Chinese Castle in the Air: The A-Shares Craze

Economist John Maynard Keynes applied psychological principles to investment theory and pronounced the “Castle in the air” theory back in 1936. It analyzes how the crowd of investors will behave in the future -- stock valuation is based on optimism and investors tend to build their hopes into castles in the air. That applied to the dotcom craze, and it also applies to the current China A-share market.

This week is the “Golden Week” in China, a national holiday that lasts for a week -- local stock markets are closed. Most Chinese will take a break from watching stock quote screens and travel to Hong Kong or overseas for vacation trips.

A relative of mine from Guangzhou visited me yesterday in Hong Kong and I took the chance trying to understand first hand the development of the A-share craze. She is a 60 years old house wife, a retired civil servant, never invested in stock market until very recently.

Here are some interesting points:

* People only talk about stocks -- no matter in restaurants, universities or work place. You can hardly set up business meetings with anyone before 3PM which is the stock market closing time.

* They are rushing to open stock trading accounts, though the initial account opening deposit requirement has been increased 10 times from RMB5,000 to RMB50,000. (RMB50,000 is almost the annual salary for an average person in Guangzhou.)

* Chinese investors are speculating not only on stocks, but also in mutual funds. Most investors think mutual funds are sure win investment because they are managed by ‘professional managers’

Interestingly, my relative knows she is gambling. She said she couldn’t understand why some stocks can keep going up even though they are money losing companies; she kept telling me the market will collapse sooner or later. This can perfectly be explained by the “castle in the air” theory -- everybody is looking for the next bigger fool.

The Chinese castle is developed because of one single reason: foreign investors are prohibited from A-share investment in general except those with QFII (Qualified Foreign Institutional Investor) quota allocation which itself is a scarce resource. Total QFII allocation is less than 1% of the total Chinese market capitalization and hence impact from international institutional investors are negligible.

In fact, international investors are becoming more cautious of the A-share craze. One very good indication is the discount/premium demonstrated by the Morgan Stanley China A-share Fund (CAF).

From the chart below we can clearly see that CAF has reverted from its all time high of 15% premium in Dec 2006 into its current discount of 15% and the discount level is still keep increasing. Similar pattern can also be observed from the iShares FTSE/Xinhua A50 China Tracker (IFXAF.PK or 2823.HK):

This is opposed to the uni-directional movement of the Shanghai Index:

It’s hard to tell when will the A-share market correct, but I would say it has to be triggered by the Chinese Government’s administrative intervention because all external forces will have no effect in this closed investment environment.

I am unwilling to bet on such timing and I have exited all my positions in CAF.

Disclosure: I have no position in the above mentioned stocks.

Comments

[izomax:]

If you have exited from A-share then you don't know what you are missing.

Look at Taiwan's stock market 10 years ago, China's stock market is an exact replica right now.

Economy is good, there're too much money floating around, the currency is undervalued, and people are just getting into the stock market.

The Taiwan stock market surged over 10,000 points in 3 years.

I expect the A-share to be the same, it still has at least a good year or two before it bursts.

2007 May 04 01:31 PM

[Chimin Sang:]

When you play poker, you want to look around and find out who the patsy is. If you cannot find one, you are the patsy.

2007 May 04 02:20 PM

[LJ:]

A friend of mine who is in the financial sector told me a different story. According to him, the large discount in CAF or other A-share exchange trade funds is just a reflection of a trading strategy commonly used by hedge funds.

Many institutions who were granted QFII went short on the A-share exchange trade funds, such as 2823.hk, CAF or IFXAF.PK. At the same, they used the cash proceed from their short positions to go long on some best-performing stocks in the Shanghai stock market. In so doing, they can benefit from the so-called China boom without injecting any capital into the Shanghai Stock market. Since many mega-cap stocks in China usually trade in tandem with the Shanghai Composite Index, the chance of losing big money is not high.

2007 May 05 05:00 AM

[davidjmills:]

Mems - this is very interesting....can you expalin this strategy in more detail and is it accessible to private investors?

2007 May 06 01:38 AM

[LJ:]

I believe these institutions could do that by selling the index futures in a stock exchange, or through some underground channels if the institutions are hedge funds.

In the case of Taiwan, foreign institutional investors cannot short sell individual shares. However, they would still be able to initiate a huge short position through the MSCI Taiwan shares index futures traded in the Singapore Exchange. This explains why EWT has been so volatile and has not been able to trade in tandem with the actual Taiwan's TWII Index for so many years.

I don't think this technique is widely accessible to private investors.

2007 May 08 04:37 AM

[Siwei Zhong:]

what you mentioned is a long/short trading strategy commonly used by hedge fund.

however i doubt how would that work in the A-share Fund/A-share pair in your example

for any Long/Short, the trader must be positive on the Long and negative on the Short, or more precisely he anticipates a widening of the long/short spread.

I dont see any reason why that would happen to the A-share Fund/A-share pair of assets as A-share stock and A-share funds are both going up starting in Jan 2007.

A-50 index future contract is available in S'pore with very low trading volume.

Selling future contracts would NOT generate cash to play a long/short strategy, future contracts are traded with margin and marked to market daily, and cash settled on expiry date.

2007 May 17 04:08 AM