Red hot: China on the rebound?

The China A shares market has soared in the last week, up 25%, in response to government stimulus measures. Is this news the catalyst that will revitalize the undervalued Chinese stock market? Are Chinese stocks a screaming buy?

A screaming buy? No way. Undervalued? I’m skeptical. Worth owning? Probably, yes.

My favorite indicator says that the China A shares market is currently overvalued by around 50%. This overvaluation suggests that long-term buy-and-hold investors should be underweight China A. On the other hand, China has frequently experienced stock market bubbles, and it shouldn’t surprise anyone if a new bubble emerges this year. China has historically experienced both bubbles and extreme price volatility in response to government policy shifts.

As I’ve previously mentioned, George Soros once said:

When I see a bubble forming, I rush in to buy, adding fuel to the fire. This is not irrational.

That’s the bull case for China A today.

Background on China A

In many ways, China A is special. It’s not a normal stock market like Japan or Canada, consisting of profit-maximizing firms with shares that freely trade in an integrated global stock market. Instead, the China A market does its own thing on its own schedule.

China is unique due to the enormous role of government in all aspects of market functioning. The authorities are not shy about intervening in markets. Here’s Brunnermeier, Sockin, and Xiong (2022):

A striking feature of China’s financial system is how actively the government leans against short-term market fluctuations. The Chinese government does so through frequent policy changes, using a wide array of policy tools …

These government interventions take place in a highly speculative stock market dominated by retail traders. I’ve previously discussed the “unholy trinity” of speculative stocks: volatility, valuation, and volume. This unholy trinity dominates the Chinese stock market, thanks to retail investors. China A shares are generally expensive (high valuation), risky (high volatility), and held for short periods (high volume).

When it comes to stock market volatility, China is the world’s unrivaled superpower. On just one trading day (May 21, 1992), the Shanghai Stock Exchange composite rose 105%. That’s volatility! Such extreme one-day moves are no longer possible in China, due to rules limiting daily price changes for individual stocks.

The China A market has experienced many bubbles in its brief lifetime, including in 2007 and in 2015. Does that mean we are overdue for a bubble today? No, there’s no law of nature that says that China must experience a stock market bubble every ten years. On the other hand, we certainly have the preconditions for a bubble: a market dominated by retail investors, recent signs of euphoria, and support from the central authorities.

China is not in a stock market bubble currently. How will we know when it happens? First, you need prices to rise, and by a lot, not the paltry 25% we saw last week. I’m talking doubling in one year (as in 2015) or quadrupling in two years (2006 to 2007). Next, we need non-price evidence. I’ve previously discussed warning signs of bubbles, such as equity issuance. Unfortunately, some indicators that work in the U.S. have limited applicability to China, because China does its own thing. Aggregate issuance (IPOs, repurchases, SEOs) in China largely reflects top-down government policy as opposed to bottom-up market conditions. One China-specific indicator that has been informative historically is the total number of retail brokerage accounts. In the past, bubbles in China A have been accompanied by a surge in retail investor activity as measured by new accounts (the Fourth Horseman: Inflows).

The AH Premium

I’ve previously discussed the AH premium. Briefly, some Chinese companies issue two types of shares, with H shares trading in Hong Kong and A shares trading onshore. On average over history, the A shares have been overpriced relative to H, a violation of the law of one price (LOOP) that indicates something is seriously awry in Chinese stock markets.

The AH premium varies across firms. As of today, some firms have a premium over 500%, meaning that the A shares are 6X the price of H shares of the same firm. A variety of evidence is consistent with the idea that when A and H prices disagree, H is right and A is wrong (see Li, Liu, and Viswanathan (2021)).

The AH premium also varies over time. As recently as 2014, the cap-weighted premium was around zero, but today, the cap-weighted premium is around 50%.

Historically, stock market bubbles sometimes create LOOP violations, and China has seen many types of LOOP violations over the years. The basic pattern is that anything traded by Chinese onshore investors can get overpriced relative to securities traded by foreigners.

Over the decades, the China A market has been a disaster for shareholders, representing the Platonic ideal of a bad portfolio: low average returns, high volatility. There are many reasons that A shares have delivered low returns, but a huge driver was that A shares were overpriced. As measured by the AH premium, A shares were grotesquely overvalued prior to 2005, fairly valued around 2014, and are now substantially (although not grotesquely) overvalued.

So according to the AH premium, China A is expensive today. Of course, that’s just one indicator, and we can arrive at a better forecast by combining multiple indicators that may operate at different forecast horizons. For example, China A looks cheap today according to traditional valuation metrics such as price/earnings, as noted by my Acadian colleagues in “Rising Tiger, Falling Dragon: Theme Du Jour in EM Equity Investing.”  

What does the AH premium say about the recent increase in Chinese stock prices? While A shares (as measured by the CSI 300 index) went up 25% in the past week, the premium barely moved. So the recent rally is a non-event in terms of the relative pricing of A vs. H shares.

Should you invest in China A?

Here’s my approach to asset allocation for China A. First, as always, start with market weights. The China A shares market is the world’s second largest stock market and thus deserves a substantial portfolio allocation. You’d need to be pretty confident to give it zero or negative weight in your whole portfolio.

However, as often in China, things are not as simple as they appear. What does “market cap” even mean when there are two different market prices? Should we use weights derived using H share prices or A share prices? In my view, you should give a haircut to China A market weights, reflecting the magnitude of the AH premium at least.

There’s a countervailing argument for China A based on security selection. China A is full of cross-sectional opportunities; there’s plenty of alpha in China. If you can identify underpriced Chinese stocks using systematic signals, your portfolio can outperform over time despite any overvaluation of the aggregate market.

So, how should you react to the recent China rally? I’m not sure you should. Whatever your view on China last month, I’m not sure you need to change that view in light of new information. Here’s how I’d think about investing in China A:

• In normal times, you should allocate a positive amount of your portfolio to China A.
  • We are currently in normal times.
  • Reasonable people can differ on whether you should be over- or under-weight today.
  • Use systematic strategies involving stock selection and prudent risk control.
• If a massive bubble emerges in China A, reduce your allocation as prices rise.
  • We are nowhere near a bubble today.
• Expect volatility.
  • Lots.

References

Brunnermeier, Markus K., Michael Sockin, and Wei Xiong. "China’s model of managing the financial system." The Review of Economic Studies 89, no. 6 (2022): 3115-3153.

Li, Fujun, Xiaoyang Liu, and Vivek Viswanathan. "The Revealed Inefficiencies of the China AH Premium." The Journal of Portfolio Management (2021).