When does market exuberance become a bubble? Some argue that the Chinese equity market is different. Their optimism could be dangerous
Douglas Adams, author of The Hitchhiker’s Guide to the Galaxy, remarked that “Human beings, who are almost unique in having the ability to learn from the experience of others, are also remarkable for their apparent disinclination to do so.” Nowhere is this more true than in the world of investing, where the manic-depressive ‘Mister Market’ (the metaphor coined by Ben Graham) habitually swings from bouts of extreme pessimism to extreme optimism. The most recent object of Mister Market’s exuberance is the Chinese equity market, which has been turbo-charged by an economy zooming along at Mach I or II.
Even with November’s pull-back, the Chinese equity market is up more than 150% over the past 12 months. Using core earnings (Morgan Stanley estimates that 42% of this year’s earnings growth is coming from investment income), the A-share market’s PER (ex-finance) is 62x, with several sectors trading on triple-digit multiples (consumer discretionary, consumer stables and health care). Market turnover has soared, a million new investment accounts are opened each week and four of the world’s 10 most valuable companies are now Chinese. Exuberance certainly, but does this constitute a bubble?
According to many pundits, one regrettable but undeniable feature of the post-1970s low-inflation world is that economic cycles have now become asset cycles, with bubbles occurring with alarming regularity, roughly once a decade (Japan in the late-1980s, tech in the late-1990s). The view that this decade is China’s turn is supported by analysis in Manias, Panics and Crashes by the ex-MIT economic historian Charles Kindleberger, who posits three preconditions for a mania: a displacement event; extremely loose money and credit, and investors jumping in euphorically, driving valuations to unsustainable levels. Let us take a brief look at each of these to assess their applicability to China.
To Kindleberger, economic ‘displacements’ consist of a sudden large change, such as radically new technology or the demolishing of trade barriers, which leaves the economy in profound disequilibrium and produces periods of abundant ‘quasirents’. The archetypical displacement event is the tech or dotcom bubble, which gathered momentum from 1995 with burgeoning hype over the ‘new economy’ and widespread adoption of buzzwords like networking, new paradigm, consumer-driven navigation and tailored web experience.
A second example is the Japan bubble, which began in earnest in 1985 as monolithic ‘Japan Inc’, with its flawless keiretsu, unrelenting pursuit of kaizen, technological superiority and masterful intertwining of business and government, appeared to be moving inexorably towards world economic domination. Both of these events were real, but it is in the nature of markets to exaggerate their short-term impact while underestimating their long-term consequences.
The most recent displacement event can trace its roots back to 1978, when Deng Xiaoping became China’s de facto leader and pioneered ‘socialism with Chinese characteristics’ (aka the ‘socialist market economy’) and opened the global market to China. This displacement is characterised by a growth-obsessed mercantilist government, a massive supply of low-wage labour (according to the IMF “the effective global labour force has risen fourfold over the past two decades”) and a seemingly insatiable appetite for resources. Bulls argue forcefully that, unlike the late-1990s tech or the late-1980s Japan bubbles, “this time is different”, as China’s ascendancy is not ephemeral and investors are only beginning to appreciate its profound consequences for the global economy. Many argue that only time will tell, but those of us with more than a bit of grey hair have seen this movie before and know that a Pixar ending is not in the script.
The second precondition for a mania is extremely loose monetary policy. Chinese loans are growing by 17% year on year, the benchmark one-year deposit rate is -2.3% in real terms and the renminbi is massively undervalued. Given a significantly positive output gap and surging activity growth that is roughly 250 basis points above potential, a conventional Taylor rule screams out for massive tightening, in stark contrast to today’s torrential liquidity conditions.
Many China bulls don’t dispute these facts, but challenge the conclusion that policy is loose on the grounds that Taylor-type analysis is not applicable to an emerging economy like China. This challenge, however, is entirely groundless, with neither theoretical nor empirical support.
During the past decade, a small library of papers has been written on the topic of emerging market monetary policy. They feature some of academia’s heaviest hitters, including John Taylor, as well as Fedearl Reserve governor Frederic Mishkin and Fed chairman Ben Bernanke. The unambiguous conclusion is that modern principles of monetary policy, including Taylor rules and inflation targeting, do apply to emerging economies like China (although often a minimal set of financial sector reforms is required).
A recent IMF paper concludes that emerging economies that have “adopted inflation targeting have, on average, outperformed countries with other monetary policy frameworks”. This paper also notes that 16 emerging economies have adopted inflation targets and that more than 60 others “envisage a shift to full-fledged inflation targeting”. While leading the emerging world in many areas, when it comes to monetary policy, China is very much a laggard.
The final precondition is that investor activity becomes euphoric, driving valuations to unsustainable levels. While all but the most ardent China bulls concede this point, they justify their continued optimism by noting that the Japan and tech bubbles exhibited more extreme symptoms and that, by comparison, a PER of only 62x appears relatively benign. While this might be a fair point, it amounts to a restatement of the greater fool theory, an investment strategy often compared to picking up nickels in front of a steam roller. A rash and reckless game indeed.
Kindleberger’s analysis suggests that China is experiencing all the traits of a garden-variety equity market bubble. While November’s decline may prove to be nothing more than a late-cycle bull market correction, economic imbalances ensure that dramatic monetary policy tightening is forthcoming and this is, always and everywhere, what finally causes bubbles to collapse.
Although Mister Market may be disinclined to learn from economic historians or even science fiction authors, maybe he will pay heed to Albert Einstein who described insanity as “doing the same thing over and over again and expecting different results”. Until then, “this time is different” will remain the four most dangerous words in investing.
Kevin Hebner is macro strategist at Third Wave Global Investors based in Greenwich Connecticut