Bubble Trouble Strikes in China

A Scary Moment in Shanghai

In a brief update on stock markets around the world, the AP informs us:

 

“Chinese stocks plunged 7 percent Friday as fears spread that a yearlong bull rally there had gotten overheated. The market is still up more than 100 percent over the past year.”

 

Overheated is the understatement of the still fairly young century in this case. Millions of retail traders have opened new stock trading accounts in recent months, most of whom reportedly know between nothing and less than nothing about the stock market. Two thirds of the new traders entering the market apprently didn’t even finish high school (see chart further below). Margin debt has soared into the stratosphere along with the number of trading accounts and stock prices.

 

china-stock-market-rallyChinese grannies day-trading during lunch

Photo credit: Reuters

 

However, it appears as if the market may really be in trouble now:

 

SSECThe Shanghai Composite Index, daily – this is beginning to look serious – click to enlarge.

 

The chart pattern above actually looks like the beginning stages of a crash. The decisive level is probably the early May low. This may provide support in the short term, but if/when it breaks, a wave of panic selling is likely to develop very quickly.

 

investoredu2_colorcorrectedFrom Bloomberg: education level of China’s new breed of traders compared to the previously existing stock of households investing in stocks.

 

It is to be expected that China’s authorities will take steps to prop up confidence, possibly before any important chart points have a chance to break. This has been a pattern that could be observed on occasion of previous corrections. However, one must be careful not to fall prey to the potent directors fallacy. Once the herd begins to stampede in the other direction, nothing is likely to stop it.

 

Conclusion

Due to China’s closed capital account, what happens in its stock market rarely has an effect elsewhere. However, if this bubble should actually implode, it may well once again turn out to be a leading indicator – it wouldn’t be the first time that China’s market was the last one to rally and the first one to plummet back to earth.

China’s real estate market has also been tottering on the brink for a while already, and the stock market has taken on the role of “Ersatz” bubble over the past year. If it keeps declining it will likely have a negative impact on economic confidence. We are not quite sure what it will take to tip the economy over the edge, but China definitely has a big debt and malinvestment problem that is likely to magnify any potential economic downturn considerably.

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