China’s stock market has foreshadowed moves in global equities the past two years. It peaked on Oct. 16, 2007, two weeks before the MSCI All-Country World Index. The Shanghai index fell 72 percent from its 2007 high and bottomed on Nov. 4, 2008, four months before the MSCI index. The Chinese measure reached its 2009 high on Aug. 4, seven trading days before the global index.

Curious, but not sure if this is statistically significant. If so, the question becomes why. What drives this process. Credit flow?

Shares in the yuan-denominated CSI 300 Index traded at 16.2 times earnings this month, compared with 8.6 times for 43 mainland companies in Hong Kong.

and that

The average gain in China is 23 percent this year, while the same companies are down 4.8 percent in Hong Kong, … China is among three of the four so-called BRICs economies where local shares are providing bigger returns than are available to foreigners … Russia’s Micex index, up 21 percent in rubles since Dec. 31, gained 2.5 percent when measured in dollars. A 9.2 percent decline in India’s Sensitive Index widens to 14 percent in dollars. The exception is Brazil, where the Bovespa Index has risen 5.7 percent, versus a 3.9 percent gain in reals.

The A-shares have always been overvalued compared to the H-shares, when measured against any benchmark currency and people have puzzled over this for a long time. The article itself offers two explanations

“Valuations are more appropriate in the H-share market [in Hong Kong] because more foreigners are paying attention.”

and

Victoria Mio at Robeco Group says mainland investors are quicker to anticipate changes in the local economy and have an incentive to spend their savings on stocks after the central bank cut interest rates five times since September.

Those may very well be the correct explanations, but don’t seem like the whole picture. A cryptic comment that Bloomberg extracted here may give a hint to an alternate explanation

Paul Chow, chief executive officer of Hong Kong Exchanges & Clearing Ltd., said in an interview last week that the valuation gap between the A and H shares is “determined by the market.”

Which is to say, the discrepancy is rational. This says to me that, in analogy to the other countries in which stock markets gained more in domestic currencies than in dollars (their currencies depreciated), China’s seemingly much excessive gains in the domestic currency would not be excessive if expectation about currency valuations is taken into account. If people believe that CNY is undervalued compared to the USD (and in the past year it has been pegged to the USD by policy rather than rising as it had for some time), they would drive up the price of the A-shares in anticipation of currency gain to the tune of the disparity between A-shares and H-shares (HKD is a USD proxy). That would indeed be a market determined phenomenon.

To be more concrete, market gain in local currency + currency appreciation against dollar = market gain in dollar. For example, Russian stocks gained 21% in roubles this year and 2.5% in dollars. So the rouble depreciated 18.5% against the dollar this year. Indeed this is true.

Now, a basket of Chinese stocks gained 23% this year in CNY and lost 4.8% in HKD (which is basically USD). The same argument says that CNY has depreciated 27.8% against the USD since the beginning of the year. But in fact the CNY-USD pair, which isn’t fully tradable, has been constant. So this is unrealized depreciation, or expectation about appreciation were full trading allowed.

One can only wonder about the actual market gain in CNY were market differences allowed to be arbitraged away. But suppose the H-shares market is “correct” at this moment and that A-shares gain in CNY should actually be -4.8% with tradable currencies, then we inevitably come to the conclusion that a one-time CNY gain of 27.8% against the USD would offset the -27.8% difference to reset the A-shares to H-share values as measured at the beginning of the year. In fact, the persistent valuation differences between A- and H-shares are perhaps not a bad measure of relative currency values in lieu of actual trading.

Stock Prices Are Still Far Too Low

By Kevin A. Hassett, James K. Glassman
Posted: Saturday, January 1, 2000

ON THE ISSUES
AEI Online (Washington)
Publication Date: March 17, 1999

The U.S. stock market, despite astonishing price appreciation over the past seventeen years, could triple or quadruple in value without exceeding its true worth.

A year ago, with the Dow Jones Industrial Average at 8,782, we published an article in the Wall Street Journal headlined “Are Stocks Overvalued? Not a Chance.” The piece drew criticism from a financial establishment that had been preaching imminent disaster, pointing to high price-earnings ratios and low dividend yields and predicting that stock prices would fall when this zany euphoria wore off. They were dead wrong. As this goes to press (on April 5), the Dow has closed at a record 10,007, and the S&P 500 and the Nasdaq Composite are also at all-time highs. Including dividends, the 30 stocks of the industrial average have returned 15 percent since our piece appeared, while the stocks of the Standard & Poor’s 500 have returned 21 percent.

