Anatomy of a Chinese Bubble: A Checklist For Spotting Bubble Tops

Spongebob: Patrick, check it out!
Patrick: Wow!
Sponge & Pat: Hooray! Bubble party!
Thug: Hey! Who blew this bubble? You all know the rules!
Thugs [in unison]: All bubble-blowing babies will be beaten senseless by every able-bodied patron in the bar

It's almost impossible to call the end of a stock bubble but there are several key indicators that investors should monitor when trying to time an exit from a bubble.

Use this handy-dandy check list next time you think you see a price bubble forming and want to call a top. I'm going to look at the most over-exhuberant market, the Shanghai Composite Index [DJSH] to see if the recent 180% run is getting a bit "extended."

1. Parabolic Price Increase

This one's pretty obvious since parabolic price increases are the definition of a bubble. We've had so many examples of bubbles now that it's getting pretty easy to spot the crazy price action that marks the final phases of a stock bubble advance. And all bubbles should be compared to the granddaddy of all bubbles - the NASDAQ from 1998 to 2000. The Shanghai's parabolic advance looks very similar to the Big Nasdaq.

Amazingly, the current advance in Shanghai makes the NASDAQ blow off look tame. Since the beginning of the move in 2005, the Shanghai has advanced 335% vs the 1998 - 2000 advance of the NASDAQ of 277%. The final acceleration higher in the NASDAQ from October 1999 to March 2000 went up 87%. The current blow off in Shanghai from September to today has registered a 180% increase. The current parabolic move in China is truly historic because at the time, the NASDAQ bubble had been the biggest bubble move ever.

Here's the three year chart of the Shanghai composite...

click to enlarge

...versus the NASDAQ composite from 1998 to 2000.

2. Strong Indexes Mask Underlying Weakness

During the final stages of a bubble blow off, most stocks have already peaked out and are beginning to head down. Here's a snapshot of some of the leading Internet stocks from 1999 to 2000. You'll notice that none of them were hitting new highs with the NASDAQ in March 2000.

Here's a snapshot of some leading China stocks right now...

3. Valuations Are Off The Charts

In 2000, Cisco traded at 180x trailing earnings and 40x sales. Amazon traded at 100x sales and had no earnings. Ebay traded at 1000x sales and had no earnings. In the Tokyo real estate bubble in the late 1980s, prime real estate went for as much as $100,000 a square foot. Now that's a bubble valuation.

In comparison, many China stocks look down right cheap. While a couple of outliers like China Life (LFC) and Guangshen Railway (GSH) trade at well above average multiples and are approaching bubble valuations, many China stocks are simply trading at slight premiums to their industries.

China Life and Guangshen Railway look expensive...

...but China Mobile (CHL), China Petroleum (SNP) and others are trading in line with their industry multiples despite the huge stock price advance.

The overall Shanghai market is trading at about 43x earnings, which, while expensive, isn't at the highest level ever.

The price to sales ratio shows a similar pattern.

4. Retail Investors Are All-In

In 1929, retail investors flocked to bucket shops to trade $200 of stock on $1 margin during their lunch hour.

In 1999, lawyers and doctors quit their jobs to trade stocks at day trading firms.

In 2007, Chinese are quitting their jobs to trade stocks. Over 27 million brokerage accounts have been opened in 2006, bringing the total to well over 100 million.

From Chinadaily.com...

Xiao Feng, a former investment consultant at a futures company in Nanjing, put his three apartments and two vehicles - worth 5 million yuan - up as collateral days ago to get a 10 million yuan loan to invest in the stock market.

But the cost of borrowing is high - with an annual interest rate of 25 percent, he'll have to pay the lender 2.5 million yuan in interest at the end of the year, reported the Nanjing Morning Post on Wednesday.

In addition, the lender will monitor his stock trading account. If the value of Xiao's portfolio drops below 8 million yuan, the lender will liquidate his stock holdings to prevent a further decrease in the principal, spelling a loss of two million for Xiao.

When the 2.5-million interest payment is also taken into account, Xiao Feng will lose what he has worked for in the past 10 years - all his collateral.

Then why take such a risk? "Maybe it is the lure of the stock market. If an investment in a stock triples, or quadruples in a short period, then why not try?" he replied.

No wonder the Chinese government is so concerned. The road to capitalism will get much more bumpy if people actually start getting a sense of risk and lose money. It will be an in vitiation for more, not less, government intervention - if that's even possible in a communist country.

So, three out of four on the Bubble Top Checklist are definitely confirmed, and one is not. That's probably close enough to call for a significant "correction". Soon, I'll take a look at how US investors might be able to make some money off of the China stock bubble "correction".

