The Bubble Last Time: Chinese Stocks in 2007-2008

Now is not the first time that massive numbers of new investors in China have rushed into the market to inflate a stock bubble. Consider this commentary:

"Cab drivers, housecleaners, college kids and Buddhist monks are opening brokerage accounts and speculating in stocks for the first time, says ChinaDaily.com.

The Shanghai composite A index — open only to local Chinese investors — is...up 50% so far this year. Those are big gains compared with the few choices available to Chinese investors, such as bank deposits and 10-year government bonds yielding just 3%, says Alec Young, international stock analyst for Standard & Poor's.

Signs of froth are prompting investors to debate the fallout that markets around the globe may experience if the bubble in China bursts."
"Still, the buy-now mentality of China's growing army of amateur investors smacks of speculation. Almost 4.8 million retail accounts were opened in April, 835,500 more than in the past two years combined, says China Securities Depository and Clearing. Top Chinese politicians and central bankers are warning that "chao gu," the Chinese brand of day trading that means "stir-frying stocks," is a mania."

Those lines were written in May of 2007:
http://usatoday30.usatoday.com/money/markets/2007-05-20-china-markets_n.htm

Back then, China's stock bubble inflated further over the summer of 2007, peaking in October 2007 around the same time as U.S. markets and the S&P 500. But while it took another 11 months for the collapse of Lehman Brothers to spark the big market crash in the U.S., in China the crash began in early November 2007 and, except for a sucker's rally in April 2008, continued virtually unabated for an entire year.

The following chart shows vividly how the 2007-2008 Chinese stock boom and bust dwarfed the rally and 2008 crash on Wall Street:

[Chart courtesy of StockCharts.com]

The red line is FXI, the index fund tracking Chinese stocks. The blue line is SPY, the main S&P 500 index fund.

The Chinese stock bubble this time is unlikely to inflate as high as it did in 2007: the level of uncertainty among investors globally right now is probably enough to rein in such extreme excesses on the Hong Kong market. That will not stop the speculative frenzy on the Shanghai market, but it will put a certain limit on it. (The "Shanghai premium" for stocks listed on both exchanges has been about 30-40% above Hong Kong values.)

Still, even without the extra inflation of the bubble such as happened in China in August-October 2007, the bursting of it will be plenty dramatic and painful as it is.

Shanghai Stocks Party Like It's 1929

Here is some essential background reading on the Chinese stock boom:

http://www.marketwatch.com/story/china-stocks-may-be-in-serious-bubble-2015-03-26

Key information:

"China has entered a new stock frenzy, like something out of America in the Roaring 20s or the dottiest days of the dot-com bubble, with trading volumes continuing to push to new record highs."

"The lure of flush times on the Shanghai market is sweeping in unlikely investors by the hundreds of thousands. This week, both the China Securities Daily and the Beijing Morning Post had dueling reports about recent college graduates and, yes, teenagers buying shares.
Typically these young investors speculate with money given to them by their parents, according to a Great Wall Securities broker quoted in the Beijing Morning Post story.
Yet another report, this time by the Beijing News newspaper, relates that at the Beijing trading halls of China Securities Co., “even the cleaning lady” has opened an account to play the market."


http://www.washingtonpost.com/blogs/wonkblog/wp/2015/03/05/is-chinas-1929-moment-coming/
Article title: "Is China’s 1929 moment coming?"
Key information:

"And now that's happening to stocks. It's still nowhere near its 2007 highs—in fact, it's barely halfway there—but the Shanghai index has nonetheless been on a tear the last six months, up 50 percent in that time. Why? Well, it's not earnings. Those are down. No, it's the debt. Investors have become so exuberant, perhaps irrationally so, that they aren't just throwing their own money into the stock market, but borrowed money, too. Margin accounts, which let people do this, more than doubled in 2014. And to give you an idea how important this has become to the market, stocks tanked 7.7 percent in a single day after the government announced it wouldn't let the three biggest brokerages open any new margin accounts for the next three months. It sure looks like China is replacing its housing bubble that just popped with a new stock bubble."

Policies Promote More Speculative Lending and Borrowing

This little article about some of the policy announcements behind the last couple days' surge in Chinese stocks is well worth a read:

http://www.minyanville.com/special-features/daily-recap/articles/china-pboc-economy-stocks-market-shanghai/3/30/2015/id/56011

The key pieces of information:

"PBoC governor Zhou Xiaochuan said the bank stands ready to cut interest rates and bank reserve requirements to fight deflationary risks."

"Additionally, down payment requirements for second homes were lowered, and sellers of homes will now be exempt from a 5.6% transaction tax on properties held longer than two years. These measures are aimed at supporting the Chinese housing market."

So basically, with the economy slowing down and a speculative bubble in housing and construction at risk of bursting, the response is to encourage more speculation by reducing the financial requirements for banks to lend and home buyers to borrow.

America tried this 10 years ago. Spoiler alert: It did not end well.

The China Stock Bubble in One Chart

Today Chinese stocks on the Hong Kong and Shanghai exchanges boomed, simply on the basis of announcements about the "New Silk Road" infrastructure investment plan and the possibility of further easing of monetary policy by the central bank. At midday the most popular index fund of Chinese stocks, the China Large-Cap ETF (ticker symbol FXI), which tracks the FTSE China 50 Index, is up almost 4%.

But these stock valuations fly in the face of all the larger signs of the past year's slowdown in Chinese construction and manufacturing. No one disputes that the collapse in the prices of iron ore, copper, and other industrial metals in the past year is largely due to this Chinese economic slowdown.

Chinese stock values are simply in a bubble now, no longer supported by underlying economic activity. The chart below clearly illustrates how this bubble has suddenly inflated since last November:

[Chart courtesy of StockCharts.com]

The red line is the value of the China stock index fund (FXI) from the beginning of the bull market in March 2009 to the present. The blue, green and pink lines are the values of the main steel index fund (SLX), the price of copper, and the stock of Australian-based mining conglomerate BHP Billiton, a leading iron ore producer, over the same time period.

As the chart shows, from March 2009 until fall 2014, the metals & mining values exceeded the Chinese stock values. But they still generally moved up and down in tandem: up in 2009, down in early 2010, up in mid-late 2010, down in mid-2011, up in late 2011, down in early 2012, up in late 2012, down in early 2013, up in mid-2013, down in late 2013-early 2014, up in early-mid 2014, down in September 2014.

But as you see at the right hand side of the chart, after the middle of November 2014 the paths of the metals & miners and the Chinese stocks sharply diverged: Iron ore, steel, copper and BHP kept crashing, while the China stock index suddenly started booming.

This is an unprecedented development that cannot be explained by any underlying economic data. Rather, the explanation lies in the launching of the Shanghai-Hong Kong Stock Connect on November 17, 2014. That date was the first time that retail investors in China were able to invest in Chinese stocks on the Hong Kong exchange, via the link to the Shanghai stock exchange. Since then, prices on the Shanghai stock exchange have boomed dramatically, and many commentators have pointed to it as a stock bubble.

The increase in the FXI China stock index fund, which is based on stock values on the Hong Kong exchange, has been more modest than Shanghai's. But the chart here shows that its value is an inflating bubble as well, driven by new Chinese investors but divorced from the reality of the Chinese economy.