Why Shanghai Will Fall More

06/26/2008 12:00 am EST

Focus: GLOBAL

Howard Gold

Founder & President, GoldenEgg Investing

We all know that Shanghai's stock market has lost half its value from its peak last fall.

So, is the worst over? Not by a long shot.

If history is any guide, Shanghai will likely fall a lot more before it reaches its ultimate lows. And Hong Kong, which has declined a lot less so far, also will lose much more ground before it hits bottom, too.

That's bad news for the millions of Chinese investors who shoveled their savings into the Shanghai market in the frenzied months before its slow-motion crash. It's also likely to hurt thousands of Americans who loaded up on Chinese stocks, mutual funds, and ETFs right near the market's top.

In fact, we may not see those lofty highs again-6,000 in the Shanghai Composite index-for at least a decade.

The magnitude of Shanghai's advance from June 2005 to last October and the immutable logic of bear markets will combine to match some of the whopping declines from previous manias.

The Shanghai bear also points to some fundamental challenges the emerging Chinese economy must face-specifically, rampant inflation and the government's need to slow economic growth to combat it.

But first, let's look at the numbers.

From a low just above 1,000 in June 2005, Shanghai rose 500% in the next two years to hit its ultimate top of 6,092.06 on October 16th. As I wrote here then, that may have been the sharpest rise in the shortest period of any major stock market in modern times.

Shanghai's surge was double that of the Nasdaq Composite index in the late 1990s and the Dow Jones Industrial Average in the late 1920s, and almost twice as big as the Nikkei's during Japan's fabulous bull market of the 1980s.

You all recall how those ended, don't you? If not, let me refresh your memory:

Both the Nasdaq and the Nikkei ultimately lost 80% of their peak value, although the Nasdaq did it in two and a half years while the Nikkei, battered by Japan's lost decade, didn't hit bottom for 13 years.

And the Dow Jones Industrial Average plummeted almost 90% from its Jazz Age bubble high as the 1929 stock market crash and subsequent Great Depression devastated American industry. It took almost three years to hit bottom.

Taiwan's stock market, which went through a similar mania in the late 1980s, also crashed in 1990, and plunged 80% from its high.

So, based on history, that looks like the magic number.

"Every time bubbles pop, they tend to go down 80%-even as much as 90%," says Nicholas Vardy, who edits the Global Guru and Global Stock Investor newsletters from his home base in London.

So, where would the ultimate lows be? "1,200-that's where I'd put it," he says. That's another 50%+ decline from Shanghai's current price around 2,900.

Steven Hochberg, chief market analyst of Elliott Wave International, which studies manias and their aftermaths, says China's bubble was eerily familiar. "The exponential slope of the rise looked like the Nasdaq in 2000," he says. "I think ultimately China will be just like the others."

His prediction: "You're going down to 1,500 or lower." Ouch.

And what about Hong Kong? China bulls routinely call Hong Kong a more mature market than Shanghai, with major institutional participation and no hot retail money from the mainland.

Still, the Hang Seng index nearly tripled from its April 2003 lows to its peak last year-just about in line with the Nasdaq's and Nikkei's massive advances. Its average bear market sell-off in the last 25 years was just above 50%. Even a 60% decline from the recent top would put it just above 12,000, nearly 50% off current prices. Look out below.

But technical factors alone don't cause bear-market collapses. The markets, as we know, reflect what's happening in the real world-and even there the China miracle seems to be fraying.

Higher oil prices are taking their toll. As I wrote here, China is one of the world's biggest energy have-nots. Rising food prices are hurting, too. As in many emerging economies, food and energy take a bigger piece out of Chinese consumers' budgets than they do here.

And to continue its phenomenal growth, China must import all kinds of natural resources-zinc, copper, cement, aluminum. Those prices are soaring as well. Just this week, Chinese steel makers sucked it up and agreed to pay nearly twice the price for iron ore they did a year ago from supplier Rio Tinto (NYSE: RTP). More pain is ahead. 

The Chinese government has been quietly trying to slow the inflationary steamroller by gradually raising interest rates, but like many Asian central banks, China's has been woefully behind the curve. Inflation is now north of 7%, and the country suffers from negative real interest rates (where inflation exceeds official rates).

That's unsustainable in the long run. So, after August's Olympic Games, I expect Beijing to start raising interest rates sharply and also allow its currency, the renminbi, to float upward more aggressively to reflect its true value in world currency markets. As China's wages rise and the currency strengthens, exports will soften. Combine that with high material prices and weak economies in the developed world and you have a case for much lower economic growth down the road than the pundits are projecting (currently 9.8% this year).

Maybe that's what Shanghai's decline is really telling us-that the China miracle may be losing some of its luster, as China tries to make the transition from a low-cost exporter to a leading provider of 21st century goods and services. That move towards globally competitive branded products, domestic consumer spending rather than saving, and cutting-edge technology looks far off.

Which brings us back to the markets. It took the Dow 25 years to retake its 1929 peak. Nearly two decades later, the Nikkei is about a third of what it was at its bubble high of 39,000. And eight years on, the Nasdaq hasn't seen 3,000 again, let alone 5,000. Remember JDS Uniphase (Nasdaq: JDSU) at $1,000? Ah, yes, those were the days.

It may not be straight down for Shanghai. Elliot Wave's Hochberg says rallies as big as 40% to 50% are common during massive bear markets. Lower oil prices and government efforts to prop up Shanghai's increasingly desperate retail investors may trigger that.

But no government can prevent the inevitable. That's why I still wouldn't put a dime into Chinese stocks until this bear market runs its course, probably well south of 2,000. Before it's all over, there will be blood.  

Howard R. Gold is executive editor of MoneyShow.com. The opinions expressed here are his own and do not necessarily represent the views of InterShow or MoneyShow.com.

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