Comments

[John Gaats:]

You forget to mention an important fact: there are much less securities than Chinese demand. China probablly has 1500 securities to satisfy 40 million investors. Over valuation can happen when demand exceeds supply by a large factor. However, I will not bet against China for all the reasons you listed. If you believe your own reasoning, try short sell Chinese ADRs or Chinese funds.

2007 Jun 01 01:40 PM

[fxinot:]

If/When the bubble bursts, will it be a slow, 2 year descent like the Nasdaq or a Mt. St. Helens elimination where I wake up one morning broke? Discuss using ETF's (FXI, CHM, CAF, etc.) with "stop loss" settings to minimize the damage. Thanks for a thoroughly researched, informative article.

2007 Jun 01 01:44 PM

[Ashkan Karb...:]

Technical analysis heaven. Not sure I agree with everything but who cares, great work.

2007 Jun 01 02:15 PM

[huangjin:]

Good analysis. One difference with the NASDAQ and Shanghai that I haven't seen covered is that China is only up 100% in 5 years. In fact, if you go back to summer 2005, the A-Shares index was down about 50% from 2002. So something significant is taking place. Why is a market people dumped to 50% of it's value 2 years ago, now shooting higher? Given that I barely read anything approaching value investing in the Chinese press when I was there during the bear market (technical analysis is dominant), it leans me towards the bubble side. But unless someone can say that 15% a year returns (100% in 5 years) in an economy growing at 10% are unreasonable , there is a clear argument to be made for fair valuation and no bubble.

John, not only is the number of securities limited, but bank deposits pay an artificially low rate as part of the policies to help state owned banks.

2007 Jun 01 02:49 PM

[LJ:]

This won't be another dot-com bubble. If my interpretation is right, China's economy is still in the right side of the Phillips curve. The inflation in China too low. There is no sign of over-heating economy at all. If there is any bubble to be burst, this must be "face bubble", or "policy bubble".

2007 Jun 01 03:40 PM

[suburban blues:]

Thoughts...what about the lower PE Chinese stocks like ADY or CAGC? Or where the PE is much less than the growth rate like FMCN (PEG is about .70)? Or reasonable valuation vs growth prospects like GIGM? Are they part of the "bubble"?....seems to be some cross currents in the Chinese markets.. Thoughts?

2007 Jun 01 11:12 PM

[omodes123:]

You mention that CHL and SNP are trading within reasonable evaluation. I would image there were companies within the same sector which remained reasonably valued as well - and after the bubble became gems. You need to compare SNP with energy sector stocks probably most similar to VLO. If one invested in VLO 2002 post bubble you would be up over 1100%. In fact the bubble doesn't even apply to VLO - starting 2000 you would be up over 1400%. I believe there are still value picks in the mix.

2007 Jun 02 11:16 AM

[Michael Jac...:]

I am nervous because I know a panic in China could be far worse than anything we've seen before, but it's a mostly irrational fear...I think there will be a correction, but that it might play out as a puncuated series of small corrections at first. And I am eager to see the next article. Very thorough analysis.

2007 Jun 02 11:16 AM

[huangthomas:]

There are 4 stock markets in China. Extrapolate A-share market to B-, H-, ADR......make that much sense? Each valuation of the same stock share in 4 markets are different. B-share market valuation is only one-tenth of the A-share market. If A-shares carry a P/E ratio of 50, B-shares are only 5. Is PE of 5 too expensive in markets which the share earnings increase, on average, 40% from 2005 to 2006 and the Q1 earnings increase 100% (yoy). (A word of caution: don't buy B-shares because of liquidity problems). H-shares and ADR are priced modestly at 15-20. And again, are they too expensive? Despite crying of wolf, fire, bubbles........... Chinese Index ETF of China H-share (FXI) and ADR (PGJ) keep rising, why? I think American investors have their own mind, unaffected by chicklittle, such as GS....... Only A-share CEF (Morgan Stanley's CAF) suffer a --20% (from+20%) discount from +20% premium, with a total drops of -40%.

2007 Jun 02 11:44 AM

[huangthomas:]

A cogent question to ask is how collapse (just assuming it may happen) of A-share market is going to affect: 1 H- and ADR markets, where the great majority of American investment are. 2. The world market. The Shanghai Stock Market Composite Index dropped 8.8% on Feb 28 was followed by a world wide correction, including H- and ADR-market. It was based on fear, but not on careful consideration. Chinese, with $2.5 trillion in bank saving, are not allowed to invest outside of China. Recent approval of $10 billion for QDII to invest in New York & London stock markets has not been wholly implemented yet. Collapse in A-share market has little effect on capital invest in the markets outside of China, because there are none. When Shanghai stock market index dropped 6.5% on May 30 following tripling of stock transaction tax from 0.1% to 0.3%. 6.5% correction in Shanghai was treated as a non-event by the rest of the world. H-share and AD-Rs market only felt a minor Jolt. After Chinese workers lose all their saving, they may be more willing to go back to work for a lower wage and cheap Chinese good will keep coming to the American shore.

