Shanghai's Own Stock Market Rules

When I first moved to Shanghai in 2004, I was told by a lot of old China hands that “Shanghai is not China”. That saying has been true for most of the 150 years that Shanghai has existed. She has always been China’s gateway to the rest of the world and was usually allowed to play by her own rules. The same can also be said about the Shanghai stock market - it too seems to play by its own set of rules, though these rules seem to be more about second guessing the intentions of the Mandarins in Beijing.

When I first came to Shanghai, the equity markets were in the doldrums after one of its typical boom bust cycles; the market had sat in a narrow trading range for many months and no economic news, no matter how positive, could seem to make the market move. The market had become weighed down by the overhang of millions of state-owned shares; almost all of the listed companies had at one time been a state-owned entity. When they had gotten their initial listings, they had issued freely tradable shares but had kept back the majority of shares in the government’s hands. These shares were not tradable, but the government started to make noises about freeing these shares to trade.



This made investors very reluctant to buy shares, even in companies that were showing very good revenue and earnings growth. The thought of having a wall of previously state-owned shares hitting the market kept investors away. It took a couple of years of effort by the government, such as cancelling some state-owned shares as well as giving additional shares to private investors, to sort this out. This exercise just reinforced in the minds of investors that the performance of their investment portfolio rested on the whims of the Mandarins in Beijing.

The Shanghai stock market is once again waiting for the Mandarins. This time, investors are waiting for the government to intervene to prop up a falling market. Since it began its long decline in November of last year, the rumor had gone around that the government will ride to the market's rescue because this was the year of the Olympics and the government would want to avoid any unrest. Many grimly hung on to their stock positions as the market began its long decent, believing that the government would intervene. The Olympics are almost over and they are still waiting. Very soon, perhaps during the closing ceremonies, it will dawn on them that there will be no rescue this time. This will be when the market finally accepts reality and will reach its bottom.



At current valuations, the Shanghai Composite Index has an average P/E ratio of 19. Now this may not sound particularly high for an economy that is expected to grow at 8.6% this year, but you should bear in mind that between 2004 and 2006, when the Chinese economy was growing at 11% +, the Shanghai Composite's average P/E ration never exceeded 13 times earnings. It’s reasonable to assume that when this market does finally bottom, it may well be trading at a low double or high single digit P/E.

In the developed economies, having growth rates of 8% would mean a stock market boom, but having growth slow this much in China is going to have a significant impact on many companies. Many firms operate their businesses on razor thin profit margins; they rely on constantly growing their top line to support their business model. With growth slowing from double digits, many of these companies will no longer be able to maintain profitability and some will simply go out of business.

A period of consolidation is what this market requires. As a number of competitors fall by the wayside, the survivors will be rewarded with greater pricing power in a less cut-throat competitive environment. This process will not happen overnight; in fact, it may take a couple of years, so don’t expect the post Olympic capitulation to usher in a new bull market.

In Shanghai, they play by their own rules. In all likelihood, this market will sit range bound for sometime, ignoring good economic news as it did in the past, until the government changes the rules and sends it soaring again to unrealistic levels. Though this is the main market of the world’s second largest economy, it is still very unsophisticated. It is driven more by rumors of government interventions than by any economic fundamentals.

Disclosure: none

Comments

[JudeJin:]

i think you no longer live in shanghai. if you do, you'll be worried about the popping of the real estate bubble. the stock market is still overvalued because:
1. there's an ongoing nationwide bust of the real estate bubble; many of the big name homebuilder's debt are trading at junk spread. we'll see a couple of them go belly up soon.
2. banks of course will be saddled with bad debts from the real estate sector.
3. concentrated unlocking of huge amount of shares are flooding the market after the "success" of the full-float stock reform. many garbage stocks will drop 80% from where they are now.
4. many stocks are still trading 30%+ premiums to their H shares listed in HK.
5. millions of mutual fund newbies bought when the index was in 4000-6000, now they are under water by 40-50%.
6. we're still far from the bottom in the US housing and stock market
7. if HK properties collapses and HK stock market goes down further, they add more downside pressure on china's properties and stock market. a lot of high-end condos in shanghai are bought up by investors from HK.

conclusion: china's stock market has a lot more downside than many foreigners think possible. be patient, you'll be able to get in when it reaches 1000 again.

