November 15, 2007
About six years ago, when China was far off the radar screen of most investors, I interviewed Paul Matthews of the Matthews Asian funds to gain some insight as to the promise of the Asian markets. I was turned off by the long-term prospects of Japan, but was very intrigued with Asia, excluding Japan.
In retrospect, given the enormous returns of Chinese stocks in 2006 and year-to-date 2007, accepting that additional risk would have paid off pretty well. Without a doubt, risk sometimes comes with rewards. But in that premise I am certainly preaching to the choir – there would be no reason to ever own any sort of equity if that were not a shared belief.
Nonetheless, at some point risk must be closely examined because with risk comes the potential for great losses. And there has been much discussion about whether or not China is now in a bubble. I don’t know if you have yet had a chance to read Dr. Alan Greenspan’s book “The Age of Turbulence” (it is a worthy read), but in it (as well during his tenure as Fed Chairman) he explains that it is impossible to identify bubbles until after it has burst.
That may very well be true, but as investors we have to at least identify the risks associated with a possible bubble. And as a nervous investor I have been fervently trying to convince myself that a Chinese bubble exists and that I should back away from these trades (if that research exploration sounds odd, please read my Nov. 10th article “Conflicting Data”). But the information I have so far found does not justify that concern.
Comparisons to Past Bubbles
Over the past six years the Morgan Stanley Capital International (MSCI) China Index has gained about 575%, which is more than the six-year gains by the NASDAQ into the 2000 peak, the Dow Jones Industrial Average (DJIA) into its 1929 peak, Japan’s Nikkei average into its 1989 peak, and gold into its 1980 peak.
That is not very reassuring, but there is one very big difference. The Chinese rise is the only one of the bunch that started after a prolonged decline in prices. From 1997 to 2003 Chinese stock prices dropped 88%. Looking back I am quite confident that that destruction in capitalization combined with the then just merely a hope of a flourishing economy played at least a role in my more conservative approach in exposure to this market.
And with the luxury of now being able to look back, it has become clear that the culmination of that 88% decline marked the end of a secular bear market and economic downtrend – and the last six years has likely been the advent of a secular economic (if not market) uptrend.
The other bubbles inflated at the end of secular uptrends. The MSCI China Index, on the other hand, has yet to break above its 1997, or even its previous 1993, high. In past bubbles new price records became commonplace, which fed waves of optimism and euphoria into the investor pool; investors felt as if the good times could never end. This time talk about an existing bubble is commonplace, but the MSCI China Index is still below where it was a decade ago.
Mr. Biggs is the former global investment strategist of Morgan Stanley and now is the manager of the Traxis Partners hedge fund. Well, he isn’t really the reason why China is not yet a bubble, but he said something that led me to do a little exploration. He said that right now China “feels like” the NASDAQ did in early 1999. Like most of us in this business he has been both right and wrong on calls, but interestingly he did call the tech bubble about a year before the decline started.
As I said, Mr. Biggs isn’t the reason, but he did put the bug in my ear regarding what is happening one year out. And one year out, in August 2008, Beijing, China will host the Olympics. This allows me to make some comparison to South Korea, who hosted the 1988 Olympics in Seoul.
In September 1987, a year before the Seoul Olympics, an economic boom that was transforming South Korea into a major industrial producer and important partner global trade was continuing. Not only did the South Korean KOSPI market gain 233% from December 1984 through August 1987, but it largely shook off the global stock market turmoil from then through the December global market low. The KOSPI continued its rally into 1988, went sideways before and during the Olympics, and then made a final surge to an April 1989 peak. The end tally was a 622% return over four-years. Long-story short, GDP growth slowed from its peak in March 1998 and the KOSPI trended down for the next three year to the tune of 54%.
Twenty years later China has emerged as the engine that leads the global economy and, as indicated, is looking to host the Olympics a year out. The Chinese stock market has followed a similar course of the KOSPI and has gained about 200% since December 2004 and remained resilient during the corrections from July.
Anecdotal evidence is important, but our good friends at Ned Davis Research went one step further and put together the below table outlining some important similarities which support the possibility of a rhyming (if not repeating) Asian stock market advance.
Regarding valuations, which are important in determining bubbles, the S&P 500 had a p/e ratio of about 35 in 2000 (and a much higher ratio for the tech sector itself) vs. a long-term ratio of about 16 (I used a long-term ratio so as not to skew the ratio with that bubble p/e data). That’s a ratio of about 2.2:1.
The MSCI China Index has a p/e of about 25 vs. a 10-year average of 13. That is a ratio of about 2:1.
That is not a very favorable ratio, but the good news is that in the US the prior year’s GDP growth rate was 4.75% whereas it is closer to 12% for China. Also, earnings growth began to contract in the US in 2000, whereas China’s year-to-year earnings growth rate is 28% with no trace of an earnings contraction evidenced for 2008.
I certainly do not mean to try and put a rosier than deserved spin on the valuation of the Chinese stock market, but the bottom line is that in the US stocks had been priced-to-euphoria. In contract, China is currently valued at anywhere from priced-to-reality to priced-to-optimistic, but nothing that denotes a bubble ready to pop.
Modified June 5, 2008