As of October 15, 2023, the Chinese A-share market has garnered significant attention, particularly as its valuation sits at a historical lowThis piques investor curiosity regarding how much further the market can riseHistorically, each bullish phase in the A-share market has seen diminishing peaks in price-to-earnings ratio (PE), indicating a maturation and rationalization within the marketThe sustainability of this upward trend largely hinges on improvements in corporate profitability.
Key to understanding the current market situation is analyzing its fundamental indicators, which hinge on both present-day valuation levels and anticipated growth in earningsUnfortunately, forecasting the latter remains a challenge, compelling us to focus on the existing valuations and profitability metrics.
To delve deeper into profitability, a fair method to assess valuation is through the equal-weighted rolling PE ratio
This approach ensures that individual company performances do not disproportionately skew the results due to market capitalization weightingsGiven that bank stocks constitute nearly 40% of net profits in the A-share market and possess comparatively low PEs, employing an equal weighting provides a clearer picture of overall market health.
On October 15, the equal-weighted rolling PE for the CSI 300 index stands at approximately 28.44, marking it at the 18.58th percentile historicallyThis suggests that the current valuation is lower than it has been for 81.42% of the time in the past, indicating a position on the lower end of historical rangesTypically, during previous bull markets, PEs soared to 45-50, suggesting that there remains a potential upside of around 58% to 76%. That said, historical performance doesn’t guarantee similar future outcomes.
The CSI 500's equal-weighted rolling PE was reported at 36.07, which is in the 22.14th percentile of historical data
- Dollar Retreats, Oil Prices Rebound
- Slight Decline in the Dollar Index
- The Downfall of Japanese Automotive Giants
- Dollar/Yen Hits Five-Month High
- AI Revolutionizes Home Decoration
PEs have previously climbed beyond 80 during market peaks, indicating a possible uptrend of approximately 120%. Similarly, the CSI 1000 index reports an equal-weighted rolling PE of 43.74, within the 22.10th percentile historicallyHere too, past bull markets have witnessed PEs cresting over 100, allowing ample space for growth.
For a comparative perspective, the S&P 500 index in the United States clocked in a PE of 27.14, placing it in the 98.94th percentile of its historical data, comparable to peaks seen during bull marketsThis contrast highlights that while A-shares appear relatively inexpensive, they are not dramatically cheaper than U.Sequities; rather, they reflect a significant historical shift in valuation standards between the two markets.
Turning to the price-to-book (PB) ratio, as of mid-October, the CSI 300 index stands at a PB of 3.06, situated in the 32.31% historical percentile
The CSI 500 and CSI 1000 offer slightly lower PBs at 2.72 and 2.83 respectively, with their historical percentiles at 20.33% and 13.37%. Comparatively, the S&P 500's PB sits at 3.165, reflecting a much higher historical percentile at 84.97%. These figures indicate that while A-shares seem at a relative low in terms of valuation, they somewhat trail behind their U.Scounterparts.
The return on equity (ROE) presents a vivid distinction between the marketsThe S&P 500 boasts an equal-weighted ROE of 11.66% against a weighted ROE of 17.85%. In contrast, the A-share indices reflect lower figures: 10.76%, 7.54%, and 6.47% for the CSI 300, CSI 500, and CSI 1000 respectively, with weighted ROEs of 10.86%, 8.67%, and 8.02%. The higher equity returns observed in U.Smarkets may be attributed to significant stock buyback activities among large companies, reducing net equity while profit margins have steadily risen.
A high and sustainable ROE bodes well for future growth, justifying higher stock valuations
This factor significantly explains why U.Smarkets have outperformed A-shares in recent years, favoring companies with enhanced profitabilityAn illustrative scenario sees both A-shares and U.Sequities at a PE of 30 with an initial profit of $1. If the A-share’s ROE sits at 10% while the U.Scounterpart boasts 17%, the former's profit moves to $1.1 in a year versus the latter’s $1.17, showcasing disparities that compound over time.
Should dividends come into play, the impact may vary; the lower dividend payout ratios in A-shares—typically beneath 30%—highlight that ROE improvements are critical for a broader market rallyIn contrast, U.Sstocks remain reliant on their high ROEs and continued stock buybacks, although rising interest rates and reduced borrowing for buybacks may threaten this system’s sustainability.
Presently, A-share valuations display a high potential for appreciation; however, the overarching challenge lies in raising the prevailing low ROE
Historical patterns indicate that significant ROE increases often materialize alongside rises in producer prices and robust demand in the export and domestic markets.
In the event of an authentic bull market, opportunities for comprehensive market reform become essential, especially in reconsidering the valuation levels of new and recently listed stocksImplementing effective IPO systems that allow for true market activities, alongside addressing limit structures for major shareholders, can enhance the long-term health of China's capital markets.
The recommendation includes adjusting the index to reflect the floating market cap and revamping policies to support the influx of new participants while ensuring that existing shareholders can adjust their positions with less frictionAmplifying market access and easing the regulatory strain could empower corporate stakeholders, inherently aligning their interests with the broader market performance.