D J INDEXES EPTEMBER CHINA STOCK MARKET IN A GLOBAL ...

[Pages:48]DOW JONES INDEXES

SEPTEMBER 2002

CHINA STOCK MARKET IN A GLOBAL PERSPECTIVE

Research Report by Sheldon Gao, PhD. Senior Director, Dow Jones Indexes

609-520-4114 sheldon.gao@

Executive Summary

China's stock market has experienced amazing growth since establishing its two exchanges in 1990, although the growth has been uneven and irregular, and the market remains in the early stages of its development. This report seeks to identify the key characteristics of China's market and how they combine to form the most dynamic and intriguing developing market in the world.

The current structure of China's market is one of its key obstacles to further development. There are very few stocks that would fit the definition of "blue-chip" trading on China's mainland exchanges. Whereas most developed markets are dominated by a limited number of large-cap stocks, China's market is cramped by a multitude of small-cap stocks. This feature allows for increased speculation and higher turnover for both investors and indexes, among other problems.

A related matter is the reliance of China's market on external expansion, that is, expansion through the issuance of new shares rather than the appreciation in value of existing stocks. Since these shares generally do not experience sustained growth, often because of market manipulation, they contribute to the dominance of smaller size stocks in China's market. Ultimately, the current structure is a major obstacle to the creation of viable index-related products in China.

Another issue is the fact that, despite the tremendous growth of the stock market, China's companies are not operating at a high level of profitability. They are plagued by poor earnings and low dividend yields. China's companies need to increase their profitability if they are to compete in global markets.

Finally, government seems to have too much influence on the market. It keeps a tight control on the issuance of IPOs, and, as a result of widespread government holdings, many listed companies in China have very low free-float ratios. Meanwhile, due at least in part to the unusual market structure, market manipulation and speculation are common. The solution is simply a matter of strengthening controls in certain areas while relaxing them in others in order to foster an environment in which China's stock market can continue to thrive.

CONTENTS

DOW JONES INDEXES

September 2002

4 Introduction 6 Abnormal Performance 9 Tremendous Volatility 12 Insulated Market 14 Substantial Government Ownership 17 Irregular Expansion 19 Influence of IPOs 21 Typical Emerging Market 24 Pyramid Structure 30 Unstable Core 33 Outperformance of Micro Stocks 36 Incredible Speculation 38 Manufacturing Orientation 40 Disappointing Earnings of Companies 44 Low Dividend Yield 47 Conclusions

6 Performance of Major Indexes Worldwide (1994--2001) 7 First Eight Years of the Dow Jones China Index 8 Ten Biggest Up and Down Days in the China Market 8 Crucial Role of the Ten Best Days in the China Market 9 Performance of China Indexes in Domestic and Overseas Markets 10 Volatility of Major Indexes Worldwide (1994--2001) 11 Bull and Bear Markets in China (1994--2001) 11 Bull and Bear Markets in the U.S. and China (1896--2001) 13 Annual Return of Major Indexes Worldwide 13 Correlation Between Major Indexes Worldwide 14 Tracking Error Between Major Indexes Worldwide 15 Float Ratios of Major Stock Markets Worldwide 15 Free-Float Ratios of the China Market (%)

CHARTS AND TABLES

China Stock Market in a Global Perspective 2

CHARTS AND TABLES (CONTINUED)

DOW JONES INDEXES

September, 2002

16 Float Ratio vs. Stock Return in China's Market 16 Government Ownership in the U.S. and Japan 18 Stock Market Expansions in the U.S. and China 19 The Role of IPOs in the U.S. and China Stock Markets 20 IPO Change vs. Index Performance in China's Market 23 Shareholder Statistics in the U.S. and Japan Stock Markets 24 Correlation Between Major China Indexes 25 Market Concentration Measured by % of Stocks 26 Market Concentration Measured by # of Stocks 26 Market Coverage of Dow Jones Country Titans Indexes 27 Market Coverage of China Stocks (January 31, 2002) 27 Comparison of Market Concentration in China and Rest of the World 28 Tracking Error Between Major China Indexes 29 Stock Number: Dow Jones Global Indexes and China Indexes 30 Turnover Rate of Blue-Chip Indexes in Market Value 31 Turnover of Blue-Chip Indexes in Number of Stocks 32 Benchmark vs. Blue-Chip Indexes in China 33 Performance Comparison of China Indexes (1994 ? 2001) 34 Composite Index vs. Stock-Selected Index in a Global Market 35 Performance Comparison of Benchmark vs. Tradable Indexes 37 Turnover Comparison of Several Stock Exchanges 38 Comparison of Sector Representation 39 Sector Representation of China's Stock Indexes 40 P/E of Blue-Chip Indexes in Several Major Markets 42 P/B of Blue-Chip Indexes in Several Major Markets 43 P/E and P/B of TOPIX in Japan 43 Ratio of Stock Market Capitalization Over GDP in China 44 Summary of Index Payout Percentage Over the Past Two Years 45 Payout Ratio and Dividend Yield of Some Blue-Chip Indexes 47 Comparison of Several New Emerging Markets

China Stock Market in a Global Perspective 3

DOW JONES INDEXES

September 2002

China's stock market has grown with amazing rapidity since the establishment of its two exchanges in 1990. However, that growth has been extremely irregular and has not followed traditional models of stock-market development. In many ways, it is still in the early stages

of development.

