Why Is Goldman Sachs Still Bullish on Chinese Stocks?

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Forget Greece. The real Greek tragedy unfolding at the moment is in China. The carnage taking place across Chinese sharemarkets is a sight to behold. Markets have lost a third of their value in the past month alone. That’s a cool $3 trillion wiped off without a trace.

So it comes as something of a surprise to hear that Goldman Sachs see no reason for panic just yet. The investment bank forecasts Chinese stocks will rebound over the next 12 months. Before we look at the likelihood of that, let’s spend some more time addressing the bloodshed taking place.

Yesterday we reported that regulators suspended 700 listed companies from trading. Overnight a further 660 companies requested to have their shares suspended too. As of writing, half of all stocks on the Shanghai and Shenzhen indices have ceased trade.

Well, that’s certainly one way to prevent the flood of selloffs. But these efforts have so far been in vain.

There was little tangible effect on investors this morning, who continued where they left off yesterday. The Shanghai Composite Index fell by 8% within minutes of the markets opening.

It was the usual suspects leading the selloffs.

Leveraged traders continued to wind back their positions; some profitably, others less so. This was made worse by brokers ramping up margin calls. We’re seeing them increasingly demand investors pony up the cash to cover potential losses.

The response from regulators has been one of bemusement. They accused the markets of resorting to ‘irrational selloffs’. But how irrational is this really?

There’s little doubt that Chinese stocks are, for the most part, overvalued. The market panic we’re seeing is simply an admission of this.

The median P/E ratio has fallen from 108 in June to 55 today. Despite that, stock valuations remain almost twice as high as those on the S&P 500. That’s irrational.

Merely pretending that the panic is irrational misses the point. Retail investors have driven up stocks to levels that are far in excess of the value they present. China’s economic fundamentals don’t support current stock valuations. That was true before the selloffs began, and it remain true now.

Stock prices still need to fall drastically before they reflect China’s current economic climate. In any sensible market, investors don’t reward companies whose profits are flat lining. But that’s been the Chinese market in a nutshell over the past year.

Despite overwhelming evidence to the contrary, not everyone remains convinced that Chinese markets are in bubble territory.

Goldman Sachs predicts the stock market will rebound

The extent of the selloffs hasn’t spooked Goldman Sachs from making some bold claims. The bank predicts the CSI 300 Index will rise by 27% over the next year. The CSI 300 is a large cap index measuring stocks across both the Shanghai and Shenzhen indices.

Goldman Sachs believes that the leveraged positions on the markets aren’t big enough to cause a market crash.

That may be so, but what should we make of retail investors? Their confidence must be dropping by the minute.

They’ve already watched the market lose US$3 trillion of its value in a matter of weeks. This is as much a game about market confidence as anything else. When investors watch the market panic as its doing, they get spooked.

In any case, Goldman Sachs believes that China’s government will do whatever it takes to halt the slide. They cite both direct and indirect measures as tools they could use. Directly, alongside regulators, they’ll continue to interfere in the markets. That means we’ll see more regulations aimed at improving investor confidence.

Indirect measures, on the other hand, will include lowering interest rates further. At 4.8%, the Chinese government will almost certainly lower rates to boost the economy and investor confidence in equal measure.

But the psychological effects of the past few weeks on investors could be scarring — and lasting.

The problem with Goldman Sachs’ conclusion is that it places emphasis on the past growth of Chinese markets. But we could easily flip that argument around. With the Chinese economy slowing, who’s to say that its decline won’t be equally as dramatic?

For the sake of comparison, take a look at the chart below.

Chinese Stocks

Source: zerohedge

The graph speaks for itself.

While we should be wary of jumping to any conclusions, the comparisons are striking nonetheless.

There’s no reason why the SCI couldn’t follow the same fate as the Dow in 1929. It’s trending more or less in line with the American index prior to the crash. Most importantly, a similar decline to the Dow would actually place Chinese stocks in line with market expectations.

Chinese markets would have to drop another 60% in order for stocks to revert to levels prior to the boom. It’s only at this point where we’d see the P/E ratio represent true value to shareholders.

On that note, I’ll leave it to ThinkForex analyst Matt Simpson to sum up the situation facing investors:

The China stock market ‘bubble’ clearly has investors more concerned [than Greece]. Considering the fact that Public Bank of China has already spent billions this week propping up markets.

To see those same markets gap down lower than their interventions is a very worrying sign for investors across the globe. [And it] could indeed just be the beginning of something far more sinister’.

Global markets should be bracing for the worst.

Mat Spasic,

Contributor, The Daily Reckoning

PS: China’s stock market is hurtling towards a major crash. The fallout from this will have big repercussions on the Aussie sharemarket.

The Daily Reckoning’s Vern Gowdie sees a major correction across the ASX in the future. Vern is the award-winning Founder of the Gowdie Family Wealth advisory service. He’s been ranked as one of Australia’s Top 50 financial planners. He believes we’re set for a catastrophic crash in stocks in the future. And he thinks the ASX could lose as much as 90% of its $1.8 trillion market cap.

Vern wants to help you avoid the coming wealth destruction. That’s why He’s written ‘Five Fatal Stocks You Must Sell Now’. In this free report, he’ll show you which five blue chip Aussie companies could destroy your portfolio — and you almost certainly own one of them. To find out how to download the report, click here.

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The Daily Reckoning
The Daily Reckoning offers an independent and critical perspective on the Australian and global investment markets. Slightly offbeat and far from institutional, The Daily Reckoning delivers you straight-forward, humorous, and useful investment insights from a world wide network of analysts, contrarians, and successful investors. Founded in 1999, The Daily Reckoning is published in 7 countries with a worldwide readership of almost 1 million people.

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