Is the Chinese Stock Market Party Over?

Investors seem to have forgotten the global equity sell-off in late February which was triggered by the 8.8% plunge in Shanghai Composite Index. This index, which tracks shares listed on the bigger of China's two stock markets, has risen since that day by 128%, or an incredible 117% year-to-date. Since the market is largely closed for foreign investors, it survives the credit crunch issues that hit the U.S. The government's efforts to slow down stock market investments through five interest rate hikes this year also seem to be inadequate. In a negative interest environment amid high inflation and low Chinese bank deposit rate, people have shifted to the "continuously rising" stock market in pursuit of higher returns. Unlike the U.S., the stock market in China is dominated by individual investors, which accounts to about 70% of trading. Moreover, Merrill Lynch estimated that only about 22% of Chinese financial assets are in securities, far less than the U.S.'s 52% level. Further investments in securities can push the stock market even higher- especially in a country that has a 50% savings rate.

However, the major concern in investors' mind is valuation, which bears view as a sign of possible bubble. The Shanghai Composite Index is currently trading at a price to earnings ratio of 60 times. The prices of Hong Kong-listed H-shares have also soared since the government announced a pilot scheme that would allow mainland retail investors to buy shares in Hong Kong stocks, narrowing the gap in price to earnings valuations between China- and Hong Kong-traded shares of the same companies, BusinessWeek reported. Following this uptrend, valuation of many American Depositary Receipts of these corresponding Chinese companies have also becoming out of whack. Legendary investor Warren Buffett had also sold all shares of Chinese oil conglomerate PetroChina (PTR) based on valuation. My favorite blue-chip telecom company China Mobile (CHL) also looks quite expensive now as it is trading at about 25 times forward earnings. Speculators have also been pouring into Chinese small cap stocks that don't even have earnings yet. In addition to valuation, some analysts are cautious about Chinese companies' earnings quality. According to Shanghai Wind Information Co., profits in Chinese listed companies grew 74% in the first half of this year- but some 38% of total net income was from companies' own investment in the rising stock market- not from operations! Should the companies fail to deliver earnings growth relative to expectations, the stock prices are poised for a major correction.

Another issue that investors should be aware of is financial transparency. One example is LDK Solar (LDK), a solar-power company that was recently sued by shareholders as a former controller accused the company of improper accounting. For those who are thinking to take profits from their Chinese stock holdings and those who are looking for another way to profit from the country's growth, I recommend investing in quality international companies that are doing a lot of business there, particularly in energy, mining, agriculture, infrastructure, and consumer sectors.

Disclosure: none