Red-chip bubble dTja vu all over again?
The A-share price correction that started in October 2007 resembles the bursting of Hong KongÆs Red-chip bubble between 1994 and 1999 (Chart 1). The correction has been aggravated recently by Beijing's sluggish response to the share price decline, which has dashed hopes of any fresh bailout measures. The authoritiesÆ pledge to keep a tightening policy bias to fight inflation is also hurting market sentiment. Meanwhile, concerns about a worsening global environment hurting Chinese growth have raised Chinese policy risks, and thus weighed on market sentiment too.
Market close to long-term trend
Economic and statistical indicators suggest that the Shanghai A-share index is trading close to its long-term trend line. The A-share index surged through the two-standard-deviation overshoot territory last October and has since been reverting back towards its long-term mean (Chart 2). A further drop in the index will bring it below its long-term trend. There is a strong economic rationale for this mean reversion tendency. From a long-term perspective, the stock market is a claim on the countryÆs underlying economic growth. Thus, GDP growth determines the return on equity, generally. Despite cyclical volatility and short-term swings, the equity market will eventually revert back to its intrinsic value which is determined by the underlying economy. Whenever the market runs significantly ahead (or behind) of fundamental justification, it will come back down (up) eventually (Chart 3).
Further, A-share valuations are no longer ultra-expensive. The Shanghai A-share average trailing PE ratio has fallen back towards its long-term mean (Chart 4). A 20% fall from the current 36 times will take the trailing PE ratio down to one-standard-deviation undershoot level.
The government factor
A further decline in A-share prices will make the authorities jittery about potential social implications. The number of retail stock investor accounts has grown exponentially in recent years (Chart 5), numbering 130 millions in 2007 or 22% of total urban population. Despite the market disappointment about the lack of new bailout measures recently, Beijing has indeed been rolling out measures, albeit gradually, to stabilise the market. In an attempt to slowdown the supply of equities, the authorities have slowed the process of large public offerings. On boosting demand, they have begun approving new investment funds applications and cut income taxes for money managers. Although this kind of government intervention will not have any real impact on the long-term market valuation, they could give the market a confidence boost in the short-term. The recent problem is that market expectations on bailout measures have been unrealistic.
The strong long-term fundamentals behind Chinese stocks are still intact. With improved market valuations and continued, albeit slower, profit growth, most of the A-share price decline is probably behind us. However, price undershoot is still possible in the short-term, due to domestic and external financial, growth and policy uncertainties. Buying opportunities will emerge in the months ahead.
Chi Lo is a research director at Ping An of China Asset Management (Hong Kong).
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