Jake's View

Long-suffering stock market investors Shanghaied

PUBLISHED : Sunday, 16 March, 2014, 3:33am
UPDATED : Sunday, 16 March, 2014, 6:24am

The authorities are alarmed at the drop below the 2,000 point mark [on the Shanghai Composite Index] for its implications for social stability in a country where millions of retail investors have put their life savings into stocks.

South China Morning Post, March 13

Thus twice last week the market was shouldered back over the 2,000 mark. Behave yourself and do your patriotic duty, the authorities said in so many words. But I'm sure they kept their fingers crossed, too.

It is remarkable that China's major stock market index should continue to perform so poorly. The Shanghai Composite is now back where it was 13 years ago, indicating that investors have since seen no return whatsoever in the average value of the stocks they hold.

Meanwhile, as the first chart shows, the nominal value of China's GDP went up six fold. What we have here is one of the world's greatest ever dislocations between the performance of an economy and returns on the money invested in that performance.

Admittedly, no law says a stock market's performance must match that of its underlying economy. There can be huge divergences at any time for any number of reasons.

To take just one, share prices are more sensitive to changes in the underlying yield structure of an economy than to its growth. For instance, since early 1982 when US interest rates peaked and began a multi-decade decline, US nominal GDP has risen five fold but US share prices have risen 15 times.

In China, interest rates have generally remained in the same range over the past 13 years and the yuan yield structure is thus unlikely to have affected share price performance to a similar extent, either up or down.

But in this environment very high economic growth rates should on their own have produced a bull market.

The second chart gives you an example of how one might expect the Shanghai market to have responded to economic growth. Since South Korea began to open to foreign investment 30 years ago, its stock market has roughly tracked GDP growth in a financial environment in which interest rates have generally trended down but not steeply so.

I would still rate the Korean market's performance slightly disappointing for this environment, however. Its corporate investments still suffer too much from nationalist considerations.

All else being equal, one might reasonably expect total returns on equity investments to run at perhaps 2 per cent more than nominal GDP growth. Why else bother concentrating money in a stock market if the odds are that any individual enterprise can do as well?

For the US, that stock market performance since 1982 was about 4 per cent more annually than GDP growth.

But just 2 per cent more over the past 13 years would have put the Shanghai Composite at about 15,000, not the 2,000 against which it is now brushing.

Yes, I would certainly feel betrayed if I were a mainland retail investor in equities. Yes, there could be implications for social stability here.