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Shanghai exchange: Tea leaves might be helpful

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It’s a stock market you’d never dream of investing in – because you can’t.

But that doesn’t stop investors around the world from watching the Shanghai stock market for clues about China’s recovery, even if its volatile index is hardly a trustworthy measure of the health of the world’s third-largest economy. North American and European markets swooned yesterday, partly in response to the 5.8-per-cent decline in Chinese equities.

“When you see big drops on the Shanghai market, investors begin to think that maybe there is something fundamentally bad happening in the Chinese economy,” said Eric Yan, a manager at Mavrix Fund Management. “That doesn’t necessarily have to be the case.”

Restrictions on the Shanghai exchange make it next to impossible for foreigners to own so-called A-shares, distorting the significance of the market’s price movements. Instead, the $15.2-trillion (U.S.) exchange is driven by Chinese retail investors who have about 10 per cent of their household wealth invested in the only market they are allowed to access. “So when the market falls, it will affect some investors on the consumption side a little bit,” Mr. Yan said. “But it’s not critical at this point, because Chinese investors can’t invest in any other markets, and we’re far below previous highs.”

While the Shanghai Stock Exchange composite index is up 57 per cent this year, it is still about half of where it was at 2007’s peak, the top of a bubble from which the index plunged 71 per cent before it finally hit bottom in October.

Since then, it has bounced back, but has been trending lower lately – down 16 per cent in the past month. That puts it officially in correction territory, classified as a drop of more than 10 per cent. “There’s still some uncertainty whether the market will go down another 50 per cent or if we’ve hit a bottom in the near term,” Mr. Yan said. “Either way, I’m not bearish on the market.”

There are some signs that a bubble is re-inflating; new brokerage account openings among Chinese residents have crossed the 550,000-a-week level for the first time since December, 2007, and market turnover is on the rise. Na Liu, a China strategist for Scotia Capital, also worries that a severe drop in the market could wipe out consumer confidence. Many retail investors in China lack investment experience, he said. “Some 30 per cent of them have less than two years of investment history and these investors tend to buy more speculative, small-capitalization, low-priced stocks.”

But while valuations may be high – the market’s forward price-to-earnings multiple is 22.5, compared to a historical average of 17.64 – Credit Suisse doesn’t see signs of an impending crash. “We can safely conclude that the A-share market is clearly expensive now but has not reached a full-blown bubble,” analyst Vincent Chan wrote in a report. “If a healthy correction does not happen in the next few months and the market continues to surge ahead, fundamental investors should start to worry.”

Patrick Chovanec, an associate professor at Tsinghua University’s School of Economics and Management in Beijing, said a falling Chinese market isn’t necessarily a bad thing.

“I’ve always felt the Chinese market needs to pop, the sooner the better,” he said. “The only thing worse than having a recession is never having one, because the deadwood never gets cleared out. I’m very bullish on China for the long term, but what China needs right now is a bout of creative destruction that will prepare it for the next round of growth.”

While Shanghai’s index may garner attention lately, the better gauge of Chinese sentiment is Hong Kong’s Hang Seng index, said Drummond Brodeur, who manages the emerging markets portion of CI Investments’ $20-billion global portfolio. The Hang Seng is open to foreign investors, and trades in tighter correlation with other global indexes. It is up 39 per cent this year, and he said a pullback is to be expected.

CTVglobemedia Publishing, Inc

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