Deep value in Shanghai stocks as index slides

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Back in May this year I reconsidered the Chinese outlook, noting that Shanghai equity prices had fallen to reasonably cheap levels while the economy was continuing to defy dooms-day predictions that it would suffer a hard landing.

I did not suggest a bottom in China stocks was yet in place, but I warned readers to keep an eye out for a potential change in trend.

Five months on, what has changed? We’re still watching and waiting. The economy is holding up while the stock market has become even cheaper and this suggesting a great investment opportunity is at hand once investor confidence improves and the economy stabilises.

The slowdown

Although the Chinese economy is still avoiding a hard landing, economic growth has nonetheless continued to slow, keeping investors nervous. Annual growth in national output slowed to 7.4% in the September quarter – the weakest since the depths of the global financial crisis and marking the seventh consecutive quarter of easing growth.

And the latest manifestation of this economic slowdown was a build-up in iron ore inventories due to weaker steel demand, which led to a sharp slump in iron ore export prices faced by Australian miners. In late September, iron ore spot prices touched a low of US$90 per tonne compared with highs around US$150 earlier in the year.

Adding to investor concerns is the fact Chinese authorities have remained reluctant to simply pump their economy with major new infrastructure projects as they did in late 2008 during the Global Financial Crisis (GFC). Some analysts suggest political leaders have been too distracted by a one-in-a-decade power transition that is set to resolve itself soon. If so, we might expect a swathe of new stimulus plans to be announced once the new leadership is firmly in place by early next year.

More likely, however, is that China’s leaders remain less worried about the economy than many international observers and have not felt the emergency stimulus measures of 2008 are justified as the global outlook is far less dire. What’s more, given the fact the 2008 stimulus helped spark a property bubble, China is more circumspect about how it supports its economy this time around, preferring more targeted measures to boost regional infrastructure and consumer spending rather than re-encourage excessive property speculation in its major coastal cities of Beijing and Shanghai.

Levelling out

Indeed, earlier this year China announced an official target of only 7.5% growth in 2012 – the economic data has since been broadly in line with this objective.

Many analyst suggest the economy is close to stabilising, meaning annual gross domestic product (GDP) growth will stop decelerating and level out at around current mid-7% levels. Data released for September provide tentative support for this view, with a lift in a key manufacturing index and stronger-than-expected retail sales and industrial production growth.

As for spot iron ore prices, they’ve recently bounced back to around US$120 a tonne due to some cutbacks in inefficient China iron ore production and a whittling down of excess inventories by steel producers.

The bottom line

As for the share market, the downtrend still remains in place. The Shanghai composite index touched a low of around 2,000 points in late September, and has since bounced higher – but prices remains well below their 200-day moving average and have yet to make a series of ‘higher lows’ and ‘higher highs’ that are needed to mark a new uptrend.

That said, valuations are even more compelling. The price to forward earnings ratio (Forward PE, which is the market share price divided by the expected earnings per share) for the China MSCI index fell to 6.2 as at the end of October – broadly equal to the lowest levels seen over the past few decades. Indeed, it was around these PE levels that the market bottomed in late 2008 and also during the turmoil of August 1998.

The market’s measure of forward earnings is turning down, but the decline is more gentle than in 2008 – consistent with a soft landing. And note, due to very cheap valuations (as now), falling forward earnings in late 2008 and early 2009 didn’t stop the Chinese market rebounding strongly once confidence in the economy was restored.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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