Should You Worry About a Chinese Stock Market Bubble?

Shanghai Skyline

China’s economic growth has recently been characterized by diminished expectations. Over the past decade the economy of the world’s most populous country has often handily exceeded the government’s usual target of 8% annual growth. But last year the growth rate failed to meet the government’s reduced 7.5% target, and in March the government reduced its target for this year to 7%. Yet despite these disappointments, Chinese stocks have been among the world’s best performers so far in 2015. Is that dichotomy a worrying sign that China’s stock market gains will prove ephemeral?

Many experts believe the answer to that question is “yes,” and there’s evidence to back up that view. Price-to-earnings ratios for many smaller companies are over 100. Chinese citizens have opened new trading accounts in record numbers. The amount of margin financing (debt being used to buy stocks) has soared. These are all classic signs of a stock market bubble.

But US investors—even those with substantial exposure to Chinese stocks—may be largely isolated from this ostensible bubble. While valuations on many smaller Chinese companies do seem excessive, those for the larger companies that make up the bulk of the stock market are more in line with historical norms. By some metrics Chinese stocks overall may even be undervalued.

Furthermore, US investors (through the funds that they invest in) typically own shares of Chinese companies listed in Hong Kong rather than mainland China. Since late last year the value of the stocks listed on the mainland has surged, and on average they’re currently about 30% pricier than the Hong Kong shares of the same companies. That might be further evidence of investors being irrational, but it also suggests that US investors will be hurt far less than mainland Chinese investors if stock prices decline.

US investors aren’t completely isolated from the bubbly nature of some Chinese stocks: a dramatic loss of wealth for Chinese investors could reverberate throughout the country’s economy and stock market. But bigger-picture issues, such as whether the government can successfully manage the slowdown in the economy’s growth rate, are likely to be more important.