Why The Bull Market In China Is The Next Huge Bubble

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Includes: CHIX
by: Lewi Ilkanaev
Summary

Economic growth in China has slowed down during the years, however there are signs of improvement in the recent months. Meanwhile markets are hitting record highs.

The stock market turnover in Shanghai and Shenzhen makes clear that volatile times may be coming earlier than we thought.

Hong Kong has challenges to handle the major capital inflows from China.

Recent developments

In this article I would like to focus on the recent happenings in mainland China. The Shanghai and Shenzhen stock markets have seen a dramatic increase over the past 12 months. The chart below shows the Shanghai Composite Index. For the first time in seven years broke through the 5000 mark.

^SSEC Chart

^SSEC data by YCharts

The economy is looking better after all. Industrial production rose 2.6% Y/Y and the official PMI rose to 50.2 in May. There is an improvement in the economy. The big system risks everyone used to talk about seem to be limited. Monetary loosening is supporting the economy and the government is moving debt off the local government balance sheets.

Volatility

China has now more stock trading accounts than Brazil has people. This number has surged dramatically during the past year. It seems that most people in China want to get on the train. It is pretty to see the euphoria in the Chinese stock markets. The trading volumes have hit a record. On a single day at the beginning of June 2015 the turnover London market was roughly $ 9bn., New York had a turnover of about $120bn. and Shanghai and Shenzhen had a record turnover of $380bn. combined. This in a single day. Obviously Beijing has made it more simple for the ordinary folks to invest in stocks, margin accounts can be opened with brokers much easier now than five years ago. Especially the mysterious surge of Hong Kong shares such as Goldin Financial Holdings, (OTC:OTC:GDFNF), or Hanergy (OTC:OTC:HNGSF) in the past weeks makes a stock market manipulation very likely. The question if Hong Kong can handle the Chinese fund inflows remains open. The Hong Kong Shanghai stock market link should have positive effects on both sides. However, regulators should need to keep the eyes open, especially when it comes to scenarios like GDFNF and HNGSF.

(Chinese stock markets are hitting records, 5th June 2015)

The reason for this irrational valuations

China has created a lot of wealth in the past two decades. From the perspective of a mainland China based investor, the most interesting place to invest your money in was real estate in China. The amount of population that has moved from rural to urban areas has been significantly high. Cities have grown to extraordinary sizes, does not matter if Tier 1, Tier 2 or even Tier 3 and 4 cities. The government policy was to create as much living space as possible, also in order to raise the living standard. Plenty of private small investors jumped on that train and purchased property, prices kept surging for more than a decade. At some point the government cracked down on property speculators because housing became not affordable in some areas, especially within some Tier 1 cities. The money that is flowing into the stock markets now comes also from the previous property investors. Chinese regulators have a tough job chasing speculators. As soon as the regulator has an eye on them, the speculators move to other places and create bubbles there. By the way there has been a big stock market bubble in Shenzhen in 2007 already. The index tripled and then lost more than 60% after its peak. Recently Bloomberg published a figure that unveils the euphoria on the Shenzhen stock market. Shenzhen has roughly 1700 listed companies, most of them are technology firms because Shenzhen is the entrepreneurial city of China, whereas Shanghai's stock market is dominated by state controlled blue chips. The median P/E ratio in Shenzhen is at approximately 100. Some stocks have surged more than 500% in the past 12 months. Just for the comparison: Western indices have a median P/E ratio of about 16-20.

(China and the next bubble, 4th June 2015)

Global X China Financial ETF, CHIX: Might be interesting to look at because I am bullish about financial institutions in China. Valuations seem to be attractive at the moment.

Conclusion

Booms end in busts. I am sure that the market will plunge at some point in 2015. Further governmental crackdown on the stock markets seems to be likely. However, the authorities will try not to kill the bull market. After all the ultimate goal is to develop functioning capital markets and sell off state-owned enterprises so they can be better companies and compete with the US rivals.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.