Markets: Shanghai-ed?
New York: March 05, 2007
By John R. Stephenson

"May you live in interesting times."

-- Chinese proverb and curse

"The stock market will carry on with its craziness, whether it collapses, oscillates, or both at the same time, collapsing in crazy oscillations."

--Liang Jing (pen name), Chinese economist

What a week it was! No one seemed to see it coming. While we had all been warned about the risks of stock market investing, it shook most of us from our complacent slumber, when unexpectedly, the Shanghai Stock Exchange plunged. But does it really matter?

Probably not! After more than doubling over the past year, the Shanghai Stock Exchange tumbled 9% on Tuesday and triggered sympathetic stock market sell-offs around the world. Nervous global investors fretted that the Chinese economy, which has been a strong engine of global growth, might be in for a major overhaul.

Figure 1: Percent of World GDP Growth, 2004-2006

Source: CIBC World Markets

With the Shanghai Stock Exchange on a roller coast ride downward, investors bailed from established markets. When the week was said and done, the S&P 500 stock index had fallen 4.41 percent, the United Kingdom's FTSE 100 Index was off 4.46 percent and Japan's Nikkei was down 5.34 percent. Surprisingly, Toronto's commodity heavy S&P/TSX Composite Index was down only 3.6 percent.

In North America and Europe, stock markets depend on strong corporate profits for their strength. That, in turn, is a function of the underlying economy. If the economy is in good shape, then companies will be profitable and corporate earnings will be fat. With visible growth in the economy, stock investors will bid up the share prices of companies on the expectation of rising corporate profits. When the economic conditions start to weaken, investors anticipate tough times ahead and sell shares in anticipation of lower corporate profits ahead. Because of this phenomenon, the level of the stock market is often considered a leading indicator of the overall health of an economy.

But that's only the case in the west. The Shanghai Stock Exchange is just 15 years old and is still riddled by corruption, lax governance and troubled corporations. Add to that a cocktail of rampant rumors, an unsophisticated investing public, unbridled speculative activity and lofty valuations and the stage is set for a rapid sell-off. Much of what fueled the run-up in the Shanghai exchange and subsequent sell-off was the greed and fear of novice investors looking to cash in on the country's economic promise. In North America, the value of most of the companies that comprise the Shanghai Stock Exchange is not related to the underlying fundamentals of the company or the economy broadly.

The link between the stock market and China's economy is a tenuous one at best. Of the 1.3 billion people living in China, the vast majority of them live on farms and in rural areas and aren't shareholders. The Chinese economy is dominated by lumbering state-owned companies that don't need to visit the capital markets (stock and bond markets) to raise money to fund future growth. Not only that, but much of the $1.3 trillion market capitalization of the Shanghai Stock Exchange is in untradable shares with only some $400 billion that can be actively traded. Some 60 percent of these tradeable shares are in the hands of state corporations, the police, the army or large private investors of dubious status. The upshot? The Shanghai Stock Exchange more closely resembles a casino than an organized efficient pricing mechanism.

Should investors worry? No. From 2001 to 2005, the Shanghai Stock Exchange shed half of its value, but the economy powered ahead unabated. Today, China powers ahead with strong economic growth near 10 percent per annum proving that, at least for now, China will be demanding lots of base metals, gold and petroleum to keep the economic miracle on track.

While this past week's events have sent a warning shot across the bow of complacent investors, sending the metals markets and resource stocks scrambling for cover, this too will be short-lived. No doubt what the Shanghai sell-off has shown is that the era of investing complacency may be over, but there still remains plenty of great value investments out there as long as investors are aware of the risks.

For sure there will be other panics and manias in the days and years to come. Globally, we are awash in plenty of cheap money that is funding a bonanza in private equity deals around the globe. With plenty of cheap money sloshing around, old-line utilities of the likes of Texas Utilities (TXU - NYSE) have fallen prey, in a $32 billion leveraged buyout funded by both KKR ( Barbarians at the Gate Fame) and Texas Pacific Group. The next crisis in the capital markets, when it comes, will be driven by problems right here at home — namely, companies that start to hemorrhage on a smorgasbord of debt.

For now, the sell-off in base metals and oil stocks has provided a rare opportunity for savvy investors to add to their positions. While weeks like the past week are a little scary, at the end of the day, it is fundamentals rather than sentiment that will rule the roost. The story in base metals and crude oil got a little better (more affordable) rather than worse over the course of the past week.