2008 Aug 24 10:05 AM

[Poohbear:]

Many westerners have too shallow understanding of China. The believers of “Shanghai is not China” obviously still live in 100 years ago when Shanghai was an international colony. How can Shanghai Stock Exchange "set its own rule" when majority of both listed companies and buying powers are from other parts of China outside of Shanghai?

2008 Aug 24 05:02 PM

[Shareholder...:]

Interesting stuff. We're not entirely agree though. The authorities are very well aware of what a slowdown could bring (many of these rapidly growing Asian economies are like 'bicycles', if they slow down they'll fall over), and they have already switched gears, as we argue in a comment too long to post here, but you can read it here:
shareholdersunite.com/...

2008 Aug 24 09:36 PM

[User 250263:]

the market is fueled by the confidence, in china it is even more obvious. whatever you do is right in bull market and whatever you do in a bear market for sure is wrong. no doubt shanghai is in its bear season but how bearish it is or it will be really depends on party leaders' advisers or shadow cabinet. and these small group of people represents a sophisticated colonies back by western and chinese institutions.

2008 Aug 24 11:39 PM

[JudeJin:]

people don't understand party leaders actually don't have control over the "market".
the "market" takes advantage of government policies.

in the beginning of 05, the government signaled tightening on real estate and started the so called full-float stock reform. back then, your favorite merchant bank is trading at 5 RMB/share(right now it is still over 20 RMB/share, 4x p/b), about 1x p/b, 10x p/e.

smart money naturally diverted some of their windfall from real estate
to the stock market.

the reform required the locked-up shareholders to pay compensation to the float holders in order for them to get unlocked. since the float was so little and so cheap, smart money rushed into the stocks to get the windfall compensation. on average, 10 float shares got paid 3 shares(some by cash) by the locked-up shareholders. so they pushed the stocks about 30% before the payment and crashed down 30% after the payment. but after a while, the market started to forget about selling down 30% after the payment because the market started to really like the stocks.

because the economy was still in a nice up swing. so earnings kept going higher. so the market went up from 1000 to 4000.

the stupid government raised stamp duty tax to stop the mania at 4000. the market crashed, but people who haven't missed the boat couldn't stop imaging the windfall their neighbors got, so more peopled lined up to buy the mutual funds. the stupid government approved a lot of mutual funds after the crash caused by the stamp duty hike. but i think even without these mutual funds, the market would still be pushed up by retail buying because the float was still very limited. smart money had mad 5-10 times profit. the market was in full control.

so the market reached 6000 in october. as 6000 made some big institutions and smart money very dizzy, some chose to leave the market. at the same time, unlocked shareholders who promised 1 or 2 years additional lockup period in the reform contract started to unlock officially one after another. thus started the viscious down cycle.

after the market broke 5000, 4000, the stupid government started to panic and cut back the stamp duty tax. but just like it didn't do the job in the boom phase, it just couldn't make any difference in the bust phase.

now the index was back below 2500, the majority of retail investors were down 50% or more. the amount of unlocked shares are still coming to the market. smart money understand that if they push stocks up, they would be the ones holding the bags for the unlocked shares.

lately the stupid government kept talking up the sentiment for no avail because
1. the real estate bubble is finally popping; banks and steel stock look cheap on P/E. but nobody dare to buy them.

2. 50% of stocks are still very very expensive, trading at 50x P/E. stocks are still trading at over 30% premium to their H shares listed in HK.

3. unlocked shares are still coming to the market.

4. smart money wants an absolute safe price to get back in again.