Introduction

China's stock market has experienced tremendous growth and development in the ten years since the inceptions of the Shanghai Stock Exchange (December 19, 1990) and the Shenzhen Stock Exchange (December 1, 1990). The number of listed companies reached 1,160 at the end of 2001 -- up from only 10 companies in the early 1990s -- with a total market capitalization of 525.6 billion USD. In addition, more than 65 million investment accounts are on record as of the end of 2001.

However, two sets of phenomena have been identified in media reports. One is the rapid growth of the stock market: almost 1,200 listed companies, swelling numbers of stock investors and the generally upward trend of the local stock indexes all indicate that the basic shape of a large country's stock market has formed. The other set of phenomena also deserves the same attention: an incomplete corporate-governance structure, inadequate regulatory capacity, intrinsic structural defects of the market, ferocious market manipulators and all kinds of traps. In other words, China's market is still in the early stages of development. Building a solid foundation and appropriate structure is pivotal to the consistent long-term growth of China's financial market.

People have been trying to understand this paradox, but have failed to figure out precisely the growth and decline of these two components. This has made it difficult to unravel the mystery of China's stock market. For instance, how high is the price-to-earning ratio (P/E) in China's market and what kind of stocks have been the driving power of the market? Furthermore, is China's market ready for financial derivative products?

On May 26, 1996, the one-hundredth anniversary of the Dow Jones Industrial Average (DJIA), Dow Jones & Company introduced its China index series. The first China index series developed by a global index provider, it consists of four indexes. The Dow Jones Shanghai and Shenzhen Indexes cover about 80% of the market capitalization of the Shanghai and Shenzhen Stock exchanges, respectively. The Dow Jones China Index, the composite of the Dow Jones Shanghai and Shenzhen indexes, tracks the general trends in China's stock market. The Dow Jones China 88 Index, a tradable index designed specifically for investment products and derivatives, is made up of the 88 largest and most liquid stocks. With a base value of 100 as of the base date of December 31, 1993, for each of its indexes, the series includes only class A shares, which are restricted to domestic Chinese investors.

China Stock Market in a Global Perspective 4

DOW JONES INDEXES

September, 2002

Since the Dow Jones China index series is constructed according to the same rules and concepts as the Dow Jones Global Indexes (DJGI), it provides a unique platform from which to make a direct comparison between China's market and major developed markets worldwide.

Using the DJGI and the Dow Jones China Index series as tools, this article scrutinizes China's stock market from a global perspective by comparing its structural characteristics and movement patterns with those of other markets around the world.

China Stock Market in a Global Perspective 5

DOW JONES INDEXES

September 2002

From 1994 through 2001, the Dow Jones China Index outpaced

many of the world's best-known indexes. But much of that superior

performance is attributable to a specific share class, specific days

and a specific year.

1. Abnormal Performance

China's stock market delivered impressive returns during the eight-year period from 1994 through 2001, as measured by the Dow Jones China Index1. The index included 549 stocks as of January 31, 2002 (282 in Shanghai and 267 in Shenzhen). As shown in Table 1, it outpaced many of the world's bestknown indexes, including Japan's Nikkei 225, Hong Kong's Hang Seng Index, the Dow Jones STOXX 600 covering Europe, and the Dow Jones World Emerging Markets Index that covers 11 major emerging markets around the world. Of the market indexes considered for this study, the Dow Jones China Index's cumulative return of nearly 80% for the eight-year period is second only to the high-tech driven U.S. stock market, measured by the Dow Jones Industrial Average (DJIA). Coincidentally, the Dow Jones China Index's annualized return of 7.61% almost matched the annualized growth rate of China's GDP. But none of this means that China's stock-market performance can be used as any sort of economic barometer.

Table 1. Performance of Major Indexes Worldwide (1994--2001)

DJ World

Nikkei Hang Emerging

DJIA

STOXX

225

Seng Markets DJ China

Cumulative Return 166.95% 68.74% -39.47% -4.13% -41.16% 79.82%

Annualized Return 13.06% 6.76% -6.08% -0.53% -6.41% 7.61%

Volatility

15.80% 14.53% 20.80% 31.09% 27.92% 51.10%

Return/Risk

0.83

0.46

?

