Investment Bubbles and the Chinese Stock Market Bubble
Real Estate

Investment Bubbles and the Chinese Stock Market Bubble

investment bubbles

It seems that investment bubbles appear once or twice a decade, and obviously they should be avoided. One of the best ways to build a successful long-term investment plan is to simply avoid big losses (such as when an investment bubble bursts). Two recent investment bubbles that the markets have experienced in the last 10 years were the tech stock bubble of 1997-2000 and the real estate/housing bubble in the last 5 years. Both bubbles have created horrible hangovers (and big losses) for investors who had too much money invested when they burst. It is very difficult (and often takes many years) to offset large losses of 25% to 50%. It’s often tempting to invest in a bubble sector (or stay invested in a bubble sector) when the market is rising and you’re hearing stories from your peers about how much easy money they’re making. Unfortunately, history shows that the risk/reward of doing so is not a good one.

Common signs of an investment bubble

o Everyone is inside. People who are not normal stock market investors for their investment money. It is so easy to make quick money in this bubble sector. You don’t need any experience or analysis; just buy what’s going up the most. Taxi drivers, school teachers, retirees and many others who have never invested in stocks are piling up.

o A feeling you can’t lose. Great long-term secular “history”.

o Dramatic increases in prices/values ​​over 3-5 years.

o The valuation does not matter. Ridiculously expensive valuation in relation to history. Creative new ways to value assets (since using traditional metrics makes them look ridiculous).

o Buying simply because they are rising, not because of any rational analysis. Impulse investment. Buyers are mostly speculators rather than investors.

o Leverage or “creative” financing. Investors in technology stocks trade daily on margin. Homebuyers using 40-year adjustable rate loans with low teasers.

o Artificial reasons that push the market up.

o Excess liquidity fueling the increase.

or big headlines. It’s the only thing people talk about. There are regular stories about the number of billionaires being created daily in the bubble sector.

o Massive and accelerated inflows of money from investors in the sector during the last 3 years or more.

The Chinese Stock Market Bubble

The market that currently most closely resembles a bubble investment sector as described above is the Chinese stock market. Warren Buffet commented on a recent trip to China that he does not find the Chinese stock market attractive after the big rise. Warren has recently been selling his stake in PetroChina. The Chinese economy is booming right now, growing at about 10% a year. The future of China is a great long-term secular story. The Olympic Games will be held there in 2008. This is an obvious positive megatrend in today’s world. Bubble markets always have great stories as to why this trend is bigger and better and will outlast others. The world is different now from the bubble of the moment. You do not get it? But what do you pay for it?

The Chinese stock market is currently exhibiting all of the bubble market indicators listed above, just as previous housing and tech stock market bubbles did. The Chinese market is now trading at about 45 times earnings compared to about 16 times for the US market. It was up more than 100% in 2006 and more than doubled in 2007. The number of new investment accounts in China tripled in 2006. Salon workers talk about which stocks to buy and are “doing research.” The Chinese have few other viable investment options now, as fixed-income investments underperform inflation. A flood of money from all over the world has been pouring in and investing in Chinese stocks. The number of China-focused US mutual funds has expanded dramatically and their inflows have increased tremendously. Could the Chinese stock market continue to rally dramatically from here (to even more overvalued levels)? Yes, it certainly could. But as a rational long-term investor, in my opinion, the risk/reward ratio is not favorable at the moment.

What usually causes the end of a market bubble?

o Excess supply/reduced demand. High prices attract more capital, leading to a dramatically higher supply of the bubble asset (more tech stock IPOs/stock issues, more homebuilding, more Chinese stock IPOs/issues). The housing bubble caused home prices to rise so high that the average home buyer could no longer afford (without creative financing) to buy the average home. This reduces demand.

o An economic shock or an external shock such as a recession, a terrorist attack, etc.

o Simply market fatigue as excess optimism dries up. Once stock prices start to fall, there is a stampede of reverse momentum to the exits that is just as dramatic as the run up to it. At that point, people start selling simply because the price is going down, just like they bought simply because the price was going up.

o The Chinese stock market could be in trouble for a number of reasons, such as rising inflation in China (food, energy), a stronger currency which, along with inflation, erodes some of its competitive advantage, slower economic growth slowing from the current very strong (10% level), government actions to slow the economy/stock market/inflation, dramatic increases in the number of shares being issued there, and changes in stock market rules that they allow Chinese investors to invest a portion of their money outside of China (and in other markets such as Hong Kong). Chinese stocks have reversed somewhat in recent months. I remain bullish on China, but not bullish on Chinese stocks at the moment.

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