2007 Jun 02 12:38 PM

[omodes123:]

what you don't understand is that fact that people in china are frenzied for money and this is really the first time they've had a chance to get a taste of it. Instead of hiding money under mattresses, people actually have the courage to invest. China should still be considered a growth market with double digit GDP growth. image what our boom would have amounted to if we were sustaining growth at those levels. China has some catching up to do. Think the inverse of what you just said: "what a wonder world we would all have if Chinese people could make just as much money as Americans". Instead of tens of millions of ipods sold apple could have sold several 100 million. The world is in dire need of an expansion to the "first world" markets. this is only the beginning...

Take a look:
finance.yahoo.com/char...;range=20020930,200706...

2007 Jun 03 11:48 PM

[aindovina:]

Before reading this column, I was more concerned about the possibility of a bubble in China than I am now. Correct me if I am wrong, but the article seems to be stating that while a couple technical indicators speak in favor of a bubble, the fundamentals, based on PE, are sound-- at least for the most important companies. The comparo from John Coppola between VLO and SNP seems sound, but also comparo LFC to AIG and the PE's are not outrageous. There are not exactly huge market cap companies like CSCO and JDSU and SUNW trading at 180x earnings in the China market, are there?


A few questions:

1) Which companies in the Shanghai Index are giving the PE boost when all the companies reviewed here are within spitting distance of reasonable valuations?

2) How much liquidity is absorbed by China versus other world indices? The size of the Shanghai market is tiny compared to other indices like, say, the Nasdaq in March 2000 or other world bourses today.

3) If Chinese retail investors were to leave the Shanghai stock market en masses either by choice or by margin call, truly how much liquidity would be lost? It seems that foreign capital would pick up the stocks as they dropped in value, spotting good values with PE's in the single digits and low double digits.

4) How would a Yuan revaluation factor in? This is left out of the article and deserves attention.

2007 Jun 02 01:31 PM

[David Lentz:]

Hmmm... the mention of the outlandish margin situations preceding the Crash of 1929 sparked a recognition of a very similar thing happening today with the yen carry trade.

I wonder how many hedge funds and trading departments are leveraged to the hilt using yen borrowed at next-to-nothing interest rates? And what will happen to them if something should happen to turn that leverage against them?

2007 Jun 02 01:38 PM

[izomax:]

Another clueless "analysis".

First, why are you comparing it with NASDAQ?

In the DotCom era companies had literally no earnings.

However Chinese companies are growing 40%-50% every year.

Second, only 8%-10% of the total population in China is in the stock market.

What do you mean by everyone is in the market?

2007 Jun 02 04:29 PM

[huangjin:]

One has to parse these Chinese companies. How many people have researched anything beyond the big ADR firms like CHL, CHU, and LFC? I remember newscasts in 2005 and 2006 talking about how SOEs were making profits for the first time, due to energy and materials prices. If those reverse, earnings will tank. The Shanghai Exchange as of end of 2006 had 66% in the top ten stocks. It cold have changed quite a bit since then, but it would still be heavily weighted to a handful of stocks, although those are heavily telecom and financial.

2007 Jun 02 05:49 PM

[ContraHour:]

Thanks for all the insightful comments. Let me address a couple of good points you brought up.

I started looking at the Shanghai market after reading Robert Hsu's excellent newsletter, China Strategy. He's a well connected and intelligent analyst that actually has experience living and trading in Asia. His analysis is coherent and well researched. He wrote in the May 3rd issue ...

“I've also heard stories of Buddhist monks becoming avid day-traders who visit local brokerage houses on a daily basis, wearing baseball caps to disguise their shaved scalps. The most interesting story to me involved hundreds of Shanghai nannies who quit their jobs last month to become full-time stock speculators. Everyone, it seems, wants a piece of the China Miracle.

The Chinese nanny story struck a personal chord with me because my childhood nanny in Taiwan, Miss Wu, recklessly plunged all of her personal savings into the Taiwanese stock market during the late '80s. She managed to turn $60,000 into $300,000 by purchasing highflying bank stocks on margin. But when the market eventually crashed, Miss Wu lost everything. She had no retirement funds left, and my family has been helping her ever since."

We've seen this thing over and over in the past decade. Unsophisticated investors drive up asset prices to unsustainable levels creating the risk for serious declines. Whether it be the NASDAQ, real estate, or whatever, it all ends the same way - when investors who don't understand risk use margin and cheap money to chase exorbitant returns, it ends in a major collapse.

So if it looks like a duck, quacks like a duck and waddles like a duck, it's probably a bubble.

I think the most compelling argument AGAINST a massive decline occurring is that 1) valuations aren't absurd and 2) we are still in the early innings of the Shanghai market run-up.