Dire warnings from professionals have accompanied nearly every step of the Dow’s rise from 777 on August 12, 1982. Could it be that the model that Wall Street has been using to assess whether stocks are overvalued—a model based largely on historic price-earnings ratios—is deeply flawed? We think so. Investors are ignoring the old shibboleths and pricing companies like Gillette at a P/E of 64 or Microsoft at a P/E of 66. This reflects not their nuttiness but their sanity.

Rationally Exuberant

Contrary to Alan Greenspan’s famous warning—made on December 5, 1996, with the Dow at 6,437—investors today are rationally exuberant. They are bidding up the prices of stocks because stocks are a great deal. Dow 10,000 is just for starters. How high will the market go? We’ll give you a hint: The title of our book, to be published this fall by Times Books, is Dow 36,000. Using sensible assumptions, we are comfortable with prices rising to three or four times their current levels. Our calculations show that with earnings growing in the long term at the same rate as the gross domestic product and Treasury bonds below 6 percent, a perfectly reasonable level for the Dow would be 36,000—tomorrow, not 10 or 20 years from now.

What do we mean by a “perfectly reasonable price”? If traditional P/E ratios or dividend yields no longer apply, then what does? Our model looks at how much money a stock will put in your pockets through the profits generated by the company that issued it. Then, using those returns, we put a price on a stock that is in line with the price of another asset that carries roughly the same risk.

That other asset, believe it or not, is a government bond. Extensive research by Jeremy Siegel of the University of Pennsylvania’s Wharton School has found that over 20 years and more, stocks are no more risky than Treasury bonds or even bills. “The safest long-term investment for the preservation of purchasing power has clearly been stocks, not bonds,” he has written.

Stocks and bonds should offer similar returns at the very least. But according to Ibbotson Associates, large-company stocks have since 1926 been producing average annual returns of 11 percent, while long-term Treasury bonds have returned just 5.2 percent.

Why do stocks return so much more? That question has vexed economists for decades. Their best answer is that investors are irrationally fearful of the volatility of stocks, and therefore demand an extra return to compensate for their fears. What has happened since 1982, and especially during the past four years, is that investors have become calmer and smarter. They are requiring a much smaller extra return, or “risk premium,” from stocks to compensate for their fear. That premium, which has averaged about 7 percent in modern history, is now around 3 percent. We believe it is headed for its proper level: zero. That means stock prices should rise accordingly.

It is this declining risk premium—not higher earnings or lower interest rates—that is the true explanation for the ascension of stocks. The increase in the number of buyers has naturally pushed up the price. To argue today that stocks are overvalued, you must believe that the risk premium, once so irrationally large and becoming rationally small, will move back to that irrationally large state again.

The bears’ view of the world is a contradiction. When the equity risk premium was high, it was a “puzzle,” and economists like Richard Thaler of the University of Chicago came up with complicated explanations for why investors were behaving in such a screwy fashion. Now that investors have smartened up and begun to buy stocks, economists are accusing them of being screwy again. Our colleague Lawrence Lindsey said recently: “We have all the signs of a bubble. . . . People get greedy, and they think nothing can go wrong.”

Will stock prices rise forever? No, they’ll rise until they reach a level where stock returns (the money stocks put in your pockets over a long period) equal bond returns. We are not there yet, but we’re on the way—as four straight years of 20-plus percent returns attest.

Assume Treasuries yield 6 percent. To equalize that cash flow, stocks can yield much less than 6 percent, because, unlike bonds, stocks increase their earnings and dividends each year. In inflation-adjusted terms, earnings per share have been rising by an average of 3.3 percent annually since World War II.

Our conservative calculations show that an earnings return of about 1 percent—or a P/E of 100—is adequate to match cash returns from bonds over long periods. Since the P/E of the Dow is currently about 26, stocks could nearly quadruple before becoming overpriced.

But 36,000 or 40,000 is not so much a precise target as the outer limits of a comfort zone for long-term investors. Certainly, stocks could fall sharply in the short term—as they did last summer after the Russian default—but, ultimately, prices reflect three things: interest rates, earnings, and the risk premium. As long as rates stay reasonable, earnings rise with GDP, and the risk premium keeps falling, stocks will remain the investment of choice.

Why is the risk premium dropping? First, investors have become better educated about stocks, thanks in large part to mutual funds and the media. They have learned to hold for the long term and to see price declines as transitory—and as buying opportunities. Look at 1998, a year in which, by some indicators, the stock market registered its highest volatility in history. Investors did not cut and run; they added $151 billion to equity mutual funds. A study by the Investment Company Institute found that during the market’s 19.3 percent decline over six weeks last summer, investors redeemed only 0.3 percent of their stock-fund holdings. And a study by the Boston firm Dalbar, Inc., concluded: “In a dramatic reversal of the behavior first identified in Dalbar’s 1993 report on investor behavior . . . the 1998 investors see the down market as a buying opportunity.”

