China Continues Its Slide - Current and Past Valuation Check

As an update to last month's post on the status of the BRIC countrie's YTD performance, we'll take another look at where China is.

As I have mentioned several times, the Shanghai stock market has shown very different behavior compared to the rest of the world.  Whereas most indexes have recovered significantly (assuming they're not in a huge recession ala Greece) since the 2009 bottom, China never really recovered from it.  That's especially strange as they continued to grow through it and are still showing GDP growth per year of 5-6%, something the US would kill for.

So why is it dropping?  This is an excellent case to remember this face: the Stock Market is NOT the economy.  It is related to it and in theory should show a lot of similarities to it.  One common thinking is that the US stock market predicts the economy 6 months down the line, etc.  But China...well look at the YTD chart below and the 3 yr chart too.

Now compare that stock market chart to China's GDP growth rate chart...

That's quite a disconnect isn't it?  For a country to be growing 7-11% and yet for its stock market to be dropping around 40% or more during the last 3 yrs.  As Bloomberg points out, the Shanghai index is now back at levels seen during the financial crisis bottom.

So either something is massively off with its previous valuations, there's something massively wrong about China companies/economy, or China is the best undervalued deal in the world.


Lets check its historical valuations:



Well...Shanghai index definitely looks historically overvalued for arguably most of the entire time period (assuming fair value PE is ~15 but China should be higher as a growing economy), especially in 2007 with a nosebleed 50 PE.  So lets look at where it is today:

According to Bloomberg's chart, China is at a current PE of 10.9, a valuation that's never been seen in the last 10 years.  In contrast, the US market have a PE ratio of 15 for the Dow 30 and 16.91 for the S&P 500.  Note again, the US is expecting almost zilch GDP growth vs China's 5-7% growth.

So the only explanations possible:

• Shanghai index was massively overvalued pre-financial crisis and it had to drop from there to become more reasonable.
• Assuming there's no massive fraud with China's economic numbers, and/or its corporate earnings numbers (a big assumption to be honest), it is massively undervalued at its current price.
• The China slowdown scare is a big catalyst for the drop but doesn't explain the entire drop (as it never actually recovered from the 2008-09 crash).  Even the huge stimulus only gave it a 60% bump before crashing again.      

While from a purely fundamental basis, China stocks look attractive, there's a whole lot of uncertainty with how its economy will land and also the strong multi-year momentum downward.  

So even though valuation looks interesting, if you really want to jump in, make sure you get your vomit bag ready as its gonna be a bumpy ride.