Editor's Note

10/18/2007 12:00 am EST


Howard Gold

Founder & President, GoldenEgg Investing

October 18, 2007

Did you lose your shirt in the dot.com bust?

Still trying to rent out that Vegas condo you bought in the real estate boom?

Then, have I got a mania for you!

In fact, it may be the Mother of All Manias-the great China Stock Bubble of 2007, and if you act quickly you can get in right at the top.

But you'd better hurry, because some day, as sure as the sun rises in the East every morning, this market will come crashing down around our ears.

From its lows just below 1,000 in June 2005, the Shanghai Composite Index has risen 500% to above 6,000-perhaps the most parabolic rise of any major stock market in modern times.

Let's compare it with the great Japanese boom of the 1980s.

The Nikkei 225 rose almost 300% from its July 1984 lows to its bubble peak. It then began a 13-year slide and now trades at less than half its all-time high near 39,000.

Finally here's our own NASDAQ Composite index during the great Internet mania.

From its August 1998 low to its record highs above 5,000 in March 2000, the NASDAQ registered a 240% gain-less than half what Shanghai has posted in the last couple of years.

Even the great bull market of the Roaring Twenties advanced less than 300% in the five years before September 1929.

And although India and Brazil rallied more over a longer time, China appears to have registered a bigger advance in a shorter time than any major stock market I can think of in recent years.

So, it's no surprise that we've seen the classic signs of a great investment bubble.

Last week The Wall Street Journal reported (subscription required) that the average first-day return for Chinese initial public offerings (IPOs) in 2007 has been 192%.  

UBS Securities recently noted that the Shanghai Composite index's price/earnings ratio of 68x trailing-12-month earnings is virtually identical to the NASDAQ's bubble high and slightly below the Nikkei's 73x P/E at its peak.

PetroChina (NYSE: PTR) recently passed General Electric as the second largest company in the world in stock market capitalization (with over $440 billion), trailing only Exxon Mobil (NYSE: XOM).

And we've read for months about the hundreds of thousands of ordinary Chinese clamoring to open brokerage accounts, often with borrowed money, to make their fortunes in the stock market. 

Like all manias of this kind, the Great China Stock Bubble is rooted in economic realities-the rise of China as a great economic power.
And indeed, Chinese economic growth has been astonishing-11.9% annually in the second quarter, with no sign of a slowdown. China may surpass Germany as the world's third largest economy this year. It has enjoyed a record $185 billion trade surplus so far in 2007, and its foreign currency reserves have reached a massive $1.4 trillion. And Chinese companies appear to be wildly profitable, with rapidly growing earnings.

But like all bubbles, this one comes with a large dose of artificiality and imbalances.

First, as an export-driven economy, much of China's growth is based on an artificially depressed currency. The Chinese government has kept a firm grip on the renminbi, so that it's appreciated a mere 9% against the US dollar over the last two years-while the euro has risen about twice as much against the greenback.

Second, to keep the growth machine humming, the government has kept a lid on interest rates. Despite five recent hikes, bank deposits in China pay less than 4%. With annual inflation near 6.5%, that guarantees savers will lose purchasing power every year. So, why not take a flyer on stocks?

Third, the Shanghai and Shenzhen exchanges are tightly controlled affairs, dominated by state-owned companies. And experienced global institutional investors can invest there only to a limited degree.

That means too many novices are engaging in what looks much more like gambling and speculation than long-term investing, making the exchanges much more vulnerable to manias and panics.

Trust me, this can't last-it never has. The only question is when it will end.

Many investors hope it will continue until the Beijing Olympics next summer, as the government pulls out all the stops to present the glorious new China to the world. That may be why President Hu Jintao, at the recent party National Congress, pledged to keep the growth engine humming and even soft-pedaled any potential conflict with Taiwan. Clearly, nothing will be allowed to stop this show.

But markets have a funny way of not following the wishes of investors, politicians or pundits (and I predicted a crash in the Chinese market in February, which duly happened-before the Shanghai index went on to double).

"They'll defy gravity and all of a sudden they'll collapse," says Professor Eugene N. White of Rutgers University, an expert on market manias.

The Chinese market could be hit by a serious slowdown in the US and Europe; by another global financial crisis like we saw this past summer, or by unexpected earnings blowups or accounting problems at major Chinese companies, among other things.

That's why I'd recommend that no investor put another dime into high-flying China-based mutual funds, ADRs, or ETFs at this time. And if you were smart or lucky enough to invest in China before, you should promptly lock in at least half of your hefty gains. In fact, I'd cut exposure to emerging markets in general to no more than 5% of your portfolio.

"It can go up another 100%, 200%, but the higher it goes, the riskier the bet it becomes," cautions Professor White.

Forewarned is forearmed, as they say. 

Related Video

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

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