5. retail investors have very little money left to put back into the money.

6. people that do have money are scared of the market.

if you think the government can pull off another bull run, you'll totally be mistaken. (unless the government wants to buy up the shares itself, that's not gonna happen!)
nobody dictates the market. the market takes advantages of the situation.

2008 Aug 25 07:19 AM

[JudeJin:]

the unlocked shareholders have waited 10 plus years for the day to sell, especially those holding over valued garbage stocks. the garbage stocks have 80% more downside from where they are now. garbage stock-heavy shenzhen index has 50% more downside.
mark my post.

2008 Aug 25 07:56 AM

[Poohbear:]

JudeJin
You have much thorough understanding about Chinese stock market than Mr. Roxburgh has.
In my opinion the biggest risk factor of Chinese economy is the very overvalued housing market. It could have effect on both domestic and global economy, for example, it could cause a serious bear market for commodities.

2008 Aug 25 01:27 PM

[Think-About-It:]

Let's assume at market PE of 19 is "too high", there are many junk companies and over-priced stocks, plus the FXI will fall some more or be range-bound for a couple of years. So what?

Would any of these facts prevent someone from making good returns investing in high-quality reasonably priced Chinese stocks? I think not. Unless I'm missing something big, there appear to be many Chinese stocks trading in the US that are attractively priced vs their growth prospects and balance sheets.

Additionally, China is assending (in many ways) so over the next 10+ years the wind will more often than not be at your back. Where as, in some more "respected" markets (like the U.S.) I think you are investing into a head wind over then next decade or so.

2008 Aug 25 03:43 PM

[eid:]

Disappointing comments. I would have thought the article could have been more informative and told us about the RULES. That was what the article was headed but alas we got a little dribble about the downturn since October last year and political intereference. Well how reliable are the results, how often do companies report, and what organizations like the SEC exist if any. Well I suppose we will need to wait until an article is written about the rules to know.

2008 Aug 25 04:15 PM

[User 142738:]

eid: The most referenced rule is that you are not permitted to short-sell stocks in Shanghai. It makes you wonder if the Shanghai composite would have fallen further if short selling (not necessarily “naked” short selling) were permitted.

2008 Aug 25 07:27 PM

[bigswing:]

Biased article. The Shanghai market is not driven by "mandarines in Beijing" as you stated. But, as in many other markets in the world, primarily by ordinary investors sentiment. If Shanghai market had rose from 1200 in 10/2005 to 2400 today, it could have been a very sound ride.(healthy gain of 100% in less than 3 years). Unfortunately, the market went through a mania stage in 2007 despite repeated professional as well as government warnings of "market bubble". Millions of naive buyers got excited and push market way too high (to 6000 in 10/07 and up 400% in 2 years). It was normal to see the frenzy was subsided and market dropped 60% since then.

The current Shanghai market shares are reasonably priced. Whether the market is bottomed or not and when it will start to move up again, that is totally depends on investors sentiment (Remember there are lots of cash among Chinese investors due to extremly high savings rate of 30% of their earnings). If they loss their confidence, the market will not be UP no matter how cheap they are or whatever govt policies trying to push it up. If ordinary investors gain confidence, the market will come back any time.

2008 Aug 25 11:59 PM

[lonie:]

Take Jude Jins' comments seriously . He is correct .

2008 Aug 26 12:20 AM

[JudeJin:]

i'd add one more perspective. if you look at chinese companies listed in hk, you might be tempted to think they are cheap because average p/e is around 15. but i beg you to examine the "e" a little more careful.

china life for example, in spite of a fall from 60 to 25, is still up 150% from about two years ago. i suggest you to examine its earnings history to see whether this company has suddenly improved its business by 150% for real over just 2 years!

the best growth period of china mobile is over. so watch out from below for china mobile too.

i bet HK will go to 15000, china mobile 75, china life back below 20!

2008 Aug 26 10:02 AM