China stocks are high but can go higher

What goes up must come down. But it can go up further before it does so.

For the latest version of a timeless investment dilemma, look at China's stock market, which has more than doubled in the past 12 months despite growing alarm about the Chinese economy.

Emerging markets as a whole have looked cheap for a while, and bargain-hunting has driven a bounce in Brazil and Russia - both troubled economies, that saw gains of almost 20 per cent during April.

Chinese stocks are plainly overvalued. Exclude state-owned groups and banks, and everything is else is expensive. Longview Economics points out that 20 of 24 sectors trade at an earnings multiple of more than 30. Ecstrat shows that private non-financials trade at a dizzying book multiple of 5.2 (state-owned stocks trade at 2.3). Over the long-term a broad investment in Chinese equities is unlikely to work out.

But, as I said last week, valuation is of little help in timing short-term market moves - particularly during a speculative bubble, of which China is now exhibiting all the symptoms. Companies are rushed to the market, then rise the maximum the market allows every day thereafter; retail investors are rushing to open new accounts; and fund managers say their clients refuse to miss out on China's returns by diversifying.

We have recent experience of bubbles. China hosted one as recently as 2007. If this bubble grows to be as large, then there is far more upside ahead. That Shanghai bubble itself was remarkably similar to the dotcom mania that burst in the US in 2000. Charts of those two incidents were almost indistinguishable.

So how can we work out what will happen in China? I suggest two strategies. One is to look at previous countries that have enjoyed economic emergence along the lines that China is now experiencing; and the second is to examine why the Chinese authorities have moved as they have done in recent months.

Historically, the three best parallels may be Japan's growth postwar, South Korea's phenomenal growth two decades later, and the growth of the US during the "Gilded Age" at the end of the 19th century.

All involved great growth, interrupted by speculative excesses and financial crises. As Merryn Somerset Webb pointed out last week, Japan's stock market growth took off largely after its postwar economic rebuilding had been achieved. Its bull market came in the 1970s and 1980s, buoyed by expansive monetary policy (as now in vogue in China). That drove its bubble and subsequent financial malaise.

Korea's Kospi also waited until much economic growth was in the bag before a series of booms and busts from the 1980s to the present, punctuated by the Asian Crisis of 1997. As with Japan, the entry and occasional sudden exit of foreign investors amplified these moves.

As for the US in the Gilded Age, it enjoyed strong growth, fuelled by foreign money and punctuated by financial panics. Like Japan, its final exponential growth towards disaster, in the late 1920s, came once the great economic growth phase was largely completed.

The US Gilded Age had much in common with today's China. But bank runs were permitted, and the threat of losses helped regulate the economy. China does it differently.

Broad lessons: markets can rally a long time, particularly once foreign money enters; and such growth usually leads to a crisis at some stage.

So what happens next in China? A year ago, the authorities seemed content to allow growth to slow, and were trying to unwind its credit problems and shift away from its export-led model. Since then, there has been a 180 degree turn. Fred Neumann, HSBC's chief Asian economist, suggests the slowdown in the labour market - a vital priority - and the failure of attempts to stabilise the property market, drove the volte-face. Construction remains central to China's growth.

With banks allowed to lend more, and lower deposit rates pushing investors towards shares, the policy is deliberately to inflate asset prices and hope they create positive wealth effects, or attract foreign funds.

That is a perilous prescription for the long run - and could grow more dangerous if Chinese domestic A shares are added to international indices. That would bring in more foreign money. At present, foreign investors are underweight China, adding a further reason why Shanghai could go higher before crashing.

So the dilemma deepens. In such situations, caution is best. Keep asset allocation constant, which means periodically taking profits in China if it keeps rising. An eventual crash will then hurt less. Timing is too difficult, and staying out risks letting someone else enjoy the boom.

© The Financial Times Limited 2015. All rights reserved.
FT and Financial Times are trademarks of the Financial Times Ltd.
Not to be redistributed, copied or modified in any way.
Euro2day.gr is solely responsible for providing this translation and the Financial Times Limited does not accept any liability for the accuracy or quality of the translation