24 August 2019
If one goes by total market cap versus GNP ratio, China's stock rally still has some way to go. Photo: Bloomberg
If one goes by total market cap versus GNP ratio, China's stock rally still has some way to go. Photo: Bloomberg

Why Chinese stocks may be still undervalued

Rumors have been flying around recently about a Chinese-version of quantitative easing (QE).

According to one version, the Chinese central bank will expand the size and usage of the pledged supplementary lending (PSL). The other line of thought is that authorities will adopt a QE similar to the European Central Bank’s long-term refinancing operation (LTRO), allowing Chinese banks to swap their local government debt for loans.

Now, we must bear in mind that central banks won’t normally launch QE unless the interest rate or yield reaches close to zero. Currently, the short-term government debt yield in China is still around 3 percent. In theory, the People’s Bank of China (PBoC) still has ample policy tools and would be in no hurry to roll out QE.

That said, the current rumors to some extent reflect the severity of the problems in the mainland economy and local government debt. Some non-traditional economic gauges indicate that the economic growth is weakening further.

First-quarter GDP figure has come in at 7 percent, the weakest showing since the financial crisis. And the real picture could be even worse. Therefore, the PBoC is likely to pump more money into the system through measures like further interest-rate and bank reserve requirement ratio (RRR) cuts and reverse repurchase programs.

The expected monetary easing has already become the catalyst for market speculation. The mainland market has seemingly followed a pattern seen in the US market. As economic data got worse, the stock market reacted even more excitedly. Thus, the bull market rally has remained intact.

There are various measurements to gauge the valuation of the overall market, like price-to-earnings ratio, price-to-book ratio and Cyclically Adjusted Price Earnings (CAPE) ratio.

And there is also the total market cap versus GNP ratio, an indicator favored by US billionaire and investment guru Warren Buffet. 

“It is probably the best single measure of where valuations stand at any given moment,” Buffet said in an interview with Fortune magazine in 2001. In fact, the tycoon had made accurate market calls with the ratio before the dotcom crash in 2000 and at the height of financial crisis in 2008.

The ratio measures the total market capitalization against the economic size. And investors could evaluate the current level of the market valuation using the mean reversion.

Therefore, if the current ratio is far above the historical average and medium level, it means the overall market valuation is expensive, and vice versa. The overall market investment return relies on three factors — dividend yield, business growth and change in valuation. If the market valuation is too high, it would affect the medium and long-term return of the market due to mean reversion.

Currently, the total market cap of Shanghai and Shenzhen accounts for 68 percent of GDP, compared with the average ratio of 47.6 percent and only 0.76 standard deviation. Therefore, the mainland market valuation remains attractive.

By contrast, the US Wilshire 5000 index already represents nearly 121 percent of the GDP, far above the peak before the 2008 financial crisis and against the average level of 72 percent. That shows the US market is fairly expensive.

This article appeared in the Hong Kong Economic Journal on April 30.

Translation by Julie Zhu

[Chinese version中文版]

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Hong Kong Economic Journal chief economist and strategist

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