I have had concerns for a few months that the Chinese market is starting to resemble a bubble, much like the markets in the 80's prior to the major correction in 87. In the last 18-20 months alone the Chinese market has risen 3 fold! With another 50-60% this year alone. It has now got to the point where Chinese stocks are trading on multiples of earnings much, much higher than their international counterparts. Whilst there is some basis for this – given the extraordinary growth prospects in China, it is looking way too high.
Interesting then to hear Alan Greenspans comments yesterday that the Chinese market is at risk of a major correction.
Last week I think it was, I watched a show on SBS about the investing hype in China. Over 100m Chinese now own shares. Most have bought in the last year or two during which stock prices have soared and the market tripled.
In my opinion, one view of the dramatic increases in share prices is that the Chinese stock prices are being driven mostly by the imbalance between demand and supply, rather than by fundamentals (the demand/supply stock price theory). With so many optimistic investors (including international funds) wanting to buy into stocks, prices get bid up due to excess demand. Hence prices end up being a reflection more so of the supply/demand imbalance rather than fundamentals (of course fundamentals are also a factor especially China's amazing growth). The point is that this supply/demand imbalance is creating a bubble. This then creates an interesting dynamic where investor sentiment (which determines the supply/demand balance) is crucial. As concerns rise of a potential major correction in China, sentiment may turn to concern and then it does not take much for this sentiment to turn negative resulting in a drying up of demand and massive supply and a resulting major correction.
Already there are some in China concerned of a correction. The Chinese government has also started insisting people are educated as to the risks of investing (as most investors have not experienced any downside!!!!).
It does not take a genius to work out that a major Chinese correction will have dramatic consequences for Australian resource stock prices and for the broader market given that many developed economies – particularly Australia – now rely more so on China for it's growth.
So how likely is this to happen?
As mentioned there is increasing concern in China itself, however many people in China also think it is an absurd idea that a crash could happen. One view is that the Chinese government, which still controls a lot of the funds in China, would not allow a crash – or at the very least would use their influence to control any descent. Another development this week was that China increased the cap of investment by US institutional firms from $10b to $30b so from a supply/demand stock price theory viewpoint – this should increase demand for stock. One risk of having larger international funds is the risk of the 'flight of capital' such as what happened during the asian crises.
The Chinese Government's control may actually be a saving grace. If we continue to see dramatic gains in China it will increase fears in China of a crash – particularly within the Government and it's true the Government will do all it can to stop this happening – we may then see the government take steps to take some of the heat out of the market. How is the question? Greenspan used to do it through his measured comments to the market which influenced investor sentiment. China may seek to do the same. They have already, as mentioned, sought to educate investors about the risk. They may also seek to initiate a controlled correction with the Government funds stepping in to control this. That is a very hard thing to do though due to the 'mob mentality' of the market – if people know or suspect shares will decline it can lead to a mad rush to get out. Hence the Government would have to be very careful it does not trigger a stampede.
The timing of all this is another question. If we see more dramatic increases in Chinese stock prices this year it will increase fears further.
I have started to reduce my holdings in resource stocks as a percentage of my total portfolio.
(20min delay)