Investment bubbles and the Chinese stock market bubble
investment bubbles
It seems that investment bubbles appear once or twice a decade, and obviously should be avoided. One of the best ways to build a successful long-term investment plan is simply to avoid big losses (like when an investment bubble bursts). Two recent investment bubbles that markets have experienced in the last 10 years were the tech stock bubble of 1997-2000 and the property/real estate bubble in the last 5 years. Both bubbles have created horrible hangovers (and huge losses) for investors who had too much money invested when they burst. It is very difficult (and often takes many years) to make up large losses of 25% to 50%. It is often tempting to invest in a bubble sector (or stay invested in a bubble sector) when the market is rising and you hear stories from your peers about how much easy money they are making. Unfortunately, history shows that the risk/reward of doing so is not good.
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 is going up the most. Taxi drivers, schoolteachers, retirees and many other people who have never invested in stocks are hoarding.
o A feeling you can’t lose. Great long term secular “story”.
o Dramatic price/value increases over 3-5 years.
o Valuation does not matter. Ridiculously expensive valuation in relation to the story. New creative ways to value assets (since using traditional metrics makes them look ridiculous).
o Buying simply because they are going up, not because of any rational analysis. Momentum reversal. 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 that feeds the increase.
o Great headlines. It’s all 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 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 great increase. Warren has recently been selling his participation in Petrochina. The Chinese economy is booming at this time, with a growth of around 10 % per year. The future of China is a great long -term secular history. The Olympic Games will take place there in 2008. This is a positive megatence obvious in today’s world. Bubble markets always have great stories about why this trend is bigger and better and will last more than others. The world is different now with respect to 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 tech and housing 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 increased 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 “investigating.” The Chinese have few other viable investment options now, as fixed-income investments underperform inflation. A flood of money from around 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 skyrocketed. Could the Chinese stock market continue to rise 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/reduction in demand. Higher prices attract more capital, resulting in a dramatically higher supply of the bubble asset (more IPO/stock issues of tech stocks, more home construction, more IPOs/stock issues of Chinese). The housing bubble caused house prices to rise so much that the average homebuyer could no longer afford (without creative financing) to buy the average house. 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 reverse momentum stampede to the exits that is just as dramatic as the run-up. 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 struggle for a number of reasons, including rising inflation in China (food, energy), stronger currency which, along with inflation, erodes part of its competitive advantage, slowing economic growth slows from the current very strong (10%), government actions to slow down the economy/stock market/inflation, dramatic increases in the number of shares being issued there, and changes to stock market rules that allow investors to Chinese invest a part of their money outside of China (and in other markets like Hong Kong). Chinese stocks have reversed somewhat in recent months. I remain bullish on China, but not bullish on Chinese stocks at this point.