Investment bubbles always look so obvious in hindsight. But when you’re in the middle of one, it’s hard to fight the crowd, even if that little voice in your head tells you to run for the hills.
Why? Bubbles produce compelling narratives that give people reasons to believe. The Internet is changing everything. Housing prices never go down. Tulips are the most precious commodity on God’s green Earth, etc.
Now the same thing is happening again in China, a market that has had one huge bubble burst only recently. The Shanghai Composite index briefly topped 6,000 in October 2007 only to plummet to just above 1,700, a sickening 70% plunge in only 12 months.
But a mere seven years later, Shanghai is above 5,000 again, and the bulls say more gains lie ahead, even though China’s economy is slowing dramatically and some valuations already are stratospheric.
They’re counting on China’s central bank to keep cutting rates. It already has reduced them three times in the past six months. Sound familiar?
Also, the Chinese government has eased trading restrictions on foreign investors. On Tuesday, index provider MSCI said it “expects to include China A shares in its global benchmarks” once it works out some issues with Chinese regulators. A flood of institutional money would presumably follow.
Indeed, mutual fund company Vanguard said last week it would gradually increase the number of mainland China-traded A shares in its Emerging Markets Stock Index Fund and ETF.
This macro “story” has powered Shanghai 150% higher in the past 12 months. Shenzhen and other mainland markets with riskier, more speculative stocks have nearly tripled.
With the animal spirits unleashed, average Chinese investors are piling in. In a reverse of what happened in the U.S. in the 2000s, Chinese investors fleeing a busted housing market have thrown their money into stocks. Talk about going from the wok to the fire!
Consider these worrisome signs:
• China’s GDP growth slowed to 7% in the first quarter, the slowest since the Great Recession, and that figure may be overstated by 1 to 2 percentage points, according to Capital Economics.
• Analysts project earnings growth of companies listed on Shanghai and Shenzhen will be 7% in 2015, the lowest in three years, Reuters reported. The biggest culprits: banks grappling with a surfeit of bad loans.
• ChiNext, an exchange focused on startups, is trading at 140 times last year’s earnings, “in the same league as Nasdaq … at the height of the dotcom frenzy,” The Economist wrote.
• According to one estimate, nearly 85% of China-listed companies are trading at higher multiples today than they did at the previous top in 2007.
• Margin debt is skyrocketing, up more than fivefold in a year to around 2 trillion yuan (about $320 billion), an “unprecedented” 8.9% of the market capitalization of the Shanghai and Shenzhen exchanges. “This could already be the highest level of margins vs. free float in market history,” wrote Macquarie, and perhaps the fastest increase in margin debt we’ve ever seen.
• From January 2014 through mid-May, 225 IPOs came to market on China’s A-share markets, with a mean price appreciation of 418% and trailing-12-month price-to-earnings ratio of 92, according to Morgan Stanley.
• In the four weeks after the government allowed investors to have more than one trading account, individuals opened 12.8 million new accounts. Chinese retail investors generate 90% of all trades, reports Barron’s, higher than the historical average of 80%.
Unfortunately, Chinese investors don’t seem to have learned from their mistakes in the last bubble, maybe because they’re not the same people. And the newbies are hardly sophisticated investors: The Economist cited a study that said more than two-thirds of them left school before the age of 15.
Meanwhile, the so-called “smart money” is cashing in its chips: Both Morgan Stanley and BNP Paribas recently turned bearish on Chinese stocks.
Jonathan Garner, Morgan Stanley’s chief Asia and emerging markets strategist, downgraded China stocks for the first time in more than seven years, citing “the weakest corporate profits since 2009.” “We’d like to recommend taking some profits,” he told Bloomberg.
I’d put it even more strongly. Back in October 2007, I called China’s stock bubble the Mother of All Manias and wrote:
“… Some day, as sure as the sun rises in the East every morning, this market will come crashing down around our ears.
“… Too many novices are engaging in what looks much more like gambling and speculation than long-term investing ...
“Trust me, this can’t last — it never has. The only question is when it will end.”
I stand by those words today. If you’ve had the dumb luck — and don’t kid yourself that it’s anything else — to have made money in the latest China stock mania, I have five words of advice:Get. The. Hell. Out. Now.
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