A bartender at my neighborhood pub recently asked me how the Shanghai stock market was performing. I said it was at about 2,600 points. He jumped and said, “No! The Communist Party wouldn’t let that happen.”
He spent the next 10 minutes trying to convince me that the Communist Party would make the market rise to 8,000 in the next three to five years.
“Look, the Hong Kong market is at 20,000,” he said. “Shanghai at 8,000 would be very reasonable.”
China’s stock market involves more investors than any other market in the world. There are 124 million brokerage accounts. From what I can gather, the collective enthusiasm of the investing community is still quite strong. The market capitalization is small at 53 percent of gross domestic product and 31 percent of money supply. Prices are at a historical low of 2.5 times book value. Why is the market still going down?
When the central government introduced tightening measures for the real-estate market, many were hopeful the money would flow out of property into the stock market. A popular yo-yo theory says money travels only between property and the stock market, never anywhere else. The property market hasn’t dropped much, while the stock market is down 20 percent.
Politics and liquidity drive China’s stock market. Neither is favorable. Though the government desires a soft landing, the bubble debate over the property market is over: Tightening is the consensus. The question is speed. When the government squeezes liquidity in the property market, it inevitably decreases it for the stock market. Both markets lose.
The stock-market pain isn’t just collateral damage. Real-estate price appreciation is the biggest source of profit for businesses, especially in the financial industry. The total stock of properties, work-in-progress, and land banks may exceed three times GDP in value. When the price rises 20 percent, the gain is 60 percent of GDP.
In a normal economy, corporate profit is about 10 percent of GDP. When capital appreciation is six times that, businesses try to play financial games to turn appreciation into accounting profit. When property prices stop rising, or even fall, very profitable companies suddenly become unprofitable.
The state-owned banks are lining up for mega fund-raising of as much as 500 billion yuan ($73 billion) in the stock market. While two-thirds is supposed to be raised in Hong Kong, one-third is still a lot for the A-share market on the mainland to bear. About 456 billion yuan was raised in all of 2009.
Banks are normally profit machines. But in one day they can lose it all. A good moment to buy bank stocks is right after a banking crisis. But when lenders are trying to raise so much capital to prepare for a property-market correction, it may not be the best moment to purchase shares in banks.
Valuations have never presented a strong case to enter China’s stock market. They are now getting there. The current price-to-book ratio isn’t cheap, but it’s reasonable by international standards. I advise you not to pay too much attention to price-earnings ratios. Asset bubbles can distort them so much. The decline in valuation, however, may just be part of a normalization process.
For a long time, China’s stock market behaved like an Internet stock with a small free float. The recent reforms have made all the shares liquid. Maybe China’s valuations are becoming normal because stocks aren’t valued by off-market trading at a discount anymore. It is a sign of progress. The conclusion: The Shanghai market won’t head back to its record of almost 6,000 points anytime soon. That will disappoint many.
Rich people aren’t in the stock market anymore. They are in the property market. An overwhelming majority believe real-estate prices only go up, not down. The people in the market today have no recollection of the market crash of 1997.
The stock market, on the other hand, experienced a crash in 2007-08 -- from 6,000 points to less than 1,700 in one year. Those who can afford to play the property market find the stock market a bad place to be. This is why real estate has kept booming since 2007, while equities have been struggling. Of course, when the property market drops like shares did in 2007, the stock market will be treated more fairly.
Stock-market investors in China often can’t afford to enter the real-estate market in big cities. They wish to get lucky, make enough money, and move on to the property market. This force caps the market upside, but not the downside.
My bartender finally asked me to recommend a stock. He said he had 70,000 yuan and wanted to make enough money to buy a car.
“I can’t buy a car with my wage income,” he said. “Look at how hard my job is. But, if I make 200,000 yuan in the stock market, I can buy a nice car.”
As long as property prices don’t collapse, ordinary investors can forget about getting free lunches and new cars from the Chinese stock market.
(Andy Xie is an independent economist based in Shanghai and was formerly Morgan Stanley’s chief economist for the Asia-Pacific region. The opinions expressed are his own.)
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