The Sky Isn’t Falling—Yet

There's another perceived risk in China. The growing view in the financial community is that the Chinese stock market is in "bubble" territory. With the Shanghai Composite Index up nearly 500 percent since its bottom in July 2005, these concerns can't be dismissed out of hand. But they are impulsive. Badly burned by the tech boom-bust cycle earlier in the decade, investors have been on "bubble watch" ever since. Financial commentators are too quick to dub any sharp asset-price increase a bubble.

A look at past market manias shows that bubbles usually tend to peak when average stock prices reach the level of 50 to 60 times projected earnings for the coming year. At least by this measure—the price/earnings or P/E ratio—China's domestic stock market is not in bubble territory yet, with its P/E ratio at about 35. Big bubbles of the past few decades, such as the NASDAQ in 1989 or the Hong Kong market back in 1973, all reached much loftier heights, with P/E ratios peaking at about 55. Even then, it took determined tightening by central banks to burst those bubbles.

The odds, then, favor a continuation of the broad bull market in stocks, with the fast-growing emerging markets lead-ing the way. The feeling of impending collapse will make way for an ever-rising sense of comfort with higher stock prices. But currently the markets are still some distance away from such a point. If history is any guide, the time to be truly concerned about a bear market will be when central banks have little option but to raise rates to ward off inflation, even if economies are slowing. We're not there yet.

Sharma is head of emerging markets at Morgan Stanley Investment Management.

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