Morgan StanleyÆs analysis of the third quarter results of Chinese domestic A-share market listed companies shows a significant slowdown in their earnings, which it says are still inflated by investment income and are vulnerable to more A-share market correction.

Morgan Stanley notes there are two kinds of stock market bubbles û earnings-driven and multiples-driven û and the Chinese domestic A-share market is a combination of both.

ôWe continue to remind investors that the A-share market hosts not only the biggest valuation bubble amongst the world equities, but also one of the largest earnings bubbles,ö Morgan Stanley says in a recent report. ôOur view on the A-share market remains cautious despite the recent mild correction."

In the report, Morgan Stanley likens the third quarter results to the 'Emperor's New Clothes', the Danish fairy tale written by Hans Christian Andersen, where the story is a metaphor for a situation wherein an overwhelming majority of observers willingly share in a collective ignorance of an obvious fact.

ôPointing out that the emperor has no clothes is not easy while the crowd is still cheering the super growth parade. We however want to remind investors of lessons from Japan in the late 1980s û earnings cut driven by investment losses and multiples contraction can happen at the same time û which can push the market into a freefall.ö

Morgan Stanley notes that the A-share market has corrected around 10% since September 30. Even if the market stays flat from here, it implies Rmb6 billion of investment loss of the 1,446 companies ex-insurers, which could translate into 6% impairment to their annualized current third quarter earnings and a 10% cut from their annualized growth.

Morgan Stanley says that the aggregate third quarter results suggest that companies, save for insurers, experienced a nominal market EPS slowed down to 59% from 67% in the first half. After stripping out investment income and non-operational income, the core ex-insurersÆ market EPS slowed down to 35% in the third quarter from 48% in the first half.

Lessons from Japan in the late 1980s show that once the stock market starts to head down, earnings cuts due to investment losses and multiples contraction can together crush the market like a snowball rolling downhill, Morgan Stanley says.

ôWe flag the warning that as the A-share market starts to struggle to stay at its current high valuations with its mild correction already happening, any further negative news could potentially accelerate the correction and get the snowball rolling to crush the large equity bubble we have today.

China's stock markets fell sharply Thursday on expectations of further measures to cool its fast heating economy, with the Shanghai Composite Index dropping 4.6% to 1,253 points. The index recovered some of its losses Friday, with the index gaining 1%.

Morgan Stanley previously concluded that the marketÆs first half earnings were largely inflated by investment and non-operational incomes and may not be sustainable.

Its analysis of third quarter results shows that not only does the problem persists, but the slowdown is actually happening with the stock market peaking.

Considering the market has already started its correction and even if the market stays flat from here, the fourth quarter could still result investment losses on the income statement, which could be the final push on the snowball to start its roll downhill, and crush the biggest equity bubble in the world today, the report says.