Investment Risks - China And Market Valuations

by: Kevin Graham

The students of Columbia Business School publish an investment newsletter entitled Graham & Doddsville. I was reading the winter issue on Saturday night and I came across an interesting comment by Jim Grant, publisher of Grant's Interest Rate Observer. Grant has been commenting on the credit markets since 1983. Here it is.

Graham & Doddsville: Given the current state of the economy and the low interest rate environment, it sounds like you perceive risks that others do not. What facts, measures, or indications bother you most?

Jim Grant:

Here's a fact: China's banking assets represent one-third of world GDP, whereas China's economic output represents only 12% of world GDP. Never before has the world seen the likes of China's credit bubble. It's a clear and present danger for us all.

And here's a sign of the times: Amazon, with a trailing P/E multiple of more than 1,000, is preparing to build a new corporate headquarters in Seattle that may absorb more than 100% of cumulative net income since the company's founding in 1994.

Now, there are always things to worry about. Different today is the monetary policy backdrop. Which values are true? Which are inflated? In a time of zero percent interest rates, it's not always easy to tell.

The risks in China have not gone away. Here is an update on why.

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As I have written before, defining risk is the most important aspect of investing. Risk is not volatility, risk is permanent loss of capital. The risks of the real estate bubble in China are huge and is a real reason to be defensive.

Once this bubble in China bursts, Canada will not be spared. We avoided the recession of 2007/2008 because of high commodity prices.

A lot of commodities were used to build 50 Manhattans between 2008-2012. At the current pace in China, they could build 1 billion housing units in roughly 16 years. I don't know how many housing units there already are in China but the math doesn't appear real good.

Once commodity prices collapse, Canada will have its recession.

Market Valuations

As Friday April 17th, the Price to Earnings (P/E) ratio of the Russell is now over 100x based on trailing earnings.

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To see current data, click here.

I read elsewhere that nine companies in the Russell 2000 index have a P/E ratio of over 1000x. Better yet, 1/4 of the companies in the Russell 2000 don't have any profits and so far this year they have outperformed the profitable companies by a three to one margin.

I often wondered why Fairfax shorted the Russell back at the 661 level, roughly half the current level. I don't wonder any more. This market is completely irrational.

Disclosure: Long Fairfax