"Wu Li Re Xin" - Irrational Exuberance in Chinese

Investors have become giddy over Chinese stocks, reminiscent of their collective enthusiasm for Tech stocks famously crystallized by Alan Greenspan as “irrational exuberance.” Then as now investors seem to be convinced that the old measures of value simply no longer apply.

Back then the justification was that the “new economy” heralded the start of an era of unprecedented growth, particularly for Tech stocks, and so earnings no longer really mattered, at least for the foreseeable future. Today we constantly hear about how the Chinese economy—and virtually everybody else for that matter—won’t be affected by a potential slowdown in U.S. economic growth.

Yes, yes, we know: the size of the U.S. economy relative to the rest of the world isn’t as large as it once was. And maybe it’s even true that should U.S. demand for China’s exports slacken it can be replaced by domestic consumption from China’s millions of new middle class consumers.

But then as now, valuations do matter. And that’s where Chinese stocks run into trouble. After rising some 200% in just the past two years, stocks in the $8 billion iShares FTSE-Xinhua China 25 fund (FXI) are now trading at a whopping 26.0x forecast 2007 earnings, compared with a price-to-earnings ratio of 15.9x for stocks in the iShares MSCI Emerging Markets index fund (EEM).

Presumably, rational investors are anticipating far better earnings growth for that kind of premium valuation. But in reality there is very little to support that multiple. Over the past five years, companies in FXI have delivered compound annual earnings growth of 26.8%, compared with a rate of 26.3% for companies in EEM—essentially a rounding error. What’s more is that both this year and next, EPS growth for FXI is actually expected to lag that of EEM (Figure 2).

Further, some investors may be surprised to find out that, unlike EEM or the S&P 500, the China 25 index doesn’t include any Tech stocks, but rather is dominated by the Financials, Energy, and Telecom sectors (Figure 3)—all sectors that would typically garner a low P/E ratio elsewhere.

Think about it: U.S. Financial firms let credit standards slip and make some bad investments; they get hammered as a result. Meanwhile Chinese banks—all models of prudent lending, of course—trade a nose-bleed level of 31x 2007E EPS.

Greenspan was right, of course, when he made his now-famous comments back in 1996, although the bull market still had another four years to run. We honestly have no idea if the current bubble in Chinese stocks is akin to 1996 or somewhere further along; it was 1998 that the S&P 500 first surpassed a P/E ratio of 23.5x twelve-month forward earnings, where FXI currently trades. All we can say for sure is that when the bubble ends it won’t be pretty. Now, what’s the Chinese translation for Alka-Seltzer?

Comments

[rlirph]

Thank you for a brilliant analysis using the traditional investment parametrics on emerging markets. I definitely would prefer to have more people like you to scare people not to invest in China. However I do appreciate that there should be more of you so that the valuation would be lower.

Many people with this outlook must think Bank Of America or Citigroup are idiots, investing US$1 billion in Chinese bank called Guangdong Development Bank and China Construction Bank. Except after two years both investments have tripled.

Another example is Alcoa $200 million investment becomes $2 billion in several years. Or take Warren Buffet's PetroChina investment which went up 7x already. But no one even talks about his stake at China Life or the more recent IPO's.

Americans like to talk about bubble because that is what we had in 2000. The difference was that back in those days, AOL, Amazon, and eBay companies made little money. You can not compare those companies with China Mobile or China Life. You should compare the internet more like China Digital TV(STV).

Did you know that with any emerging market there was a period of several years which the stock market went up several times in a few years? The same thing happened in Hong Kong, Japan and
Taiwan. With rapid appreciation occasional pullbacks are necessary.
Except with huge gains, the correction will also be big.

I have moved from LA to China for nine months. Unless you are here to see and feel the economic expansion, I suggest that one should stop using the traditioanl western parametrics (which was designed for developed markets) on emerging markets such as those in Asia or Russia or Brasil.

[evilll]

I just want to point one difference between the U.S. and China: China's saving rate is about 50% of the GDP. The US: about zero. As more and more Chinese people realize that their savings actually have a negative return after adjustment for inflation, more and more money will be pumped into the stock markets (A shares or in the near future, H shares) or real estate, or precious metals, or any "hard" asset. You will be surprised how much money the Chinese people have saved in banks. And even now, only a small percentage of that is in stock markets. The endless supply of money combined with the casino mentality of the Chinese people will propel this bubble to unprecedented level. So refrain from calling a top any time soon. In the mean time, I would suggest allocate some of your money to FXI and ride the wave for a year or two. I would not be surprised to see FXI at 250 by the end of 2007.

