes have eclipsed the value of deals on the New York Stock Exchange by a factor of four. “Worryingly”, says Fidelity’s Tom Stevenson in The Sunday Telegraph, around half of the newcomers to the equity market received no education beyond high school. “The shoe-shine boys are tipping stocks again.”

What’s more, unlike in 2007, investors are buying shares with borrowed money: margin debt (as such borrowing is known) has more than quadrupled since mid-2014. It is now worth around 3% of GDP and 8% of total trading volumes. The latter is a figure that was not even reached during the market manias in Taiwan and Japan, as Stevenson notes.

High levels of margin debt can exacerbate downswings because investors have to sell stocks to meet demands for more capital from their brokers. Last week’s tumble was ascribed to brokerages tightening rules on margin trading.

Can the rally last?

So there are several signs of an incipient bubble in the Chinese market. That said, it looks unlikely to implode anytime soon. China is “one of those central-bank markets”, says Krishna Memani of Oppenheimer Funds. “Wherever there is an active central bank, you buy.”

The authorities have cut interest rates, along with the proportion of deposits banks are required to hold as reserves, several times in recent months, thus bolstering liquidity. They have also announced more spending on infrastructure. “Sentiment will continue to be supported by government pro-growth policies,” says Irene Chow of Julius Baer.

Another bullish factor is that China’s domestic share markets, hitherto virtually inaccessible to foreigners, are opening their doors. Since November, foreigners have been able to buy Shanghai through Hong Kong brokers.

And as of next week, Chinese shares may be partly included in MSCI emerging-market indices, so funds tracking the index will have to rebalance to reflect that change, meaning they will have to buy Chinese stocks. The bull run looks set to endure. The db x-trackers Harvest CSI 300 ETF (LSE: ASHR) is a relatively low-cost and convenient way to invest in mainland stocks.