China Shares Get Cut in Half, But Don’t Panic Just Yet

So far this year, China's stock market lost nearly $2 trillion in market capitalization. Just to provide some scale, that’s equivalent to the entire value of Canada and Germany's stock markets – lost in less than four-months!

The bear market in China reached epic proportions yesterday, as I described here yesterday. The CSI 300 Index, which tracks A-shares (available only to domestic investors), listed in Shanghai and Shenzhen, has now plunged 50% from its all-time high reached just six-months ago. Over the same period, China’s output has continued to expand at an average rate of more than 11% – the world’s fastest growing economy by far.

How to reconcile these apparent contradictions? Well, that’s China for you.

Setting aside the question of whether Beijing’s economic data is accurate (just how accurate is ANY government data anyway), it is worth remembering that China’s mainland stock markets operate as a closed system.

It’s an un-real world detached in many ways from economic reality. Of course it’s still fun to watch this spectacle unfold. First we saw the stunning rise in Chinese share prices – which for the record soared 478% in 2006 and 2007. And now, the equally spectacular decline has arrived.

Shanghai Gets Too Expensive for Local Investors

But this is really just an exercise in curiosity for most of us, since China’s domestic exchanges are pretty much closed to foreign investors. While it’s interesting to watch from afar, China’s bear market has little impact on global financial markets. It doesn’t appear to be having much impact on the average Chinese investor either.

The financial media has an abundance of reasons for why Shanghai shares have dropped so sharply. “The simplest story is that the market was just too expensive,” says an analyst with HSBC in Hong Kong. At the height of last year’s speculation, China’s domestic shares traded over 70-times earnings.

The premium value awarded to A-shares listed in Shanghai, reached nearly twice that of the freely tradable H-Shares listed in Hong Kong; same companies, same earnings, but twice the price in Shanghai. That was the height of the speculative frenzy in China.

But what about the impact on Chinese investors who have just seen their investments cut in half? Here too, the fallout may not be that severe.

Chinese Speculators Run for Cover… But They’re Likely to Return Soon

To be sure, millions of new Chinese retail investors were seduced by the lure of fast profits over the last few years. At the height of speculation last year, China’s brokers were opening new retail stock trading accounts at a rate of about one-million per month! It was enough to make the 1999 dot.com bubble in the Nasdaq look positively tame by comparison.

Such behavior isn’t really surprising when the interest rate paid on savings accounts remains far below the rate of inflation. Cash is trash… wasting away in a bank account. But as Will Rogers would have reminded Chinese investors: it’s not so much the return ON your money, as the return OF your money, that’s most important!

A recent Financial Times article asks rhetorically if it’s “time to panic? Not really. Perhaps of all the world’s big stock markets, China’s can tank with the least collateral damage.”

Shanghai Share Crash Does Little Damage to China’s Wealth

The reality is that the Chinese are voracious savers, routinely stashing away about 50% of disposable income. Households and enterprises in China maintain a war-chest of over $4 trillion in savings at last count. The fact is, Chinese retail investors hold over 90% of their financial assets in cash. That’s plenty of potential stock “buying power” sitting on the sidelines.

China’s retail investors must by now be familiar with this kind of volatility in local share prices. After all, this isn’t the first time stocks in Shanghai suffered a sharp decline, and it certainly won’t be the last.

From 2000 to 2001, the Shanghai market fell almost 40% during a global bear market. In 2004 and 2005, Shanghai shares plunged over 40%, in the midst of a global bull market. Volatility is nothing new to Chinese investors.

In fact, due to the sheer magnitude of the recent decline, there’s good reason to believe the worst of the selling may already be over.

Shanghai Shares Much Cheaper Now, But Still Not a Bargain

Shares listed in Shanghai now trade at a more reasonable 26 times trailing earnings – and just 20 times estimated this year’s estimated profits – down significantly from P/E ratio of over 70 last year.

And falling share prices only explain part of the cheaper valuation. China’s corporate profits grew 48% last year at firms included in the CSI 300 Index. Earnings are expected to rise another 32% this year as well.

Solid profit growth, plus a much cheaper valuation, may lead investors back into A-shares just as soon as some upside catalyst emerges to dispel gloomy sentiment.

The government of course could provide just such a catalyst in the form of regulatory changes. Lowering taxes on retail stock is a great start, and this morning that’s just what Beijing announced. Mainland stocks responded with a rally of about 5% overnight. Last year, authorities tripled the stamp duty tax on share transactions, but could provide some relief with more tax cuts.

Another idea is to loosen restrictions on foreign institutional investment in China’s mainland markets. Entirely doing away with the cumbersome dual listing structure of A-shares (for Chinese investors) and B-shares (foreign investors), would be another positive step.

There are Cheaper and Safer Routes to Chinese Stocks

Beijing might even consider the more drastic step of using some of its $1.7 trillion worth of currency reserves to prop up share prices directly. After all, the government has dipped into its sovereign wealth before to bail out the banking sector – so why not the stock market. Remember, mainland China isn’t an open market… it’s a rigged game.

After all, China has said publicly that it wants to “diversify” its currency reserves!

Meanwhile, with Shanghai stocks down 40% so far this year, I still believe the best ways to invest in China today are through Hong Kong and Taiwan… the unrestricted gateways to Chinese stocks.

Hong Kong’s Hang Seng Index, which includes many H-share listings of top Chinese firms, is down just 10% in 2008. Taiwan is actually up 13% year to date, buoyed by recent election results that promise closer ties to mainland China.

These two markets still offer you much better bargains than mainland Chinese shares, even at 50% off!