China Stock Mania's Global Risk

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China’s flagship broad-market stock index, never mind its far-more-speculative Shenzhen-stock-index cousin, has literally blasted vertical this year. In has skyrocketed 79.5% higher in just the past 5.1 months! Extend that to 5.8m, and the Shanghai Comp is up an astounding 92.0%. And over the past 9.4 months, not much time in the grand scheme of market cycles, the SSEC has catapulted 115.8% higher!

So essentially the Chinese stock markets have nearly doubled over just the past half-year or so. Such gains would be extreme in any market in any era, but are even more incredible in a broad-market stock index representing a great nation’s best businesses. The Chinese people are flooding into local stocks with reckless abandon, racing to throw every yuan they can get their hands on at these soaring markets.

This extreme stock mania only ignited back in late November. In the first half of 2014, normal market conditions existed as the SSEC drifted 3.2% lower to properly reflect a slowing Chinese economy. The stock buying started typically as well, in late July 2014. A survey of corporate purchasing managers, a PMI report, came in at an 18-month high implying the weak Chinese economy was finally starting to recover.

By early October, a combination of better Chinese economic data, rallying world stock markets, and the surging US dollar which would make critical Chinese exports cheaper for American customers worked to fuel a 17.2% SSEC rally. These were strong gains in just 3 months, but certainly nothing abnormal. It continued into mid-November, running up to a 22.4% gain in 4.1 months. That was starting to look excessive.

So Chinese investors wisely started to realize profits, and their bearishness and pessimism mounted rapidly. Stock-market levels have a pronounced wealth effect on any country’s overall economy. The higher stock prices climb, the more optimistic businesses get and the looser their purses in spending on investment and hiring. Beijing was worried a stock-market selloff would exacerbate spreading economic weakness.

So on Friday November 21st, the People’s Bank of China made a surprise move. In what was seen by the rest of the world as a sign of near-panic, this central bank slashed its main interest rate by 40 basis points to 5.6%. This was the PBoC’s first rate cut since way back in July 2012, and was a direct attempt to combat China’s slowing economy. That central-bank-easing surprise ignited the subsequent stock mania.

The world’s stock traders are high on the notion that central-bank money printing can magically manage stock-market levels, leading to endless rallies without material selloffs to rebalance sentiment. History has proven this false in spades, showing that excessive money-supply inflation always leads to bubbles and subsequent busts. But thanks to the extraordinarily anomalous US stock-market rally, traders have forgotten.

Since early 2013, the US stock markets have powered relentlessly higher without normal selloffs due to the Fed’s radically-unprecedented third quantitative-easing campaign. The Fed conjured up $1590b out of thin air to buy bonds, forcing interest rates to artificial lows. This led US corporations to borrow vast amounts of money to buy back their stocks, around a half-trillion dollars in 2014 alone. So the US stock markets levitated.

Stock traders around the world are convinced QE3 was a huge success, even though the fat lady hasn’t sung until US interest rates are normalized and the Fed’s massive bloated balance sheet is shrunk back down to pre-QE levels. So they have come to believe that central-bank money printing is always good for stock markets globally. Now whenever a central bank eases, they rush to buy stocks in its wake.

So with the People’s Bank of China following in the easing footsteps of the Fed and Bank of Japan, investors rushed to pour capital into Chinese stocks following that surprise rate cut. In just over 2 weeks after that move, the Shanghai Comp had surged another 23.2% higher by early December! Its total rally was up to 48.2% in just 5.0 months, with over 4/7ths of those gains driven by the PBoC’s near-panic easing.

Now if you were trading during the US stock-market mania in early 2000, you certainly remember all the breathless news coverage. The mainstream media endlessly reported on the red-hot stock markets, and stories abounded of ordinary investors multiplying their wealth in a matter of months. This same thing just happened in China, really playing into that universal Chinese pastime of wealth comparison and social aspirations.

Chinese people hated the idea that their peers were getting rich in the soaring stock markets while they were not. And with Chinese real estate slumping, and gold in yuan terms dropping 18.0% between March and November 2014, there were few enticing investment alternatives. So the Chinese started to plow capital into the stock markets to chase the SSEC’s incredible gains, led by legions of new investors.

As veteran hardened investors and speculators know, buying low and selling high is not an easy game. Our human emotions of greed and fear constantly betray us, making us overwhelmingly feel like buying high and selling low when the rest of the herd is. The best way to combat these dangerous emotions is with knowledge. The more you know about market history, the less likely you’ll succumb to popular sentiment.