Like Mathew said in his comment, the Shanghai market was in a serious slump just 18 months ago. So if we go back to my NASDAQ comparison, we might well be in 1997 or 1998, not 2000. From 1995 to 2000, the NASDAQ advanced 567%. The Nikkei in the 1980s, which was probably one of the top ten bubbles of all time, increased about 470% in the entire decade.

Part of the Shanghai advance is "catch-up" because of significant reforms taken on by the Chinese government. Prior to 2005, the best Chinese companies weren't listed in Shanghai, they were listed in Hong Kong or on the NYSE. The Shanghai market was a dumping ground for virtually bankrupt State Owned Enterprises (SOEs). But recently, quality China companies like China Life, China Aluminum and Sinopec began listing their shares on the Shanghai Index. In addition, the Chinese securities regulators made all classes of shares tradable. That eliminated much of dual or triple ownership structure that made analysis of these SOEs virtually impossible. And the increased transparency lead to higher valuations.

But what worries me about the Shanghai market, is the speed of the advanced. The from 1995 to 1998, the NASDAQ advanced about 164% until it hit a 33% correction in 1998. In comparison, the Shanghai market has increased 330% in two years. That type of advance is unattainable and will result in serious downside volatility. It might not spell the end of the bull market, but it will result in some breathtaking declines.

A second argument against a massive decline is that valuations of China stocks are not absurd. This is actually somewhat difficult to quantify because, as huangthomas points out in his comment, there are four different markets in China. In addition, many of the leading Chinese stocks are listed on markets outside of Shanghai. While some shares trade at absurd valuations, some share trade at low valuations. China Life (LFC) at 73x earnings looks like a bubble valuation to me. But China Mobile (CHL) at 21x earnings looks reasonable. Cnooc (CEO) at 10x earnings looks cheap but CTRIP.COM (CTRP) at 76x earnings looks expensive. So as you see, you can't paint the China market all with one brush, which makes it difficult to say that the valuations are too high.

Just one more note. The "strong fundamentals" argument is usually irrelevant in understanding bubbles. The fundamentals are always strong as bubbles form. It's the strong fundamentals that creates excitment and increased stock speculation. Saying that internet companies were all money losing ventures is revisionist history. EBAY, AMZN, AOL, CSCO and YHOO were the fastest growing companies in the history of the world. Many are now the most profitable as well. Investors create the bubble by projecting these strong fundmetals to ininity and price shares off of those linear projections. That leads to massive overvaluation which creates the final phase of the bubble. When the speculation reaches an excessive levels, it bursts not because of poor fundamentals but because something changes investor behavior. An external shock, less liquidity or simple exhastion can all spell the end of the advance.

Therefore, I would expect a lot more serious declines on the order of 15% - 30% to shake out a lot of the new, retail investors. But I can't say for certain that its the end of the run. Hence, my call for a "correction," not a collapse in the Chinese market.

2007 Jun 03 08:26 AM

[Everyday Fi...:]

I too am concerned about the rapid uptake in interest in the market, especially from the Chinese populous. It's evident is that there's an international bubble brewing in several regions including Eastern Europe, Mexico, Columbia (yes that's right; check out last week's businessweek) and the usual BRIC countries. However, I'm no market timer and I think there's some valuable upside to be obtained prior to the correction, especially from some individual diverse high quality companies. I now have positions in some double digit yielding real estate funds, utilities and then some more speculative plays. I'm planning on taking some off the table in a few months, but for now, enjoying the ride. For instance, Friday, WBD was up over 11% on no news a couple days after I bought it. I can't sit on the sidelines during the Nasdaq 5000 of the this time period though. I've posted research and analysis at:

everydayfinance.blogsp...

Feel free to visit and comment.

Dan at everydayfinance.

2007 Jun 03 10:34 PM

[aindovina:]

Thomas,
Where do you get a PE of 73 for LFC? It closed at $47.36 Friday with TTM earnings of $4.68 and estimated 12/08 earnings of $2, for a forward PE of 23. Maybe not great for an insurance company, but not 73 either.

finance.yahoo.com/q?s=...

I admittedly don't understand the various shares classes for Chinese stocks, but valuations seem good.

2007 Jun 04 12:57 AM

[Nidhi Kadalbal:]

Interesting ..

creating-wealth.blogsp.../

2007 Jun 04 04:10 PM

[long term s...:]

The analysis is very informative.
A correction in the range between 25 to 35 percent will be healthy for the Shanghai market in the long run. A bubble is unlikely to occur with the recent measures (plus any future ones, if required) introduced by the state. Major ADR shares currently listed on NYX (such as CHL, LFC, Petrochina...) appear to be trading on not very expensive valuations based on 2008 earnings and therefore the impact on these ADRs will be minimal when the correction takes place in China.

2007 Jun 04 08:09 PM