JPMorgan Chase and BlackRock disagree about China's stock bubble. The former says last week's 13 percent share plunge is a reason to buy; the latter sees things "deflating quite rapidly."
So who's right? JPMorgan is correct in the very short run. President Xi Jinping's government has fueled China's bull market and it will do all in its power to sustain it. But in the months ahead, the odds favor BlackRock's take, which is based on the Warren Buffett school of financial analysis.
"The tide is going to go out, and there’s going to be a lot of people without their swimming trunks on," strategist Ewen Cameron Watt of BlackRock told Bloomberg Television, borrowing from Buffett's observation about investors caught swimming naked when markets get shaky.
Considering the sudden wave of sell orders in Shanghai and Shenzhen, we're about to witness a surge of investors caught skinny dipping. The math behind Chinese stock markets' more than $6 trillion surge over the past 12 months makes less sense by the day. Shares on mainland exchanges are trading at an average of about 256 times reported earnings, making China's market mania of 2007 look rational by comparison.
The question is, can Beijing put a bottom under history's biggest equity bubble? As JPMorgan strategist Adrian Mowat sees it, "policy makers will step in if the market correction gets beyond a comfortable level. I would imagine if the correction continues [this] week you will hear something reassuring." He's not necessarily wrong for the moment. China will indeed throw everything it has at the market: central bank rate cuts, tweaking margin-trading rules, slowing the pace of initial public offerings, talking up share prices, you name it.
What is wrong, though, is the belief that China can prevent the crash of a market already defying the most wildly optimistic of economic scenarios. Beijing can't do it anymore than Tokyo could in 1990, Seoul in 1997 or Washington in 2008.
China is reaching the limits of its ability to prolong a rally that turned 928 days old Friday. Beijing has encouraged companies to pursue splashy IPOs in order to sustain the excitement on stock markets, and lure Chinese households to open trading accounts. The thought is that if average Chinese feel wealthy, they'll buy into Xi's vision of a "China Dream" and the legitimacy of the Communist Party.
But the market bubble has grown to unsustainable proportions. The median stock, for instance, has a price-to-earnings ratio of 98, while the Shanghai Composite, which has a heavy weighting toward low-priced bank shares, is valued at 23 times. The reason bank shares are so depressed, of course, is China's dueling bubble in debt. China has $28 trillion of public and private debt; then there's the unprecedented $363 billion of margin debt that's supporting shares.
It doesn't help that China's economic fundamentals have turned for the worse. As Bloomberg Intelligence analyst Kenneth Hoffman detailed in a report Friday, Chinese demand for steel is collapsing. On June 18, Bloomberg's steel profitability lost $37 per metric ton, hitting a record low. Chinese manufacturing activity, Hoffman wrote, could be in for a "major decline," even if Beijing ramps up its stimulus programs.
That may explain the breadth of last week's selloff. Among 10 industry groups in the CSI 300 Index of the biggest Chinese shares, technology, phone and industrial companies plunged most -- at least 15 percent. The ChiNext Index of small-cap stocks slumped 5.4 percent on Friday alone, extending losses to 17 percent since a record high on June 3.
The selloff suggests China's stimulate-growth-via-stocks plan may be approaching an endgame. The government will surely try to backstop the market: Xi needs to maintain the aura of Chinese government omnipotence. But there will come a time when the tide turns and the market gets away from Beijing, proving that the world's most exciting stock rally has no clothes. It may soon be upon us.
This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.
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