Monday, 8 June 2009
Mainland markets are poor prognosticators
Do fundamental investors set prices on the Shanghai or Shenzhen stock markets? The mainland markets are famously speculative, and many people in China have assured me that this is because for cultural reasons Chinese are inveterate gamblers. Strangely enough these are often the same people who insist that China’s very high savings rates are also explained by Chinese culture.
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Mainland markets are poor prognosticators
Michael Pettis
8 June 2009
Are the mainland markets predicting an economic rebound?
What is the surge in the Shanghai and Shenzhen markets telling us? Are they reflecting a sustainable rebound in the Chinese economy and predicting that the worst of the global economic crisis is over?
Almost certainly not. Unlike more sophisticated stock markets elsewhere, the mainland markets do not engage in predicting the future.
With few exceptions, most investors implicitly follow one or more of three different investment strategies.
Short-term investors, who buy or sell largely because of perceptions of changes in short-term supply or demand for stocks, are implicitly speculative.
Investors who take advantage of relative pricing discrepancies or valuation models are following arbitrage or relative-value strategies.
And finally investors who buy or sell assets to profit from the long-term economic value of the associated future cashflows are explicitly following fundamental or value investment strategies.
It is important to understand that while speculators disseminate information quickly, and relative-value traders keep market prices internally consistent, it is primarily fundamental investors who are responsible for the ability of markets to make reasonable economic predictions.
Do fundamental investors set prices on the Shanghai or Shenzhen stock markets? The mainland markets are famously speculative, and many people in China have assured me that this is because for cultural reasons Chinese are inveterate gamblers. Strangely enough these are often the same people who insist that China’s very high savings rates are also explained by Chinese culture.
The fact that Chinese culture can be credited with turning Chinese people both into out-of-control gamblers and prudent, long-term savers suggests how unsatisfactory this explanation is.
What determines whether or not investors will use speculative, relative-value or fundamental strategies is largely the availability of the necessary investment tools.
Because fundamental investors need to project long-term cashflows, they are extremely sensitive to the quality of information and the predictability of corporate behaviour.
In China, many of the tools needed for successful fundamental investing, however, are not available, and it is this, rather than mysterious Chinese propensities to gamble, that explains the speculative nature of the market.
As a rapidly changing economy with conflicting objectives in the information gathering process, China struggles to put together the reliable and complete macroeconomic data needed for investors reasonably to analyse current market conditions, let alone to make reliable projections. Financial statements, even for the largest companies, are notoriously incomplete, in large part because of the serious shortage of qualified accountants.
Perhaps the biggest problem is the governance framework. There are no easy mechanisms that allow investors to enforce discipline on managers, and too often large banks and corporations are driven into behaviour for policy reasons, and not necessarily for economic reasons.
Every new stock market has various combinations of these problems, and China, like other sophisticated markets before it, will eventually work them out.
But for now, it is very clear that investors do not have the necessary tools to engage in fundamental investing in the mainland markets, and so they play almost no role in setting prices. This makes it useless to look at the local stock markets for economic forecasts.
What is driving the current market is probably mainly rapid credit growth and government signalling.
It may very well be that the Chinese economy has finally bottomed out and will rapidly emerge from the global crisis (I have my doubts), in which case the market will have seemed to have got it right. But if that happens, it will be coincidence, no more. The Shanghai and Shenzhen markets are not engaged in forecasting the economic future.
Michael Pettis is a professor of finance at the Guanghua School of Peking University
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