Is the Chinese Stock Market Going to Burst?

Shanghai's Composite Index shed nearly 9 percent last night amid concerns that additional macro-tightening could be introduced following the annual session of the China National People's Congress, which gets underway in early March. Does this represent the beginnings of a correction or, worse, a recession or a mere blip in the indexes upward march? While this is a question that cannot be answered with absolute certainty, there are certain economic and financial truths regarding market cycles as well as statistical evidence that when properly analyzed can give investors insight as to the likelihood of a recession or a correction occurring in the Chinese Stock Market. The first and most important metric investors should consider is the valuation of the Chinese Stock Market. By the standard measure of price-to-earnings ratio, local currency denominated "A-Shares" are trading at a relatively high average ratio of about the mid 30s. Worse, many companies on the index are now trading at multiples much higher than the average. Indeed China Life Insurance trades at well over 100 times current earnings. One needs to ask him- or herself if these kind of valuations can be justified given China's economic growth. The answer, in my opinion is that they cannot be justified. China is growing its economy very quickly. Still, when compared to U.S. companies who are growing earnings at an equal rate to their Chinese counterparts, the Chinese companies trade at a premium to the U.S. companies. The same is true of for European, Japanese, Taiwanese, Korean, and many other countries. Investors are currently placing a premium on Chinese shares regardless of circumstances. These developments clearly indicate the Chinese Stock Market is overvalued at least in the short term.

Furthermore, the Chinese Stock market is coming off a year when its main index gained 134% and several years of extremely high economic growth. As the old saying goes, what goes up must come down. At this point, I would not invest any new money in Chinese stocks nor those industries, which are over reliant on Chinese demand for growth as I predict quite a bit of near term pressure. This being said, I do believe that the Chinese stock market is poised for rapid growth over the long term.