China Sparks Stock Downward Spiral

♠ Posted by Emmanuel in , at 2/27/2007 06:37:00 PM
Today, a massive drop in the Shanghai Stock Exchange (SSE) sparked off a global sell-off in stock markets worldwide. At last count, the SSE was off 8.8% and over $100B in equity had disappeared. As always, the reasons why this speculative craze suddenly cratered are not necessarily clear. The first set of reasons concern investors getting spooked by the Chinese government's efforts to cool a speculative craze. The People's Bank of China raised the bank reserve requirement to 10.0% from 9.5% effective February 25. However, the SSE index reached a record high yesterday in the first trading day of the Lunar New Year. The Chinese Securities Regulatory Commission has also been working to stop insider trading and to increase broker transparency. The latter effort was just announced today. Another set of reasons deal with geopolitical events such as rising oil prices, Iran making the usual noises, US Vice-President Dick Cheney almost getting blown up in Afghanistan, and former US Federal Reserve chairman Alan Greenspan's comment that America may be headed for a recession later in the year. In our highly interconnected world, regional decoupling from global trends has become difficult to imagine.

Obviously, this laundry list of reasons for the sudden cratering is a long one. I'll cop out here and simply say that it was a confluence of various events that sent bourses the world over cascading downwards. Nevertheless, what is undeniable is that the run-up in stock prices has been overdone in Shanghai. Via Safe Haven:
Among companies listed in both Shanghai and Hong Kong, the spread in valuations has increased widely since 2005. 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. The Chinese stock market has now become the most expensive in Asia, trading at 40 times 2005 earnings, compared to 16 in Hong Kong. The high P/E ratio is supported by expectations of 25% earnings growth for 2007.

This is in stark contrast to several years ago when the Shanghai Composite was the third-worst performing global benchmark after losing over half of its value from 2001 to 2005 amidst scandal, secrecy, corruption, and poor earnings. At the start of 2004, a man attempted to light himself on fire in front of the offices of China's stock market regulator in Beijing to protest about the collapse in share prices.

The euphemism for stock market plunges is called "correction." I've always wondered: If these speculative bubbles need "correction," then were stock markets "wrong" to go up so quickly in the first place? The next few days will test how solid the foundations are of this latest stock bonanza. Let's just say that I have my doubts. It's Chinese New Year; I doubt whether it will be Happy.