The China Bubble (6/07)

With cash acquisitions, private equity and corporate stock repurchases now on pace to retire $1.5 trillion of stock for the year, there is no denying the very favorable liquidity trends that are helping drive this market higher. For perspective, this stunning pool of capital is equivalent to the combined market capitalization of the smallest 100 companies in the S&P 500 Composite! Recent data continues to signal a resilient economy, seemingly unfazed by the soft housing market and sub prime mortgage mess, and inflation reports illustrate favorable trends as the Fed’s favorite PCE deflator has fallen to an annualized rate of 2%. Meanwhile, valuations remain reasonable with the stock market selling at 16 times 2008 earnings. According to Ned Davis Research, after hitting new highs, the stock market tends to continue making fresh new highs for an average gain of 46% over a two-year period.

One data point that has become less favorable recently is interest rates, with the yield on the 10-year Treasury now tickling 5%, up from 4.6% only a few short weeks ago. Growing confidence that our economy is not headed for recession has taken most all bets for a 2007 rate cut off the table and pressured the bond market. In addition, the announcement that China will invest $3 billion of its $1.2 trillion in currency reserves for a 10% non-voting stake in the private-equity powerhouse and certain IPO of the year Blackstone Group is a potential sign that China’s appetite for U.S. Treasuries has abated. Previous studies by the Federal Reserve under the Alan Greenspan regime suggested that foreign demand for U.S. Treasuries serves to reduce the yield on our bonds by as much as .9%, so a change in allocation strategy by China, described as "an exceptionally important paradigm shift" by Blackstone co-founder Steve Schwarzman, could have material impact on our bond market.

Perhaps China’s newfound engagement with riskier investments as witnessed by its Blackstone investment is sending mixed signals to China’s growing urban middle class. There are now over 100 million securities accounts open in China, equivalent to 17% of the country’s urban population. At a pace of approximately 300,000 new accounts per day, over 20 million new securities accounts have been opened in 2007 alone. This mad rush into the Chinese stock market comes on the heels of a parabolic rise in China’s Shanghai Composite which tracks yuan-denominated A-shares listed on China’s largest exchange and is restricted from foreign investors. The Shanghai Composite is up over 250% from the beginning of 2006, surpassing the 227% increase in the NASDAQ Composite over an equivalent time span before the NASDAQ bubble burst in March of 2000. China’s stock market is up nearly 50% in 2007 alone and now trades at a PE multiple of 43. The market capitalization for the Shanghai Composite has quintupled in the last two years to $2.6 trillion and now exceeds the sum of China’s entire household bank savings.

With China having recently surpassed Germany as the world’s third largest economy and with first quarter GDP having risen 11.1%, there are definite reasons to be bullish on China’s long-term potential. However, the recent signs all point to a significant market bubble in the making. For instance, it has become a matter of principle in China that the stock market is a one-way ticket up until the 2008 Beijing Olympic Games, eerily reminiscent of the "new paradigm" discovered by NASDAQ investors in the late 1990s. Instead of fundamentals, investors often use numerology to make their bets with stocks that contain the number eight (the pronunciation of the number eight in Mandarin and Cantonese sounds similar to "wealth" or "fortune") in either the price or the stock code receiving particular interest. According to the Wall Street Journal, the retail brokerage outlets run more like casinos where investors "drink tea, smoke and chat as they make trades on computers lined up like slot machines. Instead of dropping in coins, they swipe bank cards to pay for shares". The Wall Street Journal also reports trading tips circulating among investors advising people to wear red clothes which are representative of a "hot" market, to eat beef to sustain the "bull" run and avoid reference to "dad" since the word in Chinese is a homonym for "drop".

While the government may be wary of bursting the bubble due to potentially dire consequences for the middle class and the overall economy, just as China emerges on the global stage for the 2008 Olympics, they have taken gradual measures to tame speculation, strengthen supervision, rein in money supply and generally tighten monetary policy. Perhaps the most obvious measure was taken by China’s Ministry of Finance in tripling a trading transaction charge known as a stamp tax from .1% to .3%. With China’s almost daily moves to curb speculation, the Shanghai Composite has become extraordinarily volatile with a recent 6.5% one-day drop second only to the 8.8% one-day decline on February 27. While the February 27 pullback sparked a worldwide stock market sell-off, the more recent Shanghai correction remained contained to the Chinese market, a healthy sign of discernment among global investors. We believe this discernment will remain in place and the U.S. market will remain relatively healthy, if perhaps subject to an expected bout of volatility, when the Chinese bubble does burst. The Chinese government’s investment in Blackstone Group tells the whole story: U.S. equities remain attractively priced.