By Jim Trippon, Special Contributor to Wealth Management Exchange
and editor-in-chief of the China Stock Digest

Newswires have been sizzling like never before with stories about the Chinese economy and its stock markets. Commentators and government officials in the East and the West have been issuing warnings and dire predictions with abandon. Politicians from Washington to Beijing have plunged into the fray. And bureaucratic regulators have been pulling the levers of power at an unprecedented rate. Not surprisingly, there has been some market volatility in this environment but not as much as you might expect.

Consider that the benchmark Shanghai Composite Index plunged 8.3% on June 4^th but recovered in the days that followed

Nevertheless, the skyrocketing price increases on the Shanghai Exchange dictate an increased sense of caution for investors on this side of the globe, even though there is a substantial difference between A-shares traded only in Shanghai and the much more conservative ADRs.

It's essential to bring some perspective to the torrent of news that has generated a degree of volatility and uncertainty for investors as we highlight key events over the past few months.

The Sizzling Stock Market

Even the best of news can have unexpected consequences in China's capitalist gold rush.

The soaring Shanghai Composite Index broke a new record on May 9th, racing past the 4,000-point level to close at an astonishing 4,013, an increase of 1.6% for the day.

What a change from just two years ago when the Shanghai Market was stuck in a chronic multi-year slump at the 1,200 level! China's other major equity indicator, the Shenzhen Index, had been an even worse performer.

We saw change begin in a big way last year when the Shanghai Composite Index registered gains of more than 130%. This year the market's blistering pace continues unbroken with share prices in Shanghai rising more than 50% and the Shenzhen Composite Index up 100% for the year.

But the warning signs of market mania are everywhere. During April more novice investors entered the Shanghai market than during the previous two years combined. More than 300,000 new Chinese investors are opening trading accounts every day. That is not a misprint. China is gaining more than 300,000 eager and inexperienced investors daily. It is truly a stampede.

The Beijing Evening News published this description of the stock market obsession that has gripped the nation. "People from all walks of life are entering the stock market, whether they understand it or not…babysitters, street cleaners and even monks have their A-share accounts now," the newspaper said.

China's investment spree has touched every aspect of that nation's life. In addition to the market chatter that dominates every office until the markets close at 3:00 pm, the financial behavior of the Chinese people is beginning to change in important ways. A habitual nation of savers, the Chinese have now begun to shift money with increasing speed out of their bank accounts and into the stock market. According to the People's Bank of China, more than $9 billion was transferred from savings accounts in Shanghai to stock trading accounts in the first four months of this year.

Investors Warned of Risks Of Investing in the Stock Market

Concern is increasing as overzealous investors find dangerous ways to get around the official ban on margin trading. Last year residents of Beijing pawned homes valued at an estimated aggregate of $195 million, and it is believed much of that money was used to finance stock purchases. Pawnshops have become brazen about the practice. They're charging interest rates as high as 3% a month for loans backed by deeds to apartments. Of course that money is being played on the stock market.

The China Securities Regulatory Commission (CSRC) was among the first to sound the alarm, urging stock exchanges and securities dealers to warn investors about the risks of investing in the stock market. The CSRC has ordered financial institutions to caution new investors about the risks of using all of their savings or pawning their apartments to invest in stocks.

Those of us who remember the day when the Shanghai Index dropped by 8.8% last February are well aware that sharp drops in China's mainland markets can have repercussions around the world. Although the Shanghai and Shenzhen markets are largely closed to foreign investors, global stock markets were shaken by the February plunge. This created a rich buying opportunity for many investors.

More recently it was an official warning by the CSRC that set off a new wave of volatility. In a private notice to the managers of 320 Chinese mutual funds, later published prominently in economic newspapers, the Commission warned fund managers to reduce speculation. The mid-May statement noted ominously, "With the stock market becoming more brisk, more and more new investors who lack the awareness of risk are entering, and market irregularities keep rising."

