Saturday, May 19, 2007

Canaries in the Chinese Coal Mine

In MOS' last post, we spoke about the possibility of how this global exuberance may all come tumbling down when China's searing run stops. In today's column, MOS explains why we now net sellers of holdings after evaluating the Chinese environment.

Bubbles usually come to an end when the common man gets overly involved in the stock markets. In the local Chinese press, a cleaning lady was actually feted as a "Stock market Wizard" after managing to double her money in recent months (And we know that tomorrow's weekend papers in Singapore will carry an article about a gentleman who made S$100,000 in the last few months). Stories of rapid and large gains are abound in Asia today. As such, the public without trading accounts have rushed to open one, eager to partake in the strongest bull-run since 2000. Figures we have seen suggest that the number of A share accounts opened in Apr 2007 have more than doubled that of Feb 07.

"Liquidity" was certainly awash in the markets for the average Chinese household has one of the highest savings rates in the world. Hence, another milestone was brushed aside with ease last week. The turnover of the Chinese domestic markets hit US$50 bil, more than the rest of Asia combined. Its mind boggling for the latter pool includes the more established financial centers of Hong Kong and Singapore. The measure of trading mentality also shows that participants' trading horizon has also shortened considerably. The turnover velocity measured by the annualized daily market turnover as a percentage of free float market capitalization, has been rising steadily; underlining the extent of churning in the Chinese market.

Older investors blessed with elephant memories will recall how the Taiwanese stock market staged a similar rally in the early to mid 1980s. Tellingly, before the Taiwanese bubble cracked, everyone was dead certain that the "liquidity" will keep the party going. As a result, the turnover of a single Taiwanese market had also exceeded that of other Asian exchanges as everyone had to jump onto the back of the raging bull. We run the risk of performing "mental data mining" but doesn't this remind you of state of affairs in the mainland market today?

The Chinese stocks have come a long way since bottoming in the summer of 2005. In 2006, the Shanghai index was up 130%. We believe, from memory, that it has turned in another sterling 50% in this year to date. Simple valuation measures, if anyone is still looking at them, such as the PER indicates that over 1000 Shanghai A shares are trading at close to 50x last year's earnings. Simply put, a investor today will recoup his investment only in half a century’s time unless earnings surge by leaps and bounds. The typical retort when we raise the foregoing is that earnings growth can justify such valuations. But in a country where data availability can be slow and unreliable, it is difficult for us to conclusively put a finger on earnings momentum. It is also MOS' belief that if one searches hard enough, one would stumble upon a valuation yardstick which justifies today's price. If all else fails, try eyeballs or cash burn rate.

Since we are in this light hearted vein, it is worth pointing out the exercises which some undertake to support today's prices. The latest we have read is in a prominent Hong Kong newspaper. The author moved the Shanghai index back by almost two decades to illustrate its parallels with the Taipei bull-run in the 1980s. The result? The former potentially have room to quadruple (yes, quadruple isn’t a typo) in the next year. Despite proffering some economic similarities between the two markets, we cannot help but wonder if this is a case of data mining. However, it is to the author's credit that the article ended with an ominous warning - that the resultant crash in Taiwan was so hard that today's prices are barely half of the peak then.

The other must be the prevailing "market wisdom" about the Chinese market. That the Chinese government cannot let the euphoria vanish abruptly because the 17th Chinese Communist Party Congress meeting and the Beijing Olympics which will be held at the end of this year and in 2008 respectively. We have not been able to fathom the economic reasoning behind this but financial history is littered with examples of how "wisdom" came unstuck. Or how the "January calendar effect" disappeared after investors engaged in one-up-man-ship and started buying in the prior December.

The canaries in the coal mine have started chirping. In recent months, it has almost become an agenda item for Chinese officials to talk down the market. The latest to warn about this irrational exuberance was "Superman" Li Ka-shing, arguably Hong Kong's most shrewd businessman.

We are not full time journalists or bloggers. So thoughts for this piece were progressively jotted down since Thursday evening. But before this was fit for public consumption, we hear news of that the Chinese authorities have put in a "triple whammy" of measures to rein in the market. This includes widening the RMB's trading limits, upping the domestic interest rates and reserve requirements of banks. The latter two may cause a liquidity retrenchment and panicky retail investors who have not experienced a bad hair day may stampede for the doors.

We are also not fortune tellers with a crystal ball on markets. We are strictly "extreme value investors". Hence, we often have cakes in our faces when our macro calls go awfully wrong. But, to us, it’s better to be safe than sorry. Hence, we have raised substantially more cash than before by liquidating our non core positions. For we prefer to bypass the last few pennies on the financial highway rather than risk permanent capital impairment.




Anonymous Anonymous said...

Dear Mr Market,

Read too on Friday the commentary from the "prominent Hong Kong newspaper" on the parallel of the China market with Taiwan's. Simiarly found some key points incredulous.

Incidentally I was making notes this week while re-reading a book. This one from Benjamin Graham stood out: "So they [investors] will buy it [stocks]. And in doing so they will bid up the price and hence the price to earnings ratio. As more and more investors become enamored with the promised return, the price lifts free from underlying value and floats freely upward, creating a bubble that expands beautifully until finally it must burst.”

Warren Buffett, if I vaguely recall, was dishing caution about a year ahead of the technology stock market implosion in April 2000. To our surprise, this current China uplift may even continue far longer than we expect. As for myself, given my incompetence in timing the market, one approach is preferred in such a situation.

I would rather be right early, than wrong late.


1:53 AM  
Blogger Mr Market said...

Hi Rorrim

Thank you again for leaving your invaluable comments. You made several very valid points. And the extract from Mr Graham is certainly apt for the times which we are in.

Your sign off line is neat. Probably no one knows exactly when the market party will end. But for those who care about safety of principal, it is time to think about heading for safe shores.

9:15 PM  

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