Top Four Reasons That Explain The Chinese Stock

Market Bubble

August 11, 2015

By Zahoor Bhat
Investment Research at Aranca
How would you envision a bubble of epic proportions? Consider this: in the last 12 months,
the Chinese markets created value enough to give each individual on the planet about $900.
During this time, Chinas steep stock market climb created US$6.5 trillion in value. It was
roughly about 70% of Chinas GDP in 2013, or about 40% of the New York Stock Exchanges
total value. In fact, it was enough to pay off Greeces debt 20 times over. No other stock
market has ever grown in this proportion in absolute dollar terms across a 12-month period.
This unimaginable propulsion has taken the play far beyond the fields of individual investors.
Most companies in China have been finding stock investing an attractive option as the
economy is struggling with weaker demand, excess industrial capacity, persistently high
borrowing costs, and more. According to WSJ reports, 97% of the growth in Chinese
manufacturers' profits now has been stemming from day trading. Manufacturing companies
in China have been shutting down their operations and putting their cash in the stock
market, with the hope to make some profit.
And then the inevitable happened. The Chinese stock market is in a free-fall mode, with the
Shanghai Composite Index 40% down since June 12th, 2015. The margin trading turmoil has
shifted and could be equal to 6 trillion Yuan (U$970 billion) of borrowed money into the
market, putting an equivalent of nearly 10% of Chinas GDP at risk.

Here are the four reasons for the Chinese stock market bubble:

1. Leveraged Investing: Relentless Borrowing

One of the main reasons for the mayhem is that millions of Chinese citizens have borrowed
money and poured their cash into shares, which inflated prices to unjustifiable levels. When
prices began to dip, these investors were forced to sell shares in order to repay the borrowed
money and cover losses. The vicious circle of selling is creating panic and further pushing
down prices.
According to China Securities Depository and Clearing Co, the equity market currently has
more than 90 million individual investors. Most companies whose share prices were rising
were not actually improving; the prices were on the upward swing because demand was
high and people were bidding relentlessly.
Most retail investors were investing in shares beyond what they had to invest by using their
money as collateral to borrow more money-a phenomenon termed as leveraged investing. In
simpler words, China today is experiencing what the US had faced in 1929.

2. Unprecedented Mega Valuations

In Shanghai Stock Exchange (SSE) Composite, about 94 percent of Chinese stocks have been
trading at higher valuations than the index. Industry pundits suggest this as a consequence
of its heavy-weighting toward low-priced banks. Here, wed have to use average or median
multiples to get a different picture. Chinese shares cost more than thrice than any of the
worlds top 10 markets, and almost double of what they were priced at in October 2007
when the SSE Composite peaked

3. Higher Volatility Than S&P

Chinese stock market has always been more volatile than stocks globally because retail
participation ranges at about 80% to 90% of trading in the Chinese equity markets. After
climbing for months, the mainland exchanges recently witnessed its steepest drop since
2008. In fact, the Chinese stock market has witnessed bigger fluctuations over the past 30
days than any other market, except Greece.

4. Disconnected Chinese Stock Market And The Real Economy

Strangely enough, the stock market bubble still exists despite poorly performing Chinese
economy. Its GDP, in the first quarter of 2015, grew by just 6% Y-o-Y, the slowest since 2009.
Imports, retail sales and investments have also declined.
The slowing economy and surplus supply in some cities have caused a price slump in the
property market, which has long been considered a safe and reliable investment option for
Chinese households. Hence, theres a major shift of investments from property to the equity
market.

But, Is It A Good Buy? The Buffett Indicator Thinks So

Warren Buffett had said that he prefers to compare the total value of the stock market to the
output of the economy, or the GDP. It is like a price-to-earnings ratio, but for the economy
instead of just one stock. Buffett said he likes to buy when stocks are trading at 70 to 80% of
economic output. Anything over 133% appears expensive.

Currently, Chinas stock market value is higher, but may not be too high according to the
Buffett indicator. The US stock market trades at 125% of Americas GDP. This means, despite
the volatility-as per the Buffett indicator-the Chinese stocks remain, at least relatively to the
US, a good buy.