Real Cost of Chinese Stocks Dwarfs 2007 Bubble

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Chinese stocks are getting a lot more expensive than the benchmark Shanghai Composite Index suggests.

Using the most-watched mainland equity gauge as a guide, an investor might conclude that valuations are pricey, though still within reason: the index trades near a five-year high of 19 times estimated earnings -- well below the level of 36 reached during the 2007 bubble -- and in the same ballpark as the Standard & Poor’s 500 Index’s multiple of 17.

The problem with the Shanghai Composite is that 94 percent of Chinese stocks trade at higher valuations than the index, a consequence of its heavy weighting toward low-priced banks. Use average or median multiples instead and a different picture emerges: Chinese shares are almost twice as expensive as they were when the Shanghai Composite peaked in October 2007 and more than three times pricier than any of the world’s top 10 markets.

“The market rally is more fragile than in 2007,” Francis Cheung, a strategist at CLSA Ltd. in Hong Kong, wrote in a June 12 report. “With the de-rating of banks and other large SOEs that make up the largest part of the index, it is likely more accurate to compare valuation with median PE.”

The Shanghai index lost 3.5 percent at the close Tuesday, taking its decline this week to 5.4 percent.

The following four charts show how the nation’s shares compare with global markets when the influence of banks is diminished, and why there’s such a big divergence between the Shanghai Composite’s valuation and that of the typical Chinese stock.

*China price-to-earnings ratios: The median stock on Chinese exchanges trades at about 58 times projected earnings for the next 12 months, compared with 18 for the U.S. and 16.5 for Japan.

*Shanghai Composite weightings: Financial companies account for 29 percent of the index, the most among 10 sectors. Industrial companies have the next largest influence on the measure at 23 percent.

*Now versus 2007: While the Shanghai Composite’s valuation is lower than the last bubble, that has a lot to do with the outsized influence of banks.

*Bank valuations: The CSI 300 Financials Index of shares in Shanghai and Shenzhen trades at 12 times estimated earnings, the lowest level among the gauge’s 10 industry groups. Technology stocks are the most expensive at around 65 times.