Credit Suisse: Chinese Markets Are a Replay of the Late ’90s Booms

And the dot-com bubble

Trading Chinese stocks must be stressful.

Photographer: Qilai Shen/Bloomberg

Investors are flipping through old playbooks for stock market swings that most closely mimic the stunning surge and subsequent steep drop-off in Chinese equities over the past year as they attempt to guess where shares are heading next.

Tom DeMark, founder of DeMark Analytics, thinks the Shanghai Composite will tumble to 3,200 in short order, mirroring the Dow Jones Industrial Average’s sharp descent in 1929 that heralded the start of the Great Depression.

Credit Suisse, however, believes the late 1990s and early 2000s are the period of financial history that rhymes the most with the current boom-and-bust in Chinese equities—if not precisely by price action, then certainly by theme.

The rally in the Shanghai Composite index around the dawning of the new millennium, notes Credit Suisse's head of China research, Vincent Chan, “was widely seen as supported by the government, as a means to support the SOE [state-owned enterprises] reform at that time.”

The market sold off sharply in the second half of 2001 after the government announced it would be unload shares of state-owned enterprises. Although Chinese authorities made many attempts to bolster the market in the years that followed, these moves were largely ineffectual until nontradeable share reform was completed in 2006.

“The A-share market remained stagnant, probably due to a significant loss of public confidence after the failure of the government-driven bull market,” writes Chan.

This time around, the China Securities Regulatory Commission pledged that it, along with the China Securities Finance Corp., would continue to provide support for the market on the heels of the Shanghai Composite’s worst loss in more than eight years on Monday.

Though government support is a common thread running through the Chinese rallies of the late 1990s and the mid-2000s, the anatomy of the recent surge in Chinese stocks, as well as the macroeconomic backdrop, also strongly resembles the U.S. dot-com bubble.

“Similar to the US then, the Chinese economy is rather weak now and monetary policy is loosening,” explains Chan. “With abundant liquidity in the system, but no strong economic and earnings growth, investors turned to concept stocks (such as Internet+ and One Road One Belt) which are mostly small-cap stocks driven by concept, and earnings played a much smaller role.”

You can see the parallel in the below (log) charts. Large-cap stocks underperformed the tech-heavy Nasdaq while the dot-com bubble was inflating …

Screen Shot 2015-07-29 at 9.13.20 AM

… and the same has been true during China’s equity boom.

Screen Shot 2015-07-29 at 9.17.26 AM

Meanwhile, Chan points out that China's Nasdaq-style index, known as ChiNext, is still trading at lofty levels compared with the broader CSI 300.

“Also, while CSI 300 is trading at a reasonable P/E (and did even during the peak of the cycle), ChiNext is trading at bubble valuation even after the correction.,” he saus. “Therefore, looking ahead, the experience of the downturn during the internet boom/bust cycle could recur, i.e., CSI 300 could significantly outperform ChiNext ahead.”

Setting stock market parallels aside, the big question now is whether the plunge in equities will cripple the Chinese government’s quest for 7-percent growth in the future.

In a separate note, Chan observes that the financialization of China's economic growth is evident in the GDP figures from the first half of 2015.

“A sectoral breakdown of China’s first-half 2015 GDP revealed that the booming financial sector (+17.4 percent year-on-year) is crucial in keeping GDP growth at 7 percent,” he writes. “If the growth is normalized to around 10.4 percent, first-half 2015 GDP growth would only be 6.4 percent.”

The meteoric rise in transactions has been the key contributor to the financial sector’s growth, Chan reasons, and this torrid pace is likely unsustainable.

Screen Shot 2015-07-29 at 10.27.42 AM
Credit Suisse

Says Chan: “Even if the market can stabilize after the crash, the turnover growth will likely slow down sharply, and from a high base, the financial sector GDP growth momentum could reduce significantly, particularly from the fourth quarter of 2015 onwards."