Bloomberg has a nice post up about the shaky foundation that lies beneath China’s raging bull market. No, this isn’t another post about the millions of undereducated Chinese “investors” who are fueling the bull market or the record level of margin debt that is pushing prices ever higher. Those too might make one hesitate before chasing returns in China, but the shaky ground that China’s stock rally is built upon is more fundamental than that. I’m talking about falling earnings. Earnings are the mother’s milk of stock prices. Without rising earnings continued stock market gains can’t be sustained.
The chart below paints a pretty frightening picture if you are investing in Chinese A-share stocks. Since last summer the Shanghai Composite has more than doubled while at the same time earnings estimates have fallen.
Falling earnings and rising prices can make for an expensive market. The P/E ratio of the Shanghai Composite has more than doubled over the last six months and now trades at an almost 40% premium to its emerging market peers.
Why are Chinese stock prices rising if earnings estimates are falling? If you want to plant yourself in the optimistic camp you might say that the millions of Chinese retail investors buying stock on margin know something that the analysts following China’s companies don’t.
The alternative explanation is that Chinese investors are doing exactly what investors in developed markets have been doing for years now. That would be chasing return in risky assets as central banks hoover up government bonds and drive yields deep into the basement (below the basement floor in the case of negative yielding government bonds). As China’s central bank has loosened monetary policy Chinese stocks have soared.
Sounds like a train wreck waiting to happen in China, does it not? But don’t forget, the same trend has played itself out to varying degrees in the world’s largest economies, including our own.