There's been a lot of chatter lately about the mainland stock market, with analysts debating whether A shares are good value after their recent falls. But anyone tempted to buy on the grounds that mainland stocks look cheap is playing the game by the wrong rules. Valuation has very little to do with the A share market's performance. Recently that performance has been dismal. Yesterday's close left the benchmark Shanghai composite index down 2.5 per cent over the year so far, and more than 10 per cent below its mid-April high as the first chart at right shows. Given the magnitude of the decline it's not surprising that some investors are beginning to think the mainland market looks attractive. At its current level, the Shanghai composite is trading at a multiple of just more than 12 times estimated earnings for 2011, down from 16 times at the beginning of the year and from a multiple of more than 24 times at the start of 2010. That means the mainland market is now even cheaper than the US benchmark S&P500 index. Given the growth differential between the Chinese and the US economies, you can understand why some analysts are once again talking up the value on offer in the Shanghai market. Unfortunately, however, the retail customers who make up the bulk of the mainland's investor base and who drive the stock market's performance care little for value. And they have good reason to disregard the measures of valuation followed so closely by investors in other markets. As the recent spate of scandals centred on Chinese companies listed in the US and Hong Kong, the financial statements of mainland companies are not to be trusted. Earlier this week, for example, big-four accountancy firm Deloitte resigned as the auditor of Beijing-based, US-listed software company Longtop Financial Technologies citing 'falsity' in Longtop's financial records and 'interference' by the company's management. Meanwhile in Hong Kong, shares in vegetable-grower Chaoda Modern Agriculture Holdings crashed by 22 per cent yesterday following reports that it had massively exaggerated the area of land it holds on the mainland. And as today's South China Morning Post investigation into Hong Kong-listed Real Gold Mining demonstrates, doubts continue to pop up about the accuracy of financial statements filed by other mainland companies. What's worse, these are companies listed in Hong Kong and the US, where standards of disclosure and governance are supposed to be higher than on the mainland's stock exchanges. If the information filed by companies listed here is unreliable, there is no reason to believe the financial statements filed by companies listed on the mainland are any better, and good grounds for thinking they may be much worse. Of course, mainland investors have known all along that they can't trust company statements, which is why they don't pay any attention to valuations. After all, if you can't trust a company's earnings figures, then valuation measures like price-earnings ratios are completely meaningless. In a market like the mainland where you can't value companies by conventional measures, stock price performance is dictated not by valuation, but by sentiment and momentum. And sentiment and momentum are driven primarily by the amount of excess liquidity in the financial system. You can clearly see this dynamic in action on the mainland. If you doubt that, take a look at the second chart. The black line indicates the amount of excess liquidity in China's economy, measured here as the multiple by which money supply growth exceeds the growth in nominal gross domestic product. The blue line shows the year-on-year performance of the Shanghai Composite Index. As you can see, the quantity of excess liquidity in China's economy surged in 2009 thanks to Beijing's stimulus efforts. Naturally, much of that surplus flowed into the stock market, where, with a slight time lag, it propelled a spectacular rally. Since last year, however, Beijing has been progressively tightening monetary conditions in order to draw off that excess liquidity. And as it has drained away, the performance of the stock market has slumped. The relationship is clear. The mainland stock market is driven above all by the amount of excess liquidity in the economy. As long as Beijing keeps tightening liquidity conditions, the stock market will remain under pressure. Valuation has nothing to do with it.