The dizzying rally in the Shanghai Composite Index has created a lot of buzz in financial circles. The index has doubled since the second half of last year, generating a 150% plus annualized growth rate. The rally has also increased the vociferousness of public debate between the cheerleaders and sceptics of the Chinese model. The former cite China’s impressive economic growth as the lynchpin of the equity market rally. In addition, they argue that the rally is likely to continue as households that have hitherto shunned the market rush to embrace equities. The sceptics, however, continue to harbour doubts on the sustainability of the Chinese growth model. To them, the current stock market rally bears all the hallmarks of a bubble. Who is right then and, more importantly, what investment strategy should you follow?

There is no doubt that China’s economic growth has been spectacular. Since the start of the century, China has added $8 trillion to its gross domestic product (GDP). And, in the process, it has become the second largest economy in the world, generating a vast amount of wealth, both for Chinese nationals and foreigners. Per capita GDP has grown more than six times from less than $1,000 in 2000 to $6,800 in 2013 (multiple sources, Google). Even when compared with the other so-called BRIC economies, Chinese growth has been exceptional. China’s contribution to the aggregate GDP of the BRIC nations increased to 60% in 2013 (BRICS Joint Statistical Publication, 2014,) from 47% in 2000. Despite the breakneck growth, the stock market only went up slightly more than 50% (the Shanghai Composite was 1,366 points at the start of 2000 and 2,116 at the end of 2013). Therefore, the argument seems plausible that the current rally is merely the market catching up with economic reality. This is further supported by the fact that in the US, the S&P 500 broadly tracked the 60% increase in GDP between 2000 and 2013 by going up 40% itself.

The second argument in support of the equity market rally is the increasing participation by Chinese households as they shift portfolio allocation away from low-yielding bank deposits and a rapidly cooling property market. The argument is credible since before the current rally, equity market participation rates were roughly half of that in the US (also see this), and household wealth sitting in bank deposits were more than double. Moreover, the property market has cooled substantially with year-on-year change in newly built house prices collapsing from a 7.7% increase in March 2014 to a 6.1% decline in March 2015 (the seventh consecutive month of decline). This has meant that households have moved from property to the stock market to preserve and enhance wealth.

However, the rapid increase in prices certainly seems to have some of the hallmarks of a mania. As the chart shows, the Shanghai Composite Index is closely following the pattern of the final euphoric rise of the Nasdaq in the second half of 1999.

Similar to the dot-com bubble, Chinese stock market analysts are citing that “traditional measures of value have little sway". The expectation is that the government will not discourage the equity rally in order to support household wealth as the economy slows. Therefore, monetary policy will remain supportive. It seems awfully like the Chinese version of the “Fed put".

The evidence strongly indicates that the Chinese equity rally has become a self-feeding spiral with speculators entering in anticipation of a further rise. This is supported by the rush to open new trading accounts and the growth in margin debt, which has increased by 1 trillion yuan (around $160 billion, 1% of GDP) since August 2014 according to BNP Paribas.

On balance, the sceptics seem justified in doubting the sustainability of the rally. However, as several investing stalwarts learnt in 1999 and early 2000, betting against a momentum-driven market can be a very unprofitable endeavour. However, riding with the herd is equally foolhardy.

Although largely unplayable, the Chinese equity market offers valuable clues on the larger China story. The rush into stocks is pulling capital away from other areas such as loan and bond markets (traditional wealth management products offered to retail investors were used to channel money into credit markets). This is likely to exacerbate the credit problems which are beginning to surface. Further, the stock market rally, being fuelled by liquidity, does not contradict the thesis of slower future growth and economic readjustment. This does not bode well for commodities due to China’s role as the marginal consumer. Therefore, prices are likely to stay at current low levels for a while longer. Also, the yuan is likely to weaken further as Chinese authorities try and manage the slowdown and downturn in the credit cycle through easy money. The fact that the People’s Bank of China (PBOC) has already cut rates twice in the last six months strongly suggests this to be the case.

In the final analysis, rather than trying to negotiate strong currents in the equity market, investors may be better off punting in connected markets.

Shashank Khare is an investment professional and writer. After studying engineering at IIT-D and business administration at IIM-A, he entered the world of credit derivatives before CDS became a four-letter word. Having successfully batted through the crises, he now indulges his passion for economics, finance and policy.

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