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.