Sand Spring Advisors LLC

China Bubble

May 14, 2007

by, Barclay T. Leib

The average American still doesn't realize it, but U.S. capital markets are now hostage to a huge economic experiment in China where communism embraces capitalism, and naive retail Chinese investors are speculating like crazy. The chart above shows the Morgan Stanley China A Shares ETF which despite vaulting to significant new highs in recent weeks, still is trading at a significant 10-15% discount to where Chinese speculators have recently pushed actual Shanghai A Share listings. Many dual-listed Chinese shares are trading at 70-90% premiums over the exact same shares as listed in Hong Kong or the NYSE.

As recently reported in the Economist magazine:

"Would-be share punters, keen for a piece of China's booming stockmarket, are queuing to open accounts at a Beijing branch of China Merchants Securities. A busy manager, handing out application forms, says he is taking on 100 new clients a day, perhaps five times as many as a year ago. [Overall,] new accounts at brokers are being opened at a rate of more than 200,000 a day...The total so far this year is more than 8 million, which is about ten times as many as the whole of 2005."

Another quote from MSNBC.com:

"Industrial and Commercial Bank of China now has a market cap of about $250 billion, higher than that of Bank of America...In Hong Kong, Chinese banks now trade at a price-to-book ratio above 3.0 (meaning a market capitalization three times their net assets), roughly double the standard for blue-chip multinational banks elsewhere in the world. But there are big doubts whether the banks can deliver on the hype. Since mid-2006, their results show slower than expected growth and weakening asset quality, which could lead to mass defaults if there's any major economic downturn...One disquieting indicator, highlighted recently by HSBC, is that stocks with high price-to-earnings ratios (and hence low profitability) have outperformed value stocks by some 40 percent in 2007 -- suggesting investors are buying on buzz, not fundamentals...Anecdotal evidence suggests that small-time punters are plowing whatever reserves they have into the market -- even if that means tapping retirement accounts or mortgaging their homes."

From yet another economic forecasting website, www.pinr.com:

"The sustainability of the [Chinese] bull market is questionable, and will almost certainly have to retreat in the coming months. [Some] warn that up to 70 percent of the listed companies on the Chinese exchanges are worthless and should be delisted...The Price-Earnings (P/E) ratio for companies listed on the Hong Kong market is close to 18, but the P/E ratio for the same companies in Shanghai is 33. A similar gap between the markets preceeded the 2001 collapse of the Shanghai market."

This will all end in tears. Thus the key market to watch is not really our DJIA or S&P 500, but the Shanghai Composite. As a proxy on the NYSE, CAF is an ETF to keep your eye on, as well as FxI -- the iShares FTSE/Xinhua China 25 Index. When these start to turn lower -- and they have been a bit wobbly in recent days yet again -- Western capital markets will most certainly be falling with them.