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China Bubble Revisited

The Chinese stock market has had a big break of nearly 20% over the past two weeks. Here is a daily bar chart of the last year's action of the Shanghai composite index.

And here is an image of the cover of the latest issue of The Economist.

I've noticed that some commentators are offering this cover story as a contrarian justification for thinking that the rise in the Chinese stock averages over the past 9 months is a bubble - with the implication that a crash is underway.

I commented on this situation a couple of weeks ago in this post. There I observed that bubbles can develop when markets are at all time highs, but are very, very unlikely when the market is nearly 50% below its all time high as the Shanghai composite index was a few weeks ago at 3400. Of even more importance is the fact that after a 75% drop in prices a huge bear market crowd always forms - China is no exception to this rule. And it takes years, not months, for the bear crowd to disintegrate.

So I don't think we have seen a stock market bubble in China end at the 3400 level in early August. Instead I think the Shanghai composite is in a bull market that will probably take it above the 5000 level over the next couple of years. Notice that the 200 day moving average (red line highlighted by green arrow) is trending upward with the current price well above that line. This is a positive evidence for an ongoing bull market. I expect the drop from the August highs near 3400 to end not far from current levels.

How far down is the drop from the 3400 level likely to carry? I have drawn a trend line (blue dash line) connecting the reaction lows of the bull market thus far. It currently stands at about 2650. The midpoint of the up swing that started in early March 2009 is roughly at 2775 (horizontal red dash line). So I think this reaction will end somewhere in the purple oval.

Another remark on contrarian thinking. After a bubble or a crash in any market the subsequent move in the opposite direction always attracts the attention of amateur contrarians. They offer headlines or cover stories like this one from The Economist as reasons why recent history is about to repeat itself. But in this they are generals fighting the last war because, in retrospect, it looked so easy to win. They ignore the dynamics of market crowds-it takes a long time for public sentiment to swing from bearish to bullish or from bullish to bearish.

In the case of the Chinese stock market lots of current bears want a chance to be heroes - in retrospect they see how they could have easily handled the 2007-08 bear market in the Shanghai composite if only they had seen it coming. They want to fight the last war because it looks easy in retrospect. I fear their hopes will be disappointed.