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.