Goldman Sachs sees China stocks peaking in mid-2008

Stocks of mainland Chinese companies listed in Hong Kong, or H shares, are expected, however, to generate a positive return of 8.8 percent next year, the investment bank said in a research report presented at a media briefing Wednesday.

“We believe euphoric sentiment and liquidity could potentially propel Chinese stocks to unsustainably high levels in the first half of 2008 before they subsequently retrace on growth, margin, inflation and valuations concerns,” it said, citing next summer’s planned Olympic Games in Beijing.

The report was written by a team headed by Thomas Deng, its chief strategist for China.

China’s benchmark Shanghai Composite Index has jumped 350 percent since the start of 2006, buoyed by strong economic growth and corporate earnings.

Despite a 14 percent correction since mid-October, the average A-share price-earnings ratio remains above 60 times 2006 earnings, compared with Hong Kong’s 22 times, sparking repeated warnings from global investment bankers of a possible bubble.

Morgan Stanley, in a research report published on Tuesday, said: “The A-share market hosts not only the biggest valuation bubble amongst the world equities, but also one of the largest earnings bubbles.”

It warned that the A-share market was now struggling to stay at its current high valuations and any further negative news could accelerate a correction to levels that might resemble what happened in Japan in the late 1980s.

But Jonathan Anderson, chief Asia economist at UBS, said any major A-share correction should not have much impact on China’s economy mainly because of the country’s small free float, which gives it one of the smallest equity exposures as a share of gross domestic product in Asia.

“And even the total market capitalization data put China a long way behind other historical market bubbles,” Anderson said.

An analysis of the relationship between stocks and bank deposits in Japan and Taiwan indicated that in each case total equity market capitalization reached 140 percent of broad money M2 at the height of the bubble, he said in a research report last week.

“In China today the ratio is just passing 75 percent,” he said. “On this measure, China is only half way up, more in line with Japan and Taiwan in the late 1990s than in the late 1980s.”

The Goldman Sachs report forecast that China’s CSI300 Index, which tracks 300 A shares on the Shanghai and Shenzhen stock exchanges and is used by most A-share funds as a benchmark, was forecast at 4,700 points by the end of 2008. The index closed at 4,997.62 on Wednesday.

Hong Kong’s China Enterprises Index of H shares, which closed at 15,993.50 on Wednesday, was forecast to reach 19,600 points by the end of next year, it said.

“Using a combination of valuation models and explicit cross-country comparisons, we conclude that current valuations are at most fair for H shares and unjustifiable for A shares,” the report said.

“We believe the current forward P/E, which is at around 32 times, is neither justifiable in theory nor by fundamentals. We expect it to gradually normalize to our expected long-term maximum fundamental forward of 27 times.”

China’s real GDP growth was forecast to slow to 10.3 percent in 2008 from 11.6 percent in 2007, translating into slower forecast corporate earnings growth in 2009.

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