Buckle up! China’s battered, bruised, and bloodied stock market could fall at least another 15% before it hits the bottom.
That’s the call from some top strategists and money managers, who reckon that the Shanghai Composite Index, the flagship benchmark for mainland China stocks, may find a floor around 2700, down from 3230 at Friday’s close. The index fell 8% last week, even after regaining some ground on Thursday and Friday. It is down 40% from its peak in June.
 
Contrarian-minded investors could be forgiven for wondering whether this is a rare opportunity to swoop in and buy. But if historic price-to-earnings multiples are any guide, China’s rout has yet to run its course.
 
Investors at a Shanghai brokerage monitor the stock market’s downward trajectory this month. Stocks have been slammed as China growth has slowed. Photo: Johannes Eisele/AFP/Getty Images 
           
The average stock in the Shanghai Composite now trades at 15 times earnings, a significant fall from the peak of about 22 times in June. But multiples still look rich compared with the 10 times they were trading at last year, before the big bull market took off. The Shanghai would have to fall to about 2700 to return to a P/E of 10.
 
U.S. stocks, by comparison, have traditionally provided a nice buying opportunity when selloffs pushed the P/E of the Standard & Poor’s 500 to around 12 times.
 
Francis Cheung, head of China/Hong Kong strategy at broker CLSA, thinks the unwinding of margin financing and selling to free up liquidity will indeed push the Shanghai to 2700, a level last seen in December. Cheung recommends getting in at that point, since the market should be supported by lower interest rates and bargain hunting by fund managers.
 
BUT HEADLINE NUMBERS don’t tell the whole story. Chinese stocks still range from pretty overvalued to really overvalued, if you take anemic earnings growth into account. Plus, Shanghai’s average P/E is held down by the hefty weighting of blue-chip stocks in the index. State-backed banks Industrial & Commercial Bank of China (ticker: 601398.China), Agricultural Bank of China                (601288.China), and Bank of China (601988.China) account for roughly 11% of the Shanghai Composite, and all trade at four to five times earnings. They all also have a tiny free float, at less than 10% each, compared with the investor free-for-alls at the top end of the index. Subtract these from the mix and the average A-share—yuan-denominated stocks listed in Shanghai or Shenzhen—has a dizzying P/E of 30 or higher, suggesting the broader market is still overvalued.
 
Other strategists are skeptical about 2700 as a floor. “I’m sure there were plenty of analysts a week ago telling you the floor was 3500,” quips Michael Parker, a Sanford C. Bernstein strategist. He says that for China stocks to bottom, there needs to be evidence of more effective policy making from Beijing than we’ve currently seen. Top of his wish list is for the yuan to stabilize at 6.4 against the U.S. dollar. If Beijing allows the yuan to weaken further, it would be acknowledging that the economy is looking very weak–or that policy makers are incompetent. Neither would impress investors. “The risk is they’ll do something draconian on the currency side,” Parker says.
 
Some market mavens have cautioned against relying on P/E multiples as a gauge of value for China’s volatile stocks. Magdalene Miller, a portfolio manager with Standard Life Investments, says investors should look at price/book to get a better sense of Chinese stocks’ true value. The P/B ratio measures a company’s tangible assets against its share price.
 
Miller believes P/B is less susceptible to market volatility than P/E. That’s good, because Shanghai has volatility by the bucket load. Currently, the market trades around 1.7 times average book value, down from 2.7 times at the height. The bottom for Shanghai stocks could be about 1.4 times book. Stocks last traded there in November, when the index was hurtling through 2500. “This should be a good support level,” she says.
 
The S&P 500, for its part, trades at 2.5 times book. Its peak before the global financial crisis in 2007 was three times, and it bottomed out at 1.4 times a year later.
 
Still, some Asia market veterans warn that even if valuations fall further, Shanghai is best left to experienced stockpickers. In other words, don’t buy the index. “One thing about the A-shares market is it’s all tarred with one brush,” says Andrew Swan, BlackRock’s head of Asian equities. His exposure to Chinese A shares is admittedly small. The fund selectively bought into the run-up when individual P/Es were in single digits, but backed off once they hit the high teens.
 
BUT EVEN WHILE STOCKS are approaching more palatable valuations, earnings forecasts remain weak as Beijing rolls out stimulus measures, including interest-rate cuts and easier bank-capital rules aimed at bolstering growth. Earnings estimates vary widely, with CLSA’s Cheung expecting earnings-per-share growth of 6% to 7%, while Bernstein’s Parker has a bullish forecast of 16% to 17%.

“Earnings revisions have all turned fairly negative, particularly for those areas of the market sensitive to the economy,” Swan says. PetroChina (601857.China), which has the index’s heftiest weighting, is forecast to see EPS plummet 50%. ICBC, Agricultural Bank of China, and Bank of China will see flat profit growth or edge negative.
 
For investors eager for China stocks, the usual lessons apply: Look for strong fundamentals or, as BlackRock’s Swan says, all-weather companies. And Hong Kong’s H shares tend to be better-quality names and look cheap compared with Shanghai. For a few picks from that market, “3 Cheap Hong Kong Blue Chips. 

DANIEL SHANE is a staff writer at Barron’s Asia.