China?s stock
bubble has burst, with its stock markets utterly collapsing after
rocketing parabolic. The failure of this popular speculative mania
has grave implications for the global stock markets. It shatters
the universally-believed myth that central banks can nullify normal
market cycles. No government has more power over its stock markets
than China?s, yet not even it could magically eradicate greed and
fear.
Even before their
recent calamity, the Chinese stock markets had been the
most-interesting financial story of 2015. Having the world?s
second-largest economy, China is immensely important in global
markets. And its stock markets were soaring, as evidenced by
China?s flagship benchmark stock index. It is the Shanghai Stock
Exchange Composite Index (SSEC), the local equivalent of the US S&P
500.
By the ends of
March, April, and May, the Shanghai Comp had soared 15.9%, 37.3%,
and 42.6% year-to-date! Such gains were astounding, creating the
equivalent of trillions of dollars of wealth for Chinese
stock investors. And unlike major stock markets in the West,
China?s are dominated by its army of retail investors. Ordinary
Chinese people account for over 5/6ths of all the national
stock-market transactions.
So China?s soaring
stock markets truly were a popular speculative mania. And
culturally, the Chinese people are especially susceptible to the
greed-drenched groupthink necessary to fuel one. Social status
among peers is exceedingly important to the Chinese, and that is
most visibly manifested in perceived wealth. So as the stock
markets