The Economist called it “a snort from a dragon’s nostrils.” At the end of February, as China’s stock market index fell by more than 8%, stock markets tumbled around the globe — it was their steepest decline since the September 11 attacks in 2001. The Dow Jones Industrial Average dropped more than 500 points in a single afternoon. In addition to worries about China, concerns about a possible shakeout in the U.S. sub-prime mortgage market contributed to the anxiety. And to add to the gloom, Alan Greenspan, former chairman of the Federal Reserve, commented that the U.S. economy could face a recession. In the week that has gone by, volatility has continued — markets have recovered, only to drop again, and then climb once more.
What is causing this volatility, and what does it mean for investors? Knowledge at Wharton discussed this question with Jeremy Siegel, a professor of finance at Wharton and author of Stocks for the Long Run and The Future for Investors. Next, we spoke with Wharton management professor Marshall Meyer, who closely follows China’s economy.
Knowledge at Wharton: Why did the stock markets fall at the end of February? Is it right to call this “volatility” and do you think it will continue?
Siegel: Well, I wish I could have warned all of the listeners and readers that it was going to happen, a week ago on Tuesday, but no one knew when the markets were going to take a fall. What we really saw was a very tight, upward movement of markets for a seven-month period, which had not even experienced a 2% correction.
That was the longest time period in more than seven months. And, what does that mean? That means that we get a lot of trend followers, a lot of momentum players that jump onto the market like a band wagon and say “I’m going to ride this upward, but as soon as I feel a change in trend, I’m going to sell out.” That’s basically what happened a week ago Tuesday.
There were a couple bits of negative news, not in and of themselves enough to cause the market to go down as much as it did. But, as soon as the market breached that 2% barrier, there was a flood of sell signals and sell orders, and the other 3% occurred in a matter of less than an hour. So what we did is we got a lot of trend followers that were jumping off of this train and that was the major cause of the volatility.
Knowledge at Wharton: What was interesting — and also scary — was that every market worldwide felt the same ripple effects last week. Why did that happen? Isn’t diversification meant to spread risk around, and prevent such simultaneous global meltdowns?
Siegel: Well, I think that what we saw shows how linked today’s world markets are. Really, we have the same players in the world market. Everyone is now dealing with international markets. We have instantaneous communication between traders. They’re all telling each other what they think and that produces “group think.” Emotions, fear, greed, optimism, pessimism are going to be traveling at the speed of light, throughout the markets.
It was remarkable; almost every market fell from 3-6% on that day, markets that had nothing to do with what was being discussed — but I think it tells of the linkage of markets. Now, people say, “Hey diversification does not work.” I think that that’s the wrong conclusion. What we do know is in the short-run, the very short-run. Markets are more linked than they’ve ever been. But there’s no evidence that that is true in the longer period of time. There are all sorts of things that are going to be different, economic growth, currency changes, policies, etc. And so, it is as important as ever to be diversified globally. The only thing I want to warn people about is don’t think that’s going to save you from short-term fluctuations. But, it’s going to be very rewarding for long-term investors.
Knowledge at Wharton: Many investors have been feeling jumpy because of fears about defaults in the sub-prime mortgage market. How serious is that risk?
Siegel: The sub-prime market, in and of itself, is certainly one of the causes of the anxiety. The good news is that I believe firmly that it will be isolated to this market. Also, one has to realize that the defaults that we’re talking about are not going to wipe out 100% of the value, because these sub-prime mortgages do have homes behind them.
And, even if we say that the home is not worth as much as the mortgage now with the decline, almost all experts say that 75-80% of those sub-prime loans have value. That did wipe out 25%, and there were over 500 billion of those. So, that’s $100 billion, but in the credit markets today, around the world, that is not a big number.
It is not the same as the type of credit defaults that we had from WorldCom and all of the telecom companies back in the late 1990s that were building fiber optic cable. This is because in that case, their values went down to zero. All of the sub-prime mortgages have real estate behind them, even with real estate going down, they’re still retaining most of their value. So, my feeling is that this is not going to be a serious threat to the U.S. markets.
Knowledge at Wharton: Some of the economic data that has been coming out has raised some questions about where the economy may be headed. The Commerce Department reported on March 6 that U.S.-made manufactured goods dropped 5.6% in January, which is said to be the fastest decline since 2000. And, last week, Alan Greenspan also made some comments. I was wondering if the market is right in interpreting this data to believe that a recession could be around the corner. What do you think?
