This is a Finimize article written by Paul Allison. You can read more articles like this on the Finimize website.

It might be hard to believe today, but China’s economy and stock market were the envy of the world not too long ago. Big American and European companies were falling over themselves to build out their businesses in the country, and China’s explosive growth back in the 2000s spurned a commodity super-cycle that some investors thought would last for decades. That was a few years ago, granted, but as recently as 2020 investors were applauding the Chinese government’s zero-Covid strategy and sending Chinese stocks to record highs.

 

But, it’d be an understatement to say that the world’s second-biggest economy has fallen on hard times lately. The on-again, off-again Covid playbook seems to have inflicted lasting damage on Chinese consumers’ confidence, and tensions with America now have firms that were once in love with the country starting to shy away.

 

Premium Valuations

But you know all that, so what’s the point here? Well, just take a look at the chart and let the following statement sink in: since 1992 (the year the MSCI China index was born) a $10,000 portfolio invested in the index would now be worth almost precisely $10,000. That’s no growth, nothing, nada, over a whole 32 years. Compare that to the almost 2,000% gain the S&P 500’s delivered. Then consider that the Chinese economy has grown from around $430 billion to around $18 trillion, or around 4,000% growth, over the same period. So how is this possible? How can an economy be doing so well and yet its companies fail to deliver any sort of return whatsoever?

The first reason is valuation. Exposure to the country – and all that economic growth – used to be rewarded with a premium valuation, but now it’s given a hefty discount because of all those bigger risks. Take Alibaba, the internet giant. Back in 2014, the stock traded on a price-to-earnings (P/E) ratio of more than 44x. It’s now just 7.2x, a dramatic reduction in the valuation investors are prepared to pay for the stock. Now, I should point out that’s only over the past ten years. Getting data for Chinese firms going back to 1992 is practically impossible. Still, Alibaba’s stock illustrates the point pretty clearly.

Stocks are not the economy

The second is that mantra you’ve probably heard plenty of times: stocks are not the economy. Just look at the US, which is pretty much China’s mirror image. The stock market is up nearly 2,000%, while the economy has grown by only 300%. And that divergence is because of a few key factors. One is that valuation argument again (although, interestingly, in 1992 the S&P 500’s P/E was around 20x, which is not far off from today’s level). Another reason is that company profit can grow much faster or much slower than the overall economy, grabbing or giving up share of the overall pie. And finally, there’s the fact that firms can also tap into foreign markets to grow.

The second is that mantra you’ve probably heard plenty of times: stocks are not the economy. Just look at the US, which is pretty much China’s mirror image. The stock market is up nearly 2,000%, while the economy has grown by only 300%. And that divergence is because of a few key factors. One is that valuation argument again (although, interestingly, in 1992 the S&P 500’s P/E was around 20x, which is not far off from today’s level). Another reason is that company profit can grow much faster or much slower than the overall economy, grabbing or giving up share of the overall pie. And finally, there’s the fact that firms can also tap into foreign markets to grow (something that Chinese firms can’t really do).

Holding your nerve for a bumpy ride

For China (and for the US, for that matter) it’s been a case of all of the above. And that brings us to a few important takeaways. First, again, the market is not economy: so don’t put domestic economic growth at the top of your checklist when it comes to picking stocks. It’s important, sure, but not that important. And, second, China has been shocking. That’s not exactly new news, but investors are only now realizing just how bad things have become over the longer term. And, third, for anyone with a penchant for discount shopping, it’s important to follow Warren Buffett’s advice and be greedy when everyone else is fearful. China won’t be a disaster forever, so there’s bound to be some bargains out there. You’ll have to hold your nerve, though, because the Chinese stock market is unlikely to make a V-shaped recovery. It’ll be a bumpy ride.