“Buy when there's blood in the streets, even if the blood is your own."
- Baron Rothschild
Introduction:
The talk of the town in investor circles these days is whether the Chinese stock market is in bubble-territory. In the following article, I will present the case for and against a bubble, account for my own opinion, and then proceed to argue for the wisest course of action for a value investor in the given scenarios.
Reasons it's a bubble:
Most of the signs of a bubble are certainly there: The market is setting new highs every day, people are buying on margin and a tremendous amount of wealth is being generated very quickly. More specifically, USD 6.5 billion of wealth has been created in the last 12 months - ironically due to declining macroeconomic fundamentals such as weakening imports and exports.
In the words of Rabobank Head of Financial Market Research:
"Too many people are making too much money, too fast … It's greed, fear of missing out, and willingness to suspend belief."
It is worth noting that the stock market has been forging ahead at full steam without regard to the key economic indicators that have been souring over the last couple of months. Growth has slowed to 7.8%, which is still tremendously high, but it does stand to reason that part of it is superficial, i.e. supported by the government, and a decline in growth in and of itself speaks volumes. Furthermore, at 19 times projected earnings, the Shanghai Composite is 62 percent more expensive than the MSCI Emerging Markets Index, which is arguably more attractive as a whole, due to the more attractive fundamentals and less opacity in these markets, because of the high degree of government control in most things related to China.
Why experts always disagree:
As always, there is tremendous disagreement as to whether this situation actually constitutes a bubble scenario. This is because, as Michael Mauboussin writes in his highly recommendable book More Than You Know, economics and the stock market represents highly dynamic systems with multiple degrees of freedom where so-called experts tend to disagree, as anyone who has watched Talking Heads on TV for any amount of time can attest to. Therefore, I will present the counterargument as well, so the reader might judge for himself or herself, which they find most convincing.
Why it is not a bubble:
The argument for why the Chinese stock market is not in bubble territory goes as follows: China have allowed for semi-free capital in- and outflow, and what we are seeing is a natural reaction to this phenomenon, and the Chinese government know what they are doing, as they are letting some capital flow freely, until the mechanism is self-sustaining. The People’s Bank of China has a tremendous USD 4 billion in cash, and can sustain the equity market indefinitely. Indeed every indicator points to the fact that they will be more active in the future. CIO of Oppenheimer funds in New York states: “China is becoming one of those central bank markets — wherever there is an active central bank, you buy.”
Another part of the argument is that what is happening in China is essentially what is happening in the U.S, and here equity prices have soared as a consequence of Quantitive Easing, so why is it so bad, when it’s happening in China?
In the words of one Forbes Contributor: “Waiting for a bubble to pop in China is like waiting for the Second Coming of Christ. It might be worth it when it happens and you’re first on the scene. But if it doesn’t show up for another 20 or 100 years, you’ll probably be dead by then anyway.”
In my opinion this sounds very much like: “This time is different” and every time I have heard that, things have usually not ended well.
I find the former argument most convincing by far, and in in my humble opinion this looks to me very much like past bubbles– the IT and housing bubbles spring to mind.
When bubbles inevitably burst, prices usually drop from sky-high valuations, to levels that are unreasonably low. In other words, Mr. Market goes from being overjoyed – some might say manic – to really depressed, in a very short time span. This is very fortunate for us as value investors, because it presents us with a tremendous opportunity.
What must a Value Investor do?
The key message of this article is not about if or when the bubble bursts, as the vagaries of the market are hard to explain, and even harder to predict. I will also not recommend shorting any stocks relating to the Chinese market, because it is well known, that markets can stay irrational longer than we can stay solvent. Rather, I will expound upon the idea of how to behave as a value investor when we notice a bubble is forming:
The first, and most important aspect is to practice good old assiduity. Sit on your ass, until the bubble pops. How to know when it has popped? If you’re in doubt it hasn’t happened yet. But it likely will. And if it does, it will happen with tremendous force. Remember; history doesn’t repeat, but it sure does rhyme.
The next step is to filter out all the opportunities that will suffer from adverse market conditions. Market liquidity tends to dry up in a financial crisis – ironically when it is needed the most – so any companies that might suffer from a lack of liquidity should be avoided at least in the short term. These companies include banks, insurance, anything related to real estate and might include some companies, which are expanding aggressively, and are dependent on the capital markets to do so.
If the market takes a tumble of 25-40%, which is not unreasonable to assume, given the history of bubbles, it stands to reason that even very attractive companies can be purchased at a significant discount to intrinsic value. As such, the situation will warrant severe consideration as to spending one of Buffet’s 20 “lifetime-investment”-clips.
The companies one should focus on are the companies that are established and renowned nationally, as well as internationally. Companies such as Petrochina (PTR, Financial) – which can be considered further attractive due to the recent drop in oil prices - and Alibaba (BABA, Financial) spring to mind, depending on the volume of the drop, and the subsequent valuations. Further, there might be value in buying these stocks on Chinese exchanges, due to the positive currency effect for U.S investors, and lower valuation, which are likely to occur as a consequence of this, if one can stomach the severe governmental oversight and regulation of the Chinese economy as a whole.
I believe there is an 80% chance that this is a bubble, and that it will burst within the next 12 months, meaning significant drops in equity values.
One final thing to note is that if this bubble bursts, then it will most likely cause ripple effects throughout the international financial system due to the international linkages between the economies and stock markets. The nearby Asian markets will likely drop substantially as well, but the U.S stock market might also be affected to some degree, so being on the lookout for drops in stock prices, especially regarding companies that have operations in China, might be a good idea.
I will never base an investment decision on anything related to macro-related fundamentals, but as a value investor, it can pay to pay attention to the global macro developments, as it can provide valuable insight, as to where one might begin to search for undervalued companies.
And in the case the bubble never bursts? Well, keep searching for that fertile soil, that is the Value Investing hunting ground. Happy hunting.
