The “Bubble” in Shanghai!

Author: David Kotok, Post Date: June 4, 2007

The world is watching a stock market bubble in Shanghai. Here are some bubble bullets; then, we’ll comment on the risk with Chinese “A” shares.

When stock markets are rising quickly and the curve turns parabolic, emotion takes over and valuation no longer drives pricing. Using valuation techniques is irrelevant in decision making during bubbles.
No one can forecast where the bubble ends. Upside price targets are meaningless.
The outside limits of bubble pricing can be astounding. History offers the Tulip Mania centuries ago as an example. For a treatise on bubbles read “Extraordinary Popular Delusions and the Madness of Crowds” by Charles Mackay originally published in 1841. My edition has a valuable foreword written by Bernard Baruch in 1932.
Bubbles do not “pop” in isolation. All bubbles have some ripple effect. The outcome is not predictable prior to the “pop.”
Bubbles come in all sizes and in all asset classes, not just stocks. Remember the Florida land boom and bust early last century or the Florida condo speculation now starting to unwind. Or you may recall the silver futures bubble a few decades ago.
In the US stock markets, we’ve had a bubble in bowling alley stocks. Anyone remember American Machine and Foundry and Brunswick? And in casino stocks for those who remember Resorts and Bally’s? And of course, we had the tech stock bubble 7 and 8 years go. Note that each of these started in a sector and then spread beyond the sector to other assets classes and to the general economy. That is the nature of a bubble; it is the contagion or spreading which makes bubbles dangerous.
We are in a bubble period on the Shanghai and Shenzhen exchanges. The Shanghai index is up almost fourfold from its bottom in 2006. In China there are a 100 million new investment accounts (gamblers?) playing the stock market for the first time. This occurs in the world’s 4th largest economy and at a time when economic growth is 10% per year. The Chinese “A” share market contributes about 10% of China’s capital; bank loans make up about 90%. (Data from BCA Research)

Chart patterns show the US based NASDAQ bubble and Japan’s Nikkei bubble of the late 1980s had curves similar to the current Shanghai Index. For perspective we note that the Chinese “A” Shares’ stock market capitalization exceeds 2 trillion US dollar equivalents. It is about half the size of Japan’s market and about one-fourth the size of the euro zone 13 countries.

Would a bubble “pop” hurt in China? Yes, of course, domestic Chinese investors would suffer losses. Would it sink the Chinese economy? No, unless there were a contagion. Jim Bianco rightly notes: “non-Chinese investors cannot own A-Shares, neither short selling nor derivatives trading by domestic Chinese investors is allowed.”

If the bubble “pops”, 100 million young and inexperienced investors may express their discontent with civil unrest. These folks have risked their savings and have no reference point for what they are doing and have done. The risk of a sell off in Shanghai is not just financial. It is in the political sphere. That is why it must be taken seriously.

At Cumberland, we are watching the Mainland China market closely and daily. It is a bubble in process. We do not for one minute assume that a “pop” can be contained in isolation.

Protection from a bubble requires diversification of risk. That is the soundest of principles. One needs to do that in all asset classes and all sectors and in diverse global markets. Broad diversification of risk means you cannot lose all at once. That is how one stays insulated in a bubble period. We do that by globally using exchange-traded funds (ETF). We combine them with fixed-income strategies and asset classes outside the traditional stock markets.

A second form of protection comes from the mobility. Highly liquid markets allow selling even when the markets are falling. But liquidity may disappear quickly so one should not assume that the liquidity today will be there tomorrow. Real estate, art, coins, metal in storage—none of these are liquid. That is why one needs to achieve a higher investment return when using those asset classes. The higher return is your compensation for taking the risk that liquidity may not be available if you need it. Non-believers may obtain corroborating evidence by asking Florida condo flippers about liquidity today.

This bubble in Mainland China is clearly intense. It involves the new Chinese investor class. So far, it is geographically contained which is why the Hong Kong exchange has not moved in parallel fashion. This bubble does present a risk because contagion effects may go beyond the “A” shares and cannot be forecast with any accuracy. Cumberland’s China exposure was more fully discussed on May 29th by Bill Witherell. See: .

There are strategies for bubble periods and we are applying them. Our US stock accounts have a little cash reserve being built. We have taken some of the profit from the energy position. Our non-US stock accounts remain fully invested and globally diversified. All equity account use ETFs. We are maintaining a neutral or shorter duration on bonds. Bond credit quality remains at the highest credit ratings.

We are soon off to Dublin for the GIC conference. Much of that discussion will focus on these types of risks and approaches to global investing. We will have more to report when we get back.

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