The public warning caused an immediate tumble. The Shanghai Composite Index fell 3.6% in one day to close at 3,889. But it didn't stay there for long. In fact, even as the Composite Index was falling, shares of the Bank of Communications jumped by 71% during their IPO on the Shanghai exchange.

Then in early June the Shanghai Composite Index slid 8.3% as news spread that the government would triple the duty on share trade transaction charges. The Index recovered somewhat in subsequent days but volatility is still the norm.

Greenspan on the Rise in Chinese Equities

Rarely have so many people sounded a warning about an impending market bubble with so little effect. One of Asia's richest and most respected investors, Li Ka-Shing said he was worried about high share prices and warned investors to be cautious about trading on China's markets. Li told the Singapore Press he was "worried about the China market because of its high P/E ratio". The news service estimated the P/E ratio for Shanghai at approximately 50 compared to an Asian average below 18.

Joining the chorus of concern was the Governor of the People's Bank of China and China's State Council which hinted that a capital gains tax might be needed to cool off the soaring markets.

The most dire prediction of all comes from the former star economist at Morgan Stanley, Andy Xie. Now independent consultant, Xie is warning of an imminent stock market crash in China. But how seriously should we take his warning? Xie also predicts a global market crash in 2008 caused by rich stock valuations, an event that would be followed by a worldwide recession.

To give him full credit, Xie is famous in the Eastern financial arena for his contrarian views, but this time he has strained our credulity to the limit. Despite his end-of- the-world predictions, Xie is actually planning to set up a private investment club, open only to his "friends." This exclusive club would invest approximately $300 million in unlisted firms. With breathtaking audacity, Xie has announced that his fund will invest only in firms located in China. Needless to say we won't be joining Xie's end-of-the-world fund.

A more credible warning came from the former Chairman of the US Federal Reserve, Alan Greenspan. Speaking to a conference in Madrid, Greenspan called the rise in Chinese equities "clearly unsustainable." He said Chinese stocks would undergo a "dramatic contraction" at some point, but he didn't predict when. In fact, Greenspan's words caused their own immediate "contraction" although it was a brief and mild setback. Indexes throughout Asia traded lower and the Shanghai Composite suffered a one-day loss of 0.54%.

But Greenspan's latest attempt to tamp down irrational exuberance had little lasting effect. Nor did the efforts of government regulators to cool off the markets by raising interest rates tightening credit restrictions. Despite some volatility, mainland markets rose to new highs on heavy volume.

Is It a Bubble?
Valuation of Stocks is Key

Although many analysts have jumped on the bandwagon, declaring a "red alert" for Chinese markets, there are many reasons to avoid pushing the panic button.

For investors, the key consideration is the valuation of stocks. Stocks of Chinese companies are priced differently (as measured by their P/E ratios) on various exchanges. Many ADRs are among the most conservatively priced compared to listings for the same companies in Shanghai, Shenzhen and Hong Kong.

Nevertheless, we cannot be complacent about the potential consequences of what Alan Greenspan calls a "dramatic contraction" in Chinese markets. While we watch the movements of the markets closely from our offices in the Far East, we also note increasingly strong results from Chinese companies. A little-noticed report from Xinhua estimates that of the 1,028 listed companies that have filed quarterly reports to date, 941 have delivered average profit increases of more than 100% compared to the same quarter a year ago. Another study calculates that average earnings per share of companies listed in China went up 78%.

With new reports of record profits and strong fundamentals from Chinese companies, P/E ratios may not be as high as once feared. As corporate results continue to be reported, current and predicted P/E ratios are actually on a downward slope with stocks on the Shanghai Shenzhen 300 Index reporting a P/E ratio of less than 40. That's still high but some analysts are predicting the average P/E ratio of the two markets will drop to 28 for the whole of 2007 and may fall to a relative cheap 23 during 2008.

Optimistic predictions about future profits and share price multiples are welcome, but China's economy is a moving target. The return on equity of profitable companies listed in Shanghai and Shenzhen has risen to 15%, an increase of almost 50% from two years ago. But enthusiastic investors continue to drive share prices up, and a correction on mainland markets may be inevitable if the buying pressure continues unchecked.