Here are some things that we know. We know that long-term stock market returns are utterly unrelated to economic growth; instead, they are related to the price at which you buy your stake. Buy a market when it is cheap, and history tells us you will make good long term returns; buy a market when it is expensive, and history tells us you will not.
We also know that when a market is cheap, sentiment will be such that everyone will have a reason why it will stay cheap forever, and must be avoided at all cost. The clever investor is the one who ignores the noise and looks at the price.
This brings me to China - people keep telling me how cheap it is. Brian Dennehy of fundexpert.co.uk sent me a chart this week showing how the major markets have performed since October 2007. The S&P 500 is down 10% and the FTSE 100 is down about 11%. But the Shanghai Composite index is down a nasty 62%. China doesn't look that good over a 20-year period either: the MSCI China Index started at 100 on December 31 1992; it is now at 59.
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It is a story borne out if you look at short-term fund performance too. The best performers in the US market are up between 18 and 20% over the past year, while even the very best performer in the Chinese market First State Greater China Growth is up only just over 4%. Its runner-up, Baillie Gifford Greater China, is down 2%.
Dennehy points out that the Chinese market bears many of the hallmarks of a bear market hitting bottom. There is a consensus growing against it among foreigners note Barron's Falling Star' cover from July this year, explaining why low Chinese growth is bad news for stocks and among locals. The number of new trading accounts being opened has fallen to 2008 levels, and trading volumes on both main markets (Shanghai and Shenzhen) dropped by 30% in the first half of this year.
Next up is the fact that its price/earnings ratio, "depending on who you believe", is either at or near a record low, somewhere between ten and 12 times and much where it was in 1995. Chinese stocks used to trade at a massive premium to those in the rest of Asia; now they trade on a discount. Dennehy isn't alone in his enthusiasm. The idea that Chinese equities are historically cheap is gaining momentum: even Asia-based stock guru and ber bear Marc Faber told me a few weeks ago that at these prices, China is due a major bounce.
Given that I am usually keen to push you into cheap equities (it is the only way to survive this kind of very low interest rate environment) you might now expect me to suggest that you start buying. But while I wouldn't be at all surprised to see China rally nicely from these levels, it just doesn't make sense as a long-term hold. Why? Two reasons.
First, it isn't cheap enough. Very few valuation methods have ever shown themselves to be of any use in predicting where stock markets might go. The cyclically adjusted p/e ratio (Cape),however, does. And on Cape, China still looks expensive: cheap would be under 11 times, and China is on more like 16 times.
But the real argument against anyone but traders investing in the Chinese market isn't really anything to do with the current price or with the various theories about how equities should or could be valued, or about the noise surrounding the political changes and economic slowdown.
Instead, as CLSA's Russell Napier pointed out to me this week, it is about something more fundamental the usual measures don't hold good because the things listed on Chinese exchanges aren't proper equities. An equity is a real share in an asset that you hope represents growth in the productive part of an economy and a share that entitles you to all the rights that come with owning that asset.
But if you buy into a market such as China's where the vast majority of shares are state-owned (about 80% of the market), that is not really what you are getting.
As one long-term China bear noted this week, "what is a Chinese bank but a branch of the Ministry of Finance which makes non-performing loans to state-owned companies, some of which are funded with equity sold to foreigners?" Quite. Own the Chinese market and you just don't have the same kind of effective ownership as the word equity' suggests you should, something that surely makes most of our theories on valuation more or less irrelevant.
It is also worth noting that state control matters more than usual at the moment. Why? Inequality, the corruption that causes inequality, and the new focus on both in China.
In the West, if governments want corporates to distribute more of their profits to labour (which they surely do) they have to beg, legislate or take the money in taxes and redistribute it themselves. In China, the government (old and probably new too) can work to smooth things a little with a firm endorsement of fast-rising wages, something it can directly deliver via its ownership of the corporate sector regardless of whether the small pool of private shareholders agree with the policy or not.
That obviously suggests a state-sponsored squeeze on profit margins, says Napier. The other obvious risk to bear in mind is that the Chinese government probably doesn't want to own most of the market forever, so we can surely expect it to sell parts of the various stakes it holds whenever prices rise.
As I've written before, in turbulent times you need to invest as far away from anything controlled by government as you can. Stocks owned by the state and listed in a command economy are too close to government for comfort.
This article was first published in the Financial Times
