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A shares: a resting bull or a bursting bubble?

(chinadaily.com.cn)
Updated: 2007-02-09 17:29

The structural force behind the boom in both domestic and overseas-listed Chinese equities is a strong profit picture. The domestic market performance has dramatically lagged profit growth, which also confirms the equity market is not at excessive levels.

Finally, the Chinese economy remains severely undercapitalized compared to other emerging economies, despite the large number ofinitial public offerings in recent months. The equity market is still at an early development stage, compared with other developing countries such as India and Brazil.

All in all, the rally in the A-share market underway since last year, is for the most part, a mean reversion process following the prolonged bear market between 2002 and 2005 - not a massive overshoot. Importantly, previous boom-bust cycles and extreme price volatility in A shares in the early 1990s were all associated with inflationary flare-ups and subsequent monetary austerity, a situation that is absent in the current macro environment. Therefore, so long as Chinese inflation remains well behaved, strong structural forces will continue to underpin equity performance going forward.

Strategy In A Low Interest Rate Environment

China's ultra-low interest rate environment not only means the equity market should have high multiples, but also suggests that multiples are extremely sensitive to interest rates. Basic principles of finance dictate that the P/E ratio is the inverted function of domestic interest rates, and the relationship between interest rates and equity P/E ratios is convex.

Therefore, in a country like China, even a small move in interest rates can lead to a large fluctuation in equity multiples due to the convexity of the curve. This suggests that the Chinese equity market is inherently more volatile than other countries with high interest rates. In terms of investment strategy, we have the following recommendations:

From a long-term perspective, we are structurally positive on Chinese equities, and an equity portfolio is the best way to directly capitalize on the country's superior economic growth.1 A buy and hold strategy is well-warranted, and patience will be handsomely rewarded.