Not everything that goes down stays down. Anyone who lived through the 2008 financial crisis knows that.
After plunging 52 percent from its 2008 peak to its bottom in March 2009, the S&P 500 has since quadrupled.
But anyone who’s been investing in Chinese stocks over the past year might feel differently.
With the exception of Turkey, China was the worst-performing stock market in 2018. The Shanghai Composite Index fell 25.5 percent during the year.
The Chinese stock market has since recovered only 6.2 percent from its recent lows. That’s little consolation to investors who had to endure last year’s rout.
But Chinese stocks could be gearing up for a rally based on one indicator…
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A reliable indicator just turned bullish
I’m talking about the price-to-book value of China’s markets.
For a listed stock, the price-to-book (P/B) ratio refers to the price of the stock relative to the book value per share, or net assets per share. (You compute net assets per share by taking the value of all assets minus all liabilities, then dividing the amount by the total outstanding shares.)
For a market or index, the P/B ratio is the total market capitalisation of all the included listed companies divided by their total book value (net assets).
The P/B ratio is a useful tool for valuing markets because it relies on book value, which is more stable than earnings, and gives an indication of how much more (or less) an investor is paying relative to the underlying net assets.
In this case, we’re looking at the P/B ratio of the MSCI China A-Shares Index.
The MSCI China A-Shares Index is designed to capture large and mid-cap representation across China securities listed on the Shanghai and Shenzhen exchanges (China’s two stock exchanges).
A-Shares are shares listed on the Shanghai and Shenzhen stock exchanges and traded in China’s currency, the renminbi.
The MSCI China A-Shares Index covers only those securities that are accessible through the “Stock Connect” investor programme, which is designed to allow investors from China and Hong Kong to trade selected securities in each other’s markets.
This is only one of two ways foreign investors can trade A-Shares. The other way is through a Qualified Foreign Institutional Investor (QFII) programme, which is limited to large, institutional funds.
The stocks included in the MSCI China A-Shares Index are the Chinese stocks available for trading by international investors. They include many of the biggest and most profitable Chinese companies, like liquor giant Kweichow Moutai, Ping An Insurance, property behemoth China Vanke, as well as the largest banks.
Since 2010, every time the P/B ratio of the MSCI China A-Shares Index has gone below 1.6 times, it was followed by large rises in the index over the next 12 months. (See the table below.)
Prior to 2018’s year-end rout, the MSCI China A-Shares Index has seen its P/B ratio fall below 1.6 times a total of five times since 2010.
In every single instance, the index was higher a year later. The lowest 12-month gain was 2 percent, while the largest 12-month gain was 84 percent. On average, the index saw a gain of 41 percent a year after.
The shorter-term performances were also impressive. The index was up an average of 12 percent and 35 percent just three and six months after the P/B ratio fell below 1.6 times, respectively.
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Is this time different?
The last time the MSCI China A-Shares Index fell below the 1.6 times P/B level was on October 8, 2018.
Since then, the index has posted a three-month loss of 7 percent. Stock markets all around the world fell sharply in the final weeks of December on global economic slowdown fears.
That’s not an encouraging start.
But things have changed dramatically since then. In January alone, the MSCI China A-Shares Index climbed 8.8 percent, wiping out all the losses since the index broke the 1.6 times P/B ratio in October.
It’s also worth noting that even after a similarly slow start in January 2014, the index still ended up a remarkable 50 percent after one year.
China is also undervalued based on P/E
One other common valuation metric used on markets is the price-to-earnings (P/E) ratio. This essentially takes the combined market capitalisations of all the companies included in the index and divides it by the combined earnings.
For the MSCI China A-Shares Index, the P/E ratio as of January 31, 2019 was 12.1 times. That compares with 16.6 times P/E for the MSCI All Country World Index, 20.9 times for the S&P 500 Index and 14.9 times for the MSCI Europe Index.
So China is undervalued relative to other markets around the world.
In short, this year could turn out to be very prosperous for Chinese stocks.
Editor, Stansberry Pacific Research