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Meet the world’s biggest stock market bubble since the dot-com boom


China’s stock markets have soared in recent months REUTERS/Aly Song

Shanghai Duolun Industry, a Chinese real estate company, managed to win over investors with a little re-branding in May. In the midst of a technology stock boom, the company decided to change its name to “P2P Financial Information Services Co.” The company didn’t actually develop a peer-to-peer lending business — it just bought the domain name www.p2p.com — but its shares jumped 10 percent anyway.

“P2P Financial Information Services Co” wasn’t alone in this strategy. One Chinese floorboard company doubled its share price by shifting to online gaming. A hotel group became a high-speed rail company and a ceramics specialist re-branded as a clean-energy group. Investors rewarded these decisions.

China’s domestic stock markets have climbed to near-historic heights this year. The bigger of China’s two main stock exchanges, in Shanghai, was up 45 percent from the beginning of the year as of June 24, while the other one in Shenzhen, a city in southern China across from Hong Kong, had risen 99 percent. Those figures are down a bit from a June 12 peak, raising concerns that the great Chinese stock bubble of 2015 is coming in for a dangerous end.

No one knows for sure what will happen next. It’s possible that Chinese stocks are undergoing a slight correction, which will calm everyone down and lead to a more sustainable growth, rather than a crash. But it’s also possible that a correction will spook China’s unsophisticated investors and trigger a stampede for the exits. That could weigh on China’s financial system and economic growth more broadly, with negative consequences for other economies around the world.

Here are five facts about China’s stock market bubble — each of which help explain why the bubble arose and what might happen to it.

1. In just 12 months, Chinese stock markets have created enough value to give every person on Earth almost $900. 

This is a bubble of epic proportions. In 12 months, Chinese stock markets rose enough to create $6.5 trillion of value. It’s hard to picture, but that’s a stunning amount of money. It’s the equivalent of about 70 percent of China’s GDP in 2013, and about 40 percent of the total value of the New York Stock Exchange. It’s enough to pay off Greece’s debt 20 times over, circle the Earth 250 times with $100 bills, or build 43 International Space Stations.

Here is what growth in Shanghai’s stock index has looked like over the last year. The exchange more than doubled, before drawing back in recent weeks.

And here is the same period of time for Shenzhen. Compared with the Shanghai exchange, Shenzhen has more technology stocks, which have particularly benefited from the recent boom.

sze

No other stock market has ever grown this much in dollar terms over a 12-month period. David Woo, the head of Global Rates and Currencies Research at Bank of America, has called it the world’s largest stock market bubble since the dot-com boom of the 1990s.

Some argue that valuations are not that extreme. Joyce Poon, an analyst at research firm GaveKal Dragonomics, argues that Chinese stocks have a lot of catching up to do with the broader economy. While China’s economy has recorded impressive growth rates for years, its stock market had languished since an abrupt crash in 2008, before starting to climb again in 2015. 

But others see a more ominous future. A survey of fund managers by Bank of America Merrill Lynch reveals that seven out of 10 global investors agree that China’s equity market is in a bubble. Bocom International Holdings, an investment banking and securities group, has said that it expects a market crash within six months, while Macquarie has eliminated its exposure to mainland shares entirely.

2. The majority of Chinese investors don’t have a high-school degree.

People often say that stock markets follow the “greater fool” theory – even if a stock is irrationally overvalued, it still might be worth purchasing if there is another fool out there willing to pay a higher price.

That may now be the calculus for many Chinese stock investors. As high as valuations are, novice investors keep rushing into the market. Just last week, 1.41 million new investors opened stock accounts, according to Reuters, a similar number to each of the two weeks before.

New share accounts, BNP Paribas

The make-up of these new investors isn’t encouraging. A survey last year showed that that two-thirds of Chinese investors haven’t completed high school. Even Chinese farmers are giving up tending their fields in order to tend their stocks. And many investors are young: According to Chinese-language media cited by Foreign Policy, over a third of China’s 100 million investors are 30 or below.

Data suggest these uninformed investors could be increasingly on the hook for losses, as more experienced investors cash out of the market. According to data compiled by Reuters, senior executives of listed companies in China or their relatives sold 1.68 billion shares in May, triple the amount in April.

“A lot of people are bullish because they think this is going to run some more, and they’ll be able to get out before anything happens,” Patrick Chovanec, a chief strategist at Silvercrest Asset Management, said in an interview. “There will be people who say it’s going to go up because it’s going to go up. But I don’t think you’ll find anyone who says it’s going to go up because it makes sense financially.”

3. China now has the world’s most volatile stock market outside of Greece.

After climbing for months, mainland exchanges took investors on a scary dip, falling by more last week than they had since 2008. The drop could have something to do with 11 new companies joining the exchange, but in general, the ride is getting bumpier. According to data compiled by Bloomberg, the market has experienced bigger swings over the last 30 days than any other market except Greece.

4. There’s a troubling disconnect between Chinese stocks and the real economy.

The stock bubble may seem all the more strange, since the Chinese economy is not doing that well anymore. In the first quarter of 2015, the economy grew at its slowest pace since 2009. Other metrics are no better: Imports fell 18.1 percent from the previous year in May, the third straight month of decline, while retail sales and investment have also dropped off.


China’s retail sales are slowing sharply, CLSA

Chovanec of Silvercrest says the boom has more to do with larger trends in investment. The recent slow-down in the Chinese economy took a toll on the property market, which has long been considered the safe and reliable way for Chinese households to invest. The combination of a slowing economy and a supply glut in some cities caused the price of property to slump.

As a result, people started shifting their money out of the property market and into the equity market. “You squeeze one side of the balloon and the air goes to the other side of the balloon,” Chovanec says.

5. The bubble is really fueled by borrowing.

The other reason for the stock market boom is China’s huge expansion in lending in recent years. The Chinese central bank has cut interest rates three times since November, following years of an easy monetary policy. As the American Enterprise Institute’s Derek Scissors writes, China’s M2 — a measure of the amount of money sloshing around the economy — was $20 trillion at the end of 2014, an incredible 70 percent larger than in the U.S.

In both the U.S. and China, monetary expansion was intended to stoke the economy, but often instead ended up in the stock market. In fact, China’s stock market has tended to go up when bad news about the economy comes out, since people think that means the government will loosen monetary policy further.

The other trend fueling the Chinese stock market has been a huge increase in the use of margin debt, which has more than tripled in the past year.


Monthly changes in margin debt, GaveKal Dragonomics

That increase in margin debt especially raises the risk of a stock market crash. In a margin trade, an investor uses some borrowed money from a broker to buy stocks. If the value of a share falls below a certain level, investors will get a margin call, meaning they need to either deposit more money in their account, or sell shares to make up the difference. This dynamic means that a dip in prices in China could quickly spark an even bigger sell-off, as investors sell stock to pay their brokers.

Margin balances among Renminbi-denominated mainland stocks have risen 10-fold in just two years to reach RMB 2 trillion, GaveKal’s Joyce Poon wrote in a note in late May. “That is equivalent to more than 3% of China’s onshore stock market capitalization, or 8% of its free float—higher than any other market in history,” she writes.

Despite these troubling trends, the market could continue to climb in China. As the adage goes, markets can stay irrational longer than investors can stay solvent.

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