On the (absurdly) weak Chinese stock market4 December, 2012, 13:19. Posted by Zarathustra
Hong Kong/China investors have certainly learned in a hard way in the past two years that the rate of economic growth may have very little to do with stock market return. However, we, as everyone else, are amazed by the weakness of Chinese stock market. It was as if even bears were not bearish enough.
While we are very notably pessimistic on both Chinese economy and its stock market in the longer timeframe, we are at the same time constantly surprised the the failure of Chinese stock market to produce any respectable bounce. This comes as an even bigger surprise for optimists as everyone seems to be convinced (much more convinced than we are, obviously) that the Chinese economy has somehow bottomed, with incoming data improving. Shanghai Composite simply does not care, while the H-share counterparts are doing significantly better in the recent months, but still underperforming the developed market for the past 2 years or so.
There have been a lot of reasons being suggested by many people as to why Chinese equities have performed so poorly. To us, the main fundamental reason remains profitability, and we are somewhat surprised that not many more people are talking about this. Companies with falling profit simply do not deserve higher stock prices and multiples. As the economy slowed and corporate profits fell for the index as a whole, it simply should not be a surprise, especial with the benefit of hindsight, that the market has done pretty badly in the past 2 years or so.
The question we get, then, is that while we have been rightly bearish on the Chinese market overall in the past two years, surely there comes a point where stock prices have fallen so much that it is finally a buying opportunity?
To that, we would point to the following chart, which should be familiar to regular readers, showing the major stock market bubbles in the past and how the market performed in the years following the burst of the market bubbles. The red line is the Shanghai Composite.
There are many reasons (which we may discuss later) that we think China is going down the path of Japan in the years to come if there is no major changes in how the economy is run. So let us say that NIKKEI 225 is a template for how Chinese stock market could perform in the very long-run. This is a very bearish view on China in the long-run, and this is certainly a very big assumption. We may change our mind in the future, but let us stick with it for the time being.
While Japan’s stock market has been in a super bear market for more than 20 years, there are in fact a few strong bull runs along the way down. In the chart below, we only show NIKKEI 225 alongside with Shanghai and Hang Seng China Enterprise Index. The horizontal axis shows the number of years away from the all-time highs of the three indices.
Note that about 5 years into the long super bear market of Japan, NIKKEI 225 rebounded very strongly, only to come all the way back down (then broke down later). Other strong bounces happened 9 years and 13 years into this long bear market, again, only to come all the way back down. In particular, the bounce 5 years into this long super bear market started on July 1995, and peaked on June 1996. In the space of 11 months, NIKKEI 225 rose 56%.
For China and Chinese stocks in the long-run, our view has not changed much. Namely, the reliance on investment across sector for economic growth produces overcapacity, which destroys corporate profit in the long-run. We are in no way looking for a sustained bull market. In a 6-12 months timeframe however, you are welcome to draw your own conclusion as to whether Shanghai Composite is due for a 50% bounce, then coming back all the way back down.