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September 11, 2007

Shanghai Stocks and Hong Kong Stocks Are Converging

posted by MR WAVETHEORY at 9/11/2007 01:48:00 AM
I have a theory that stocks that are dual listed on the Hong Kong Stock Exchange and the Shanghai Stock Exchange will converge in price. That is because the P/E of the stocks listed in Shanghai are on average 2x the P/E of the dual listed stocks in Hong Kong. Today's market action proves it is starting to happen. The Shanghai stock index fell about 4.5% while the Hong Kong market fell 0.22%

^SSEC Shanghai Composite 5,113.97 -241.32 (-4.51%)
^HSI Hang Seng 23,946.27 -53.43 (-0.22%)

This is a unique example of free market economics at work. In a perfectly free market with no arbitrage opportunities, one would expect two geograpically similar markets like Shanghai and Hong Kong to trade at a similiar P/E. Today, they are not. Since Shanghai was a closed market, it traded at a significant premium. In economics this is the theory of segregated markets in action, where price premiums exist because investors in mainland China are unable to invest in the Hong Kong stock market. High demand and scarcity of stocks lead to higher prices in Shanghai. The convergence had to wait until the loosening of capital flow. That is happening now.

Ever since the Chinese government allowed mainland investors to invest in Hong Kong, Hong Kong stocks have been performing much stronger than Shanghai stocks. Some stocks I follow are Aluminum Corporation of China and China Eastern Airlines and China Southern Airlines. You can see that stocks like Chalco are demonstrating the rule of converging. Chalco rose today in Hong Kong even as their Shanghai listed counterparts tanked. That's because the Shanghai listed shares of Chalco Shanghai trade at a greater than 100% premium to Chalco Hong Kong. That is an enormous price premium that would not exist in arbitrage free markets. An investor in a free market would short Chalco Shanghai and buy Chalco Hong Kong - assuming no limits on shorting (which is of course not the case since shorting stocks is not allowed in Shanghai).

The chart below shows that Aluminum Corporation of China Limited aka Chalco rose 5.55% in Hong Kong while the Shanghai shares fell 0.44%
Hong Kong (2600.HK) 20.35 +1.07 (+5.55%)
Shanghai (601600.SS) 47.01 -.21 (-.44%)

Chalco is not the only stock that is starting to converge in price with its Shanghai counterpart. China Eastern Airlines fell in both Shanghai and Hong Kong but fell more in Shanghai than in Hong Kong. That is the expected price action based on the theory of arbitrage free conditions in perfectly efficient markets. The charts below show the price action.

China Eastern Airlines
Hong Kong (0670.HK) 6.68 -.04 (-.60%)
Shanghai (600115.SS) 16.74 -0.28 (-1.65%)

The market is not perfectly efficient yet. You can see in the charts below that China Southern Airlines rose more in Shanghai than in Hong Kong. That is not expected behavior. One would have expected the opposite.

China Southern Airlines Limited
Hong Kong (1055.HK) 10.22 +0.16 (+1.59%)
Shanghai (600029.SS) 23.25 +0.97 (+4.35%)

I will be the first to admit that this is a very exciting time in the development of the Chinese stock market. The adoption of market based policies is taking hold every day as seen from the convergence of the prices of stocks listed on the "free market" of Hong Kong and the "insulated market" of Shanghai. History is being made. It will be painful for Shanghai listed stocks and it will be positive for Hong Kong listed stocks which have been neglected. The removal of market inefficiencies is the cost of moving to a free market, and it will be the first real lesson for mainland Chinese investors who have tasted the sweetness of pure profits up until now. Investors will learn that not only can markets bring tremendous profits when they go up, but they can also bring devastating losses when they fall.

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