Long-Term Holding

Second, partly because of new laws, 31 million Americans (an increase of 48 percent in less than a decade) keep stocks in tax-deferred retirement accounts, which force long-term holding. Third, businesses themselves have restructured and become more efficient, thanks to shareholder pressure, global competition, and computer technology. They are less likely to suffer devastating reversals in a recession. Fourth, government monetary and fiscal management have greatly improved. Fifth, the regulatory and tax environment—while far from perfect—is more benign. Sixth, foreign threats have diminished.

In short, investors’ enthusiasm is well founded. The risks of stock investing—never so great as imagined—really have declined. In 1952, a New York Stock Exchange survey found that only 4 percent of Americans owned equities; today, the figure is nearing 50 percent. It is this broad ownership of stocks that is the most profound evidence that investors have become more rational and that Dow 10,000 is only the beginning.

James K. Glassman is the DeWitt Wallace-Reader’s Digest Fellow at AEI. Kevin Hassett is a resident scholar at AEI. Their book Dow 36,000 will be published this fall by Times Books.

Source Notes: A version of this article appeared in the Wall Street Journal on March 17, 1999.

AEI Print Index No. 10347

Yes. Actually this isn’t that nutty, but unfortunately still wrong. The authors were wrong on the call that the risk premium declined in such dramatic fashion in explaining the market rise. Clearly, the risk premium cannot approach zero, as long as there is undesirable uncertainty in stock performance over any time period (including short-term) and over the collection of stocks. There is also a funny sentence in there about historically rising earnings per share justifying a lower (current) earnings return… but in the past, rising earnings per share led rising share price — earn more and then higher share price follows to reflect it; before every company can guarantee a rising income stream, they would have to borrow money to reflect current earnings or, if it were to reflect future earnings, then at a significant risk premium. And since no company (and not even an entire economy) can guarantee clockwork-like earnings rise, this article’s premise is unfounded.

Here’s an excerpt

The growth in China’s reserves is driven by the rapid growth of its exports, which brings in dollars, euros and other foreign currency, and by the billions of investment dollars being poured into the country.

The surge in money flooding in from abroad forces the central bank to drain billions of dollars from the economy every month by selling bonds in order to reduce inflationary pressures.

The precise composition of China’s foreign currency reserves is a secret. But economists believe that as much as 75 percent is believed to be in U.S. dollar-denominated instruments, mostly Treasuries, with the rest in euros and a small amount in yen.

Stephen Green, chief economist at Standard Chartered Bank in Shanghai, calculated that last year the central bank made a $29 billion profit on its Treasury holdings after paying interest on its own bonds and other expenses.

But even that represents a return of less than 3 percent on the $1 trillion in holdings.

By contrast, Singapore’s Temasek says it has averaged an 18 percent annual return since it was created in 1974.

When a country sells more than it buys, and when other people make investment (gives the country a loan), the excess money ends up parked somewhere, in this case, at the central bank. According to this article, the central bank takes this money and invests it in US Treasury Bonds, but is looking for other investments. But it also mentions, as a separate matter, the central bank sells its own bonds (denominated in RMB, presumably) to absorb excess RMB. But the selling of bonds is not much different from offering a time deposit account, so all that the central bank does is to encourage more savings in it. The intention to remove excess money means the government has determined that the economy can’t bear any more production/investments so that investments should be made to external projects. But it’s strange that the central bank can pay its bonds and still get 3% additional return on behalf of the depositors (which it keeps). Why wouldn’t people just invest in US Treasury Bonds or whatever other external investments themselves? Is it due to the non-convertibility of the RMB? Or is it something else?

In fact, why does any country end up with a huge reserve, even ones with convertible currencies? Some reserve for safety is understandable, but a huge reserve must mean that its people just like to save save save. But why do they like to save? It must be because they have low risk tolerance as individuals — that makes them seek out the government as an investment fund? If so, then it only makes sense for the central bank to leverage its large funds to make risky but diversified investments to give its depositors a high return at a still tolerable risk. In that case, it makes sense that China is making adjustments to its reserves investment policy away from the completely safe US Treasuries, ahead of any further loosening of RMB convertibility. That way, when convertibility arrives, the reserves will be competitive enough to remain large enough for the government to still have its monetary levers on the economy.

In contrast, the US sells less than it buys. But the US Federal Reserve is still awash in money. It gets money from the rest of the world well in excess of what would be the usual investments in the US economy, due to the status of the dollar as the world’s preferred reserve currency. So even with large deficits and lack of savings, the Federal Reserve still can do what it needs to do — and this includes handing out cheap loans to the US government and banks (and indirectly, consumers). Nice.