[jerry parker]

i can't stand it when i read caucasians write about china like they're experts. when will the smart people figure that "one day" china will stop being thought of as an "emerging country or economy." china size and growth rate will dwarf most of europe and this world's countries. why not compare china's p/e to US's 2008? in fact, let's also compare it to other developed countries and then factor in the growth rate. china has both the domestic consumption growth as well as export growth...who else has that critical mass on both? as far as i'm concerned, MSCI is similarly non-thinkers who are driving forward while looking in the rear view mirror. my $.02.

[ETFResearchCenter]

Being caucasian has nothing to do with it; shame on you for suggesting otherwise. I've spent quite a bit of time there and do not dispute the county's impressive economic growth record or its prospects, as I stated above.

However, the value of a stock is determined by many things other than the economic growth rate of the country where it is listed. My analysis was a look at the numbers as they are: the valuations accorded the stocks in relation to profits being produced.

To conclude that stocks are overvalued is a judgment call--ultimately I may be right or I may be wrong--but is not an indictment of the country, it's people, or its growth prospects. It appears that your pride has prevented you from telling the difference.

[Hua]

I am a Chinese and I searched to see how Irrational Exuberance was translated by mainstream media in China, because the translation offered doesn't sounds right. Here is what I found, there is a book by Yale professor Robert Shiller in 2000 called "Irrational Exuberance", it's title was translated as "非理性繁荣", you need Chinese GB2312 font to view this, it is pronounced as Fei Li Xing(Irrational) Fan Rong(Exuberance).

The translation offered in the article is more casual and amateurish, while the mainstream one is more academic/arcane. It matches the greenspeak. And it is the widely accepted translation. Whenever you say Fei Li Xing(Irrational) Fan Rong(Exuberance). people know it's a quote of Greenspan referring to the late 1990s stock market. actually it is coined almost just for that Greenspeak quote.

Wu Li means "no reason", it is usually used in phrases like "causing trouble for no reason"; while "Re Xin" is "warm hearted", usually used in phrases like "be warm hearted to help others", it is strange to native speakers to see these two words are put together.

[ETFResearchCenter]

Thanks for the correction. I know it was a clumsy translation, but the best I could do on short notice with only a few years Chinese language training under my belt. But thanks just the same...now I know.

[Hua]

I am a Chinese and I searched to see how Irrational Exuberance was translated by mainstream media in China, because the translation offered doesn't sounds right. Here is what I found, there is a book by Yale professor Robert Shiller in 2000 called "Irrational Exuberance", it's title was translated as "非理性繁荣", you need Chinese GB2312 font to view this, it is pronounced as Fei Li Xing(Irrational) Fan Rong(Exuberance).

The translation offered in the article is more casual and amateurish, while the mainstream one is more academic/arcane. It matches the greenspeak. And it is the widely accepted translation. Whenever you say Fei Li Xing(Irrational) Fan Rong(Exuberance). people know it's a quote of Greenspan referring to the late 1990s stock market. actually it is coined almost just for that Greenspeak quote.

Wu Li means "no reason", it is usually used in phrases like "causing trouble for no reason"; while "Re Xin" is "warm hearted", usually used in phrases like "be warm hearted to help others", it is strange to native speakers to see these two words are put together.

[HeadlineWhore]

Wow! You've heard it here first, an analyist is calling China a bubble.

[J.D]

Coming up on four years in China for me and the whole economy feels like a bubble. In a society where information is actively manipulated, stats are questionable, transparency is low, duplicity is high, and analysis is built upon partial facts and big assumptions it's only a matter of time before reality sets in. Smart money arrived a long time ago, the upside is currently limited and downside underestimated. No wonder Buffet's selling. And that savings? Better take a closer look if you think it's money in the bank. Think infrastructure and real estate development by state-controlled companies (aren't they amazing at generating profits - new paradigm?). Those companies getting a good return on their hefty stock market investments for now, but are turning the bubble market into a pyramid. Hey, the stock market - bastion of capitalism that it is - is 80% government controlled companies. Time to cash in and re-assess when the dust has settled.