Here are some figures which make China's stock market rally look dangerous

If the RBA were a stockbroker it’s unlikely it would slap a buy recommendation on Chinese stocks.

Lost in today’s RBA statement on monetary policy, on page 32, was a section titled ‘Recent Developments in Chinese Equity Prices’. It’s a beauty, and well worth a read if you have the time.

To give you a recap here’s a reminder of what has happened in Chinese stocks over the past year – it’s a daily chart of the Shanghai Composite.

Up more than 100%, it has been the talk of markets, particularly in Asia. It has also caught the eye of analysts at the RBA.

Here’s its take on the breathtaking rally:

“Equity prices in mainland China have more than doubled since mid 2014, with both the Shanghai and Shenzhen exchanges rallying sharply over this time. This rally has been broad based across sectors, and has occurred despite slowing economic growth. It has, however, coincided with rapid growth of debt-financed retail investment in the stock market”.

That’s not a bad assessment and, frankly, not all that unusual. Since 2009, despite subdued economic conditions, most developed equity markets have increased significantly. Leverage, be it retail or institutional sourced, has also been a feature.

However, it’s what the RBA goes on to say which will surely raise some eyebrows.

Here’s its view on the current valuation of listed Chinese firms:

“With analysts’ earnings forecasts for Chinese companies actually being lowered since mid 2014, the forward price-earnings (PE) ratio has increased a little more sharply than overall share prices to around 20. This follows a prolonged period in which the PE ratio was low, largely reflecting scepticism about the outlook for earnings at Chinese banks (which account for around 15 per cent of market capitalisation), such that it is now only moderately above its average since 2007. However, half of the companies listed in Shanghai have a PE ratio greater than 40, with over 10 per cent having a ratio greater than 100. By comparison, only 4 per cent of companies included in the broad US Russell 3000 Index have a ratio greater than 100.3 Moreover, the premium paid by investors to own mainland listed shares of companies that are listed in both Shanghai and Hong Kong increased sharply in late 2014, meaning the same companies now command an average 30  per cent premium in Shanghai, compared with Hong Kong“.

Here’s the chart demonstrating the earnings comparison made above.

So, many stocks are looking very expensive and overall the index is above its long-term average, at least based on forward earnings metrics.

However, it’s the RBA’s analysis on the use of leverage within the stock market rally that really caught our eye.

Leverage has played an increasingly large role in this rally, in contrast to the previous upswing in 2005–07 when margin financing was prohibited. (Chinese authorities only allowed margin financing from March 2010, predominantly for institutional and wealthy investors, but have since relaxed restrictions to extend its availability to retail investors.) Outstanding margin positions in Chinese equities have more than quadrupled since early July 2014 to CNY1.9 trillion, equating to almost 9 per cent of the free float market capitalisation in China (compared with 2½  per cent for the United States and 1 per cent for Australia). Daily purchases using margin financing have increased tenfold over this time, and currently account for almost 15 per cent of turnover. Margin account balances may also be underestimating leveraged purchases of equities, as some investors are reportedly funding equity purchases with money borrowed from other sources. The increase in leverage has been mainly driven by retail investors opening new accounts, though little else is known about the distribution of margin debt.

The increase is shown in the chart below.

If the earnings weren’t concerning enough, this certainly should be. Margin positioning, something that can amplify gains and losses, now makes up close to 10% of total market cap, has grown 10-fold in less than a year and is being used by what are likely unsophisticated retail investors.

While it’s undeniable that the breakneck rally in Chinese stocks is being encouraged by the government, with foundations as “solid” as these, it’s no wonder investors outside of China are wary of participating.

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