Chinese stocks and economic growth have long had little to do with each other. Between 2010 and early 2014, when China boasted the world's fastest-growing economy, its stockmarket was consistently among the world's worst performers. Since July of last year, this relationship has flipped. Whereas China's growth has drifted steadily lower, its share indices have doubled in value. Does this mean that China's previously beleaguered markets are now veering into bubble territory?
For those with a cautious bent, there is no shortage of warning signs. Three are especially noteworthy. First, valuations are beginning to look stretched and, in some cases, plainly absurd. ChiNext, China's small-cap board, has a trailing price-earnings (PE) ratio of 90, more than double that of internet stocks at the peak of America's dotcom bubble in 2000. Second, leverage has soared over the course of the rally. Outstanding loans to stock investors reached a record 1.67 trillion yuan ($269 billion) as of April 13th, up some 300% from a year earlier. Finally, many of those rushing to snap up stocks are small-time day traders with little understanding of what they are buying. Chinese investors opened nearly 5m trading accounts in March, a stampede that has continued into April. A survey by China's Southwestern University of Finance and Economics found that two-thirds of new investors last year did not complete high school.
Nevertheless, as in any rally, plenty of investors and analysts believe, almost by definition, that the surge is justified. Valuations for smaller companies are increasingly irrational but the market as a whole is less frothy. The Shanghai index, which includes China's biggest companies from banks to oil majors, is trading at a forward PE of about 15, in line with its ten-year average. From this perspective, the rally looks more like a "mean-reversion trade" than something wildly unsustainable, says Francis Cheung of CLSA, a broker. The disjuncture between economic growth and stock performance is also much less of a mystery once policy is added to the equation. An overheated economy after the stimulus push of 2009 led the government to tighten monetary conditions. The rally, by contrast, has coincided with a return to looser policy. Since November the central bank has cut interest rates twice. Short-term funding costs in China have plunged by nearly 2 percentage points over the past month, adding fuel to the roaring market. Moreover, there is optimism that financial reforms, which have gathered pace in recent weeks, will support share prices. A programme to restructure government debt has, for instance, addressed one of the risks weighing on equity valuations.
The most striking feature of the Chinese rally in recent weeks has been its crossing of borders. Initially, the bull run was largely confined to mainland stocks (known as A-shares). Over the past month it has spread to Hong Kong, with Chinese stocks listed there (H-shares) soaring by 20%. In retrospect that seems unsurprising: Chinese companies with dual A and H listings had traded at a 35% premium in the mainland as of late March (see chart above). This implied that there was easy money to be made by arbitraging the difference and effectively swapping China-listed stocks for their Hong Kong equivalents. Yet many people had thought the valuation gap would narrow in the opposite direction—namely, that Chinese share prices would collapse back to Hong Kong levels.
The jump in Hong Kong stocks is, on one level, a sign that China's financial reforms are working as intended. A programme to connect the mainland and Hong Kong stockmarkets has provided a corridor for channeling excess liquidity out of China. With A-shares still trading at a 20% premium to H-shares, Lu Wenjie, a strategist at UBS, a bank, predicts the convergence will continue. "Both markets will meet each other halfway," he says.
But at the same time, some of the mainland's more-worrying trends are spreading into Hong Kong. Many of the top gainers in Hong Kong have been stocks of the kind favoured by investors in China: thinly traded stocks that can be linked to big themes such as new energy firms like Hanergy or internet firms like Kingsoft. Stocks like these offer stories with "lots of room for imagination," as one broker puts it. China may not be in the grip of a big stockmarket bubble just yet, but it takes little imagination to see it getting there if the rally goes on much longer.