Siegel: Well, today Greenspan actually clarified his comments a bit and said that he thinks there is a one-third probability — which surprised me, it’s higher than I thought he would say — for a recession by the end of this year. I think that it’s lower than that; I would say probably 20% or so, not 33%. The bottom line, yes, the economy is slowing down.
You know, we can give a lot of indicators. It grew 3-3.5% in 2003, 2004, 2005 and 2006. By the end of 2006, it had slowed down to around 2%. It looks like it’s at around 2-2.5% at the beginning of this year, in the first quarter. And, I wouldn’t be surprised if for the whole year we see about a 2% increase. This is not a recession.
This is a very typical, what I call “mid-cycle slowdown.” We had the same thing in 1995, after Greenspan and the Fed raised interest rates aggressively in 1994. That was also a mid-cycle slowdown. I think that 2007 will be also slower for growth, but I think looking to 2008 and even the end of this year, we’re going to see growth accelerate again.
Knowledge at Wharton: How do you foresee the situation developing in China? The Shanghai index fell close to 9% last week in reaction to rumors that the Chinese government was going to clamp down on speculation. But after that, Chinese stocks have bounced back. What do you think will happen in China and what impact will that have on global markets?
Siegel: Some people wonder, is China now the market that can set these problems off? Certainly, China is becoming more important. But I don’t think [the Shanghai index drop], in and of itself, justified a world sell-off of many times the entire value of the Chinese market — if we look at the drop in values around the world.
One has to realize that even though 9% certainly is a dramatic number, the Shanghai Index had increased by 130% in 2006. And, even after the 9% decline — and by the way it’s now up from that position — it was still higher than it was just two weeks before. So, when people think of a meltdown in values, almost every investor in the Chinese markets, over the last year, has been up and up, very, very big.
So, my feeling is that China doesn’t like the speculation in the markets, really no central banks like excessive speculation. They could have taken measures to slow it down and those rumors were one of the triggers for that market. I do not see though, anything serious with the Chinese economy. I still think it’s going to grow extremely well. And I don’t think that we have to worry about that contagion being essentially important for the world markets.
Knowledge at Wharton: What do you expect the markets to do over the coming weeks? What factors should investors watch out for?
Siegel: Well, this is my projection going forward. Once we’ve gotten a big decline, we are going to see more volatile markets. I actually think that we will not see it go down much further. I think that we’re going to see it backing and filling for a few weeks, forming a base and then moving upward. And I still believe that by the end of 2007, we’re going to see stock prices higher than we did in 2006.
Knowledge at Wharton: We’ll close with the question that we usually do: What strategy do you recommend for investors in the coming weeks?
Siegel: I still think that there is great value in the Stock Market. In fact, now that it’s lower, I think that there are better values now than there were two or three weeks ago. We clearly will not have the earnings growth that we have had over the last three or four years …. Experts are looking for 6-7% earnings growth. With a 2% dividend yield on top of that, that’s a good return for investors.
If earnings growth is slower or even if earnings decline, I think it is an absolute certainty that the Fed will start lowering interest rates and that will help the markets. So, I think that even with a slowdown in earnings growth, there is very good value in U.S. stocks and in International stocks. And, if the slowdown produces a further fall in the earnings growth or even an outright decline in earnings, I’m certain that the Fed will lower the rates, because that would threaten a recession and that will have the impact of boosting stock prices. So I think that there’s a lot of protection on the downside with very good prospects on the upside.
Knowledge at Wharton: We will now speak with Marshall Meyer of Wharton’s management department, who watches China’s economy closely and has done several case studies on Chinese companies.
Professor Meyer, We were just speaking with Jeremy Siegel, and he noted that China’s securities markets have risen 130% in the past year. What has been driving this bull surge?
Meyer: It’s quite a bull surge, driven by a number of factors. In part, the markets were way down. The markets from 2003 through 2005 dropped — I’m not sure what percentage, but pretty substantially. People were very, very pessimistic, not about the economy, but about the ability of the markets to deliver sustained growth to investors, deliver dividends and so forth. So, it’s a recovery.
But there is something else driving the bull surge and it’s a very, very interesting set of developments. One of the developments is the compensation that the listed firms are paying current holders of A-Shares, that is tradable shares, as the State shares are made tradable. For a long time the states debated whether or not to circulate the Legal Person Share, State Owned Shares.
They finally compromised as so many things are done in China. They decided that to prevent the effects of dilution or to minimize the effects of dilution, that they would compensate existing holders of A-Shares. And, the compensation was pretty high — up to 30%. So, people were betting on the compensation. If you bought at the right time and the company decided to pay out a 20% or 30% share dividends, you could make a lot of money really quickly. And, in some sense, the market was run up by this.