?

?

0.15

Source: Dow Jones Indexes. From December 31, 1993 to December 31, 2001.

The performance of the Dow Jones China Index in the first two tumultuous years of its calculated history was grim at best -- the index fell more than 50% even while China's economy experienced explosive GDP growth. Excluding 1994's performance causes the annualized return over the past seven years to rise steeply from 7.6% to 16.8%. Eliminating 1995 as well, the annualized return for the six years would jump to 23.3%.

The story behind this performance is unusual and intriguing. The China stock market displays unique performance characteristics at three different levels, suggesting that the historical outperformance of China's market is concentrated on a particular year, on particular days and within a particular segment of the market. We have labeled these three trends the "1996 Oddity," the "Single-day Oddity" and the "Segment Oddity."

1 The base date for the Dow Jones China Index Series was set at December 31, 1993. This date roughly coincides with the availability of reliable data and adequate market supervision, qualities that were lacking in the stock market's early stages.

China Stock Market in a Global Perspective 6

DOW JONES INDEXES

September, 2002

Chart 1, below, tracks the performance of the Dow Jones China Index for the past eight years. Each 50-point interval of the Dow Jones China Index seems to constitute a threshold. After dropping 30% in the first three months of 1993 and more than 60% in the first eighteen months of its existence, the index took almost two and one-half years to recover its losses and regain its base value of 100. Thanks to a 125% surge in 1996, the index broke through both the 100- and 150-point barriers. But while the index first passed the 200-point mark in mid 1997, it finally encountered resistance at 250 points when three upward surges in 2000 failed to cross that particular milestone. The index's high close remains 249.80 on August 21, 2000. The market downturn that began in July 2001 has driven the index back to its levels at the end of 1996. Therefore, while China's stock market experienced five strong upward surges in eight years, as marked in Chart 1, the one in 1996 was in actuality the sole contributor. This phenomenon can be termed the "1996 Oddity."

Chart 1. First Eight Years of the Dow Jones China Index

300

5 250

3

4

200

150

2

1

100

50

0 12/31/93

6/30/94

12/31/94

6/30/95 12/31/95

6/30/96 12/31/96

6/30/97 12/31/97

6/30/98 12/31/98

6/30/99

12/31/99 6/30/00

12/31/00 6/30/01 12/31/01

Individual trading sessions also play a similarly decisive role in the index's performance, as shown by the "Single-Day Oddity." Table 2 lists the top ten one-day percentage gains and losses in China's stock market over the past eight years. The two worst years, 1994 and 1995, contain nine of the ten largest "up" days and five of the ten largest "down" days. This concentration might be due in part to the implementation of a 10% circuit breaker since December 26, 1996. However, since the circuit breaker is applied to individual stocks rather than a particular index as at the New York Stock Exchange, its effectiveness in muting fluctuations in the entire market is still fairly limited.

China Stock Market in a Global Perspective 7

DOW JONES INDEXES

September 2002

Table 2. Ten Biggest Up and Down Days in the China Market

Date

% Gain

Date

% Loss

1

08/01/94

34.20

05/23/95

-17.20

2

05/18/95

28.57

10/05/94

-12.27

3

08/03/94

19.18

08/09/94

-10.73

4

08/05/94

16.59

12/16/96

-9.95

5

08/10/94

16.44

12/17/96

-9.86

6

09/05/94

15.93

10/14/94

-9.36

7

05/19/95

11.37

12/18/97

-9.28

8

10/07/94

10.91

05/22/97

-8.97

9

04/26/96

10.24

09/29/94

-8.42

10

02/22/95

10.04

05/16/97

-8.28

Average

17.35

-10.43

Source: Dow Jones Indexes. From December 31, 1993 to December 31, 2001.

Experts and academia strongly advocate long-term investment and buy-andhold strategies and often provide justification for their theories by showing what might befall an investor who missed the ten best trading sessions through inept market timing. China represents an extreme case due to the frequency and magnitude of these exceptional trading sessions, as well as the contrast between the best and worst. For example, as illustrated in Chart 2, if an investor missed all the ten best days in Table 2, he would have suffered a 65% loss over the past eight-year period, even if he was in the market on all other days including during the best year--1996. Therefore, these ten best days determined much of the positive performance of the investor's portfolio.

Chart 2. The Crucial Role of Ten Best Days in the China Market

250 DJ China Index

200

150

100

Missing 10 Best Days 50

0 12/31/93

6/30/94 12/31/94

6/30/95

12/31/95

6/30/96 12/31/96 6/30/97 12/31/97

6/30/98 12/31/98

6/30/99 12/31/99 6/30/00 12/31/00

6/30/01 12/31/01

China Stock Market in a Global Perspective 8

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