Is China sneezing?

Is a bubble bursting in China's stock markets, or have this month's events been more about healthy profit taking?

JOHANNESBURG - 

Stock markets in China touched 12-month highs during the first few days of this month, and have since declined sharply, by close to 20% in some cases, creating, for some investors at least, the notion that an apparent chill may gain momentum in the country ranked for years as the epicenter of global economic growth.

In Western markets there has long been a loose rule of thumb that when markets correct by 20% or more, a bear trend is underway. Stock market levels in China, as measured by MSCI Barra, reached multi year highs in 1997, and waited a full decade to reach similar levels, as seen in October 2007. Stocks then declined on average by more than 70%, to October 2008, and then doubled before blowing off earlier this month. The levels seen earlier this month were about half the highs seen in 1997 or 2007.

But this may not allay some fears that Chinese stock markets have popped a bubble and are about to collapse. This month's sell off has been inspired mainly by a growing belief that China's monetary authorities may become somewhat hawkish, after the country's monetary base was allowed to expand by around US$1 trillion so far this year. This may, however, have been enough to create necessary upside momentum.

Seen over the longer term, China's economy has managed to post double digit annual growth for more than 30 consecutive years. For the bulls, the so-called global financial crisis, where the biggest single nuke was unquestionably the 15 September 2008 collapse of erstwhile Wall Street investment bank Lehman Bros., did little to derail China's growth record of three decades.

Chinese exports have been affected, to be sure; the country's economic growth was a relatively modest 6.1% in the first quarter of this year, but expanded to 7.9% in the second quarter. A gigantic stimulus spending package, inspired by global financial crisis, real or otherwise, was allied in China by interest rate cuts and, once again, careful driving from the centre. China's burgeoning middle class is increasingly adding a flip-side dimension to the once export-heavy economy; so far this year, industrial output has increased by 10.8%, and retail sales have expanded by 15.2%. The Goldman Sachs Group anticipates that the country's annual economic growth for 2009 could come in at 10%, a number revised upwards from 9.4%. The double digit growth record over three decades may yet survive intact.

All told, the recent sell off in Chinese stocks can be seen, for now at least, as a healthy round of profit taking. The CSI 300, a broad index measuring the performance of 300 China-listed stocks, is still 96% above its 12-month lows; the narrower Shanghai Composite is 75% above its lows. While the net performance of these indices ranks up there with the best, overall, in the world, there is little in the background to suggest that bubbles are bursting in China's stockmarkets.

From a valuations viewpoint, there is little question that stock valuations had become somewhat overcooked of late. Mining stocks, which can be most readily compared with peer-type stocks outside China, had overreached the valuation metrics derived from mining stocks elsewhere. Recent bouts of profit taking have restored a degree of neutrality to comparative valuations.

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