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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):

caf

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

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.

Source: Chinese Castle in the Air: The A-Shares Craze