By Hong Liang (China Daily)
Updated: 2007-11-20 07:25

As the market is going into a correction phase, investors are beginning to question the upside potential in coming months.

From a macro point of view, the answer seems to be positive. Despite the surge in world commodity prices, particularly oil, and the shadow cast by the US subprime mortgage crisis on world investment markets, the Chinese economy is humming along at a brisk pace.

Export growth has remained robust, indicating that the slack in the United States has largely been offset by increases in the EU, Japan and other markets. Domestic fixed capital formation, including property investments, is showing little sign of slowing down and the feel-good-factor seems to be driving a healthy increase in consumer spending.

But what weighs most heavily on the minds of investors is whether the market is over-valued after the surge in the index of more than 100 percent, despite occasional faltering, since the beginning of the year. Trading at an average price to earnings ratio of 60 times, Chinese shares certainly look expensive compared to those in other markets, including Hong Kong, Singapore and Tokyo.

To be sure, high PE ratio alone does not rule out upside potential provided that corporate earnings are widely expected to continue to surge at rates seen in the past couple of years. But the market consensus seems to suggest that the high profit cycle is beginning to stabilize.

It has been suggested that windfall profits from share and property investments have contributed much to the big earning increases in the past several quarters posted by many mainland enterprises. If that is the case, the expected cooling off of the stock market will seriously impede these companies' performance in 2008.

A major shift in the supply and demand equation appears to suggest that the rally is losing steam. A spate of mega IPOs, or initial public offerings, have vastly increased the supply of scripts. This, coupled with the spectacular price surges in the past several months, have combined to push the total market capitalization to 45 percent of financial assets, compared to no more than 30 percent in developed markets, according to calculations by UBS Securities Asia, a unit of Swiss financial house UBS AG.

This means that the mainland stock market has already absorbed such a large chunk of liquid financial assets that has caused further asset reallocation, the shifting of money from bank deposits to the stock market. The stock market rally, as we have seen so far, simply cannot be sustained without that flood of fresh investment capital.

Of course, we do not expect to see a serious liquidity crunch even in a massive price correction because margin trading is prohibited although some enterprises are said to have channeled part of their bank borrowings to the stock market. On the other hand, the lack of gearing denies the market an important source of liquidity that could drive it to new heights.

In the absence of hedging tools such as index and stock futures, those investors, who feel skittish, can only realize their gains by selling in the market. The question then is where to park your money.

The popularity of the QDII, qualified domestic institution investors, funds appears to suggest that a growing number of investors are keen to diversify at least part of their investments to overseas markets. But that does not seem such a smart move because the prospect of many overseas markets is clouded by the possible fallout of the US subprime mortgage crisis.

The common advice from investment experts is to sit tight and prepare for leaner returns ahead. It is really not so bad after all.

E-mail: jamesleung@chinadaily.com.cn

(China Daily 11/20/2007 page10)