But there are other factors as well, including the growth of the Chinese economy and some other changes occurring in the stock market, which I think we’re going to get to in a few moments.
Knowledge at Wharton: The South China Morning Post has reported that China’s Premier, Wen Jiabao, has just announced a series of measures to prevent Chinese stocks from becoming too risky. In your view, what is required to stabilize the Chinese markets and the economy?
Meyer: Oh, I think a number of things are needed to stabilize the markets a bit and to ensure long term growth of the economy. The most important thing, actually, is not in the stock markets themselves; it’s in all of the internal blockages in China. China is not one economy; it’s thirty-one or thirty-two provincial economies right now.
Doing business within China is very, very difficult. There are internal tariffs or non-tariff barriers internally and the cost of moving goods within China far exceeds the cost of moving goods from China to foreign destinations. And, ultimately China is going to have to build a real domestic economy for sustained growth. There’s just going to be too much push back on the export drive that is in many respects at the core of their economy right now.
Now, there are some other things that probably should take place in China. The most important piece here is the nature of the growth in China. China has replaced production targets with GDP targets. Provincial governors are rewarded for achieving and over achieving GDP targets and this leads to an interesting sort of growth. Just to give you one number: Over 50% of China’s GDP last year was fixed asset investment, basically pouring concrete.
And, it can be argued that China, much in contrast to India, has way too much — as opposed to too little — infrastructure. It’s surprising when you get out onto the new Chinese highways; they’re beautiful highways and basically you’re all alone out there. The trucks aren’t rolling on these highways. So, the government is trying to redirect the economy toward domestic, especially household consumption. Doing that is going to be very hard, however, as long as the present incentives are in place.
Knowledge at Wharton: According to media reports, Mr. Wen plans to continue the macroeconomic control measures that have been in place since late 2003 to cool down the Chinese economy. Is that the right move?
Meyer: Well, I’m not sure. For example, raising interest rates is an uncertain proposition in China, given that many borrowers don’t repay their loans. As you know, China has worked very hard to get the NPLs of the big four banks — Bank of China, ICBC Industrial Commercial Bank and so forth — down and yet everyone acknowledges that the NPLs will go up in 2006, when we finally see the totals, and they will go up again in 2007.
So, the interest rate controls haven’t worked too well. They’ve tried raising reserve requirements for banks. Again, I’m not sure how well they’ll work, given the banks are politically constrained by local governments. I think that as they redirect investment towards the west of China, towards the poorer providences, that this could help a little bit because that’s going to be a pretty productive investment.
But, I also think that the ability of the government simply to control the economy, the ability of the government to collect taxes, the ability of the government to prevent the kind of excessive GDP growth at the provincial level is going to be key to economic change in China.
Knowledge at Wharton: The nearly 9% drop in the Shanghai stock index last week has been attributed to rumors that the government was about to clamp down on speculation. Is that likely to happen?
Meyer: Are they likely to clamp down on speculation? It’s hard to say. One of the numbers that I picked up this morning was that 60% of the share ownership in China is still individual. I’m not sure what the percentage is in the U.S., but at this point I know it is much, much higher than that.
Playing the stock market in China is — let me make a comparison, and maybe it is unfair — it’s like going to the track. The polite phrase for it is “momentum investing.” People are betting on the way that other people are betting and that induces kind of a natural volatility into the stock market.
And to change this, you’re going to need more institutional investors and more sophisticated institutional investors. You’re probably going to need a little more opportunity for folks in China, through QDII mechanisms, to invest outside of China so that they get more exposed to sophisticated analysis and forms of investment, and probably more opportunity for folks outside of China to invest in the A-Share market, through QFII [Qualified Foreign Institutional Investment] mechanisms. So, over time, I think the speculation will calm down, as the market matures a little more. But, I’m not sure what steps the government can take fundamentally to change this near-term.
Knowledge at Wharton: What are the long-term structural changes that are going on in the Chinese Stock Market and what are their implications for long-term growth and stability?
Meyer: Let me go back to something I mentioned a couple of minutes ago. Again, there is a process of converting Legal Person Shares to Circulating Shares in the Shanghai Shenzhen markets. The Legal Person Shares, until this time, could only be owned by institutions. They could be traded, but in a very restrictive market at prices much below the Circulated Shares. The consequence of this was that State Owners weren’t interested in financial results
As the Shares that remained held by State Owners and Institutional Owners become tradable, they also become priced by the market. And so, the State Owners become sensitive to financial results. The consequence of this will be greater discipline on the firms and perhaps, not certainly, but perhaps, better performance of the Chinese firms.
Now, let me give you an indication of the way this is changing. Your introduction mentioned that I’ve written some case studies of Chinese firms — I’ve just finished another one. It’s not been signed off yet, so I can’t describe the details of it here…. But, I will assure you that this is a large Chinese firm. The name is fairly well known and it’s a very large and very significant Chinese firm.
I’ll just describe something that just happened in the course of wrapping up the case. Never in the process of writing this case, did I ask them, “What’s your profitability?” because the group corporation is a 100% State-owned firm that’s not listed. About a week ago, I get an email saying, “Here are our revenues, and here is our profitability for the past ten years.” They are beginning to disclose this stuff. That tells you that slowly the market discipline is working its way into the firm.
One of the long-term strategies of this firm is to list the entire firm. Right now, about half of the business is listed. So, long term, I think that there’s going to be a sorting out in the market. The firms that just aren’t going to do well will manifest this. They can’t cover up their poor performance by listing only good assets and the firms that are going to do really well will show this.
And, it will give the investor an opportunity, if she or he is smart, to make some money on a sustained basis in the Chinese stock market. It won’t be quite the casino that it’s been. So, in that respect, I think that you can be moderately optimistic about the long term in Chinese markets provided this process continues.
Knowledge at Wharton: How do you expect China’s economy to perform in the coming months, and what impact will this have on international firms doing business in China?
Meyer: Well, I don’t know how to measure the performance of the Chinese economy. Remember, GDP is on a quota system, and it’s a ratchet. Everyone ratchets up their GDP year to year. And if you look at the numbers, particularly if you add up the provincial numbers for GDP, they’re going to exceed the number reported by the central government.
This is because this is the nature of any quota system. And again, there lies one of the major problems in China, because under the aegis of a socialist government that still has quotas, macroeconomic quotas, you’ve created this form of “Dodge City capitalism” – Wild-West capitalism where people are just racing to pour more concrete to show that they’ve created more jobs, etc. It’s not sustainable in the long run.
So, I think that efforts to move away from, not so much to suppress GDP, but to move away from a GDP quota system, will have the short-term effect of slowing reported economic growth. I’m not saying actual economic growth, but reported economic growth and will also have the long term effect of improving real economic growth in the country.
There are two conversions taking place from the Legal Person Shares which are not tradable, which disincentivize the state to Circulated Shares, which incentivize everyone to improve the performance of the firm and the move away from GDP quotas toward more realistic reporting of GDP, which ultimately will lead to sustainable as opposed to unsustainable economic growth. All of this I think is very good news for investors.
I think that if you went back to the Soviet Union, prior to 1989 especially, and looked at the effects of their incentive systems, you’d see the same results. Any time that you have production quotas or economic quotas, they’re going to set in effect some processes that will give people a good incentive to distort statistics.
There are some issues of compatibility of Chinese accounting systems with Western accounting systems. Often there’s a reconciliation, particularly in the B-Share market where the shares are in foreign currencies. And, there are still some interesting habits in China of keeping different sets of books for different constituencies. But, I think that it’s the system, it’s not anything that’s peculiar to Chinese culture that produces these distortions.
Knowledge at Wharton: One last question. You have done a lot of research on the globalization of Chinese firms. Do you expect that the recent volatility that we have seen in the Chinese stocks will affect their ability to make overseas acquisitions?
Meyer: That’s an interesting question because the higher your share price, the easier it is to make an acquisition — at least in the West. Now, if you look at some of the large acquisitions that were proposed and one or two that actually went through, in some cases they didn’t involve shares at all.
For example, the purchase or the intended purchase of Unocal — that was going to be pretty much a cash transaction, funded by very low-interest loans from theBank of China. So the share price there, I’m not sure, made a huge difference. I think that if you look at the Lenovo acquisition of the IBM PC business, there it made some difference, but there was also some cash involved.
So, I’m not terribly concerned about the volatility of shares affecting the ability of Chinese firms to make overseas acquisitions. I think the main concern today is political resistance in the United States. And I’m confident, in fact, that the Chinese government has shifted its policy somewhat and you’ll see smaller Chinese firms, rather than the largest firms, making acquisitions more or less below the radar.
I’m fairly confident that you’re going to see the government supporting these acquisitions, not through bank loans or not through loans from the commercial banks, but probably through some help from The Export-Import Bank in China. There will be more acquisitions.
I think political resistance is far more significant than stock market volatility. And, I think that the Chinese government’s policy — the policy of going out — has shifted not dramatically, but incrementally as a consequence of this political resistance.