The new Chinese investors plunging into the stock markets were far-less-educated than the existing ones. Bloomberg reported on some research in late March showing that a staggering 2/3rds of new Chinese investors in recent months had a junior-high-level education or less. A quarter only completed some elementary school, while 1/17th were actually considered “not literate” with no formal education at all!

Now there are likely ultra-rare edge cases where some whiz kid raised on the streets forges himself into an elite trader, running circles around others with doctorates. But in general, the lower someone’s education level the greater the odds they won’t really understand what drives stock markets and how risky they are at any given point in time. It’s not pejorative, but “dumb money” truly fueled this Chinese stock mania.

And it gets even worse. Just like in the US stock mania back in early 2000, many if not most of these new investors opened margin accounts. They didn’t only throw their own capital into soaring stocks, but rushed to borrow more money to multiply their holdings. By mid-April, Chinese stock traders had already borrowed the equivalent of a record $194b to buy stocks! That is crazy-high relative to the size of those stock markets.

Just like in the States, Chinese stock investors are legally limited to 2-to-1 margin through their brokerages. They can only double the money they have deployed in stocks. But also like in the US mania back in early 2000, Chinese investors have been circumventing these limits with personal debt. They are borrowing on everything they can, and eagerly casting that money too at their red-hot stock markets!

The net result of this frenzy of uneducated new investors borrowing to buy stocks is striking in this chart. The light-red curved line above is directly traced (and then slightly offset) from the Shanghai Comp’s price action since last summer. And it is a perfect parabola, the most dangerous price pattern in all the markets at a large scale during a popular speculative mania. There is no doubt this thing is going to collapse.

For many weeks the skyrocketing SSEC has been exceeding its upper Bollinger Band®. This is a key technical construct 2.5 standard deviations away from the base stock-index level. Seeing any price 2.5 standard deviations above its 50-day moving average is rare, as that encompasses just 0.6% of the entire probability band. And the Shanghai Comp has been beyond 2.5 standard deviations above for weeks on end!

In addition, as of this essay’s Wednesday data cutoff the SSEC was stretched an astounding 57.1% above its 200-day moving average! To see a major stock index push just 10% above signals serious overboughtness, and 20% over is extreme. The higher this gap between an index and its 200dma balloons, the greater the probabilities a big and sharp selloff is imminent to restore balance to euphoric markets.

So this Chinese stock mania really looks like it is on the verge of a total collapse. And provocatively it almost happened last weekend! Three hours after the Chinese stock markets closed for the weekend on Friday April 17th, a report emerged of an official crackdown on the excessive Chinese stock speculation. Chinese regulators were apparently discussing restricting margin trading for over-the-counter stocks.

Sharply reducing margin debt is the quickest way to kill a stock mania, forcing traders to stop borrowing to buy more stocks. And depending on how it is implemented, it may even require traders to sell down their existing leveraged holdings to repay those debts. On top of that, Chinese regulators said they were going to start allowing institutional investors to short sell Chinese stocks, another downside influence on prices.

While the Chinese stock markets were closed for the weekend, the reaction in the futures markets was swift and brutal. SSEC index futures were soon plummeting nearly 6%! And since Chinese investors had all weekend to stew over this and worry, Monday morning was shaping up to be a total bloodbath. It would not have surprised me one bit to see the Shanghai Comp crash on the order of 10% that day.

The Chinese government was well aware of these risks too, so I imagine many tense weekend meetings on how to deal with this furious stock selloff. Once parabolic stock markets break, the selling cascades for a long time. And if the millions of new leveraged Chinese stock investors were wiped out, there were serious risks of sharply reduced spending from the negative wealth effect and even widespread civil unrest.

So on Sunday, the People’s Bank of China swung back into action to arrest the popping of the bubble that it itself had spawned back in late November. It slashed Chinese banks’ reserve-requirement ratio by 100 basis points to 18.5%. This reeked of panic too. Not only was it a surprise, but it was the biggest triple-R cut since December 2008 in the dark heart of that global stock panic! The Chinese government was scared.

And that last-ditch gambit to prevent the parabolic Chinese stocks from cratering paid off. Monday’s loss on close in the SSEC was a mere 1.6%, trivial compared to what was likely to transpire before China’s central bank rushed to the rescue. But all stock manias inevitably end in a symmetrical collapse, their demise can only be delayed for so long by any means. So China’s ugly day of reckoning is still coming.

Smart Chinese investors who study market history should know exactly what to expect. This next chart extends the SSEC back to 2007, which encompasses the Chinese stock markets’ last popular mania that year. And just like today’s is certain to do, the last one ended badly. The parabolic stock markets didn’t just correct, they utterly collapsed. That’s the common outcome after all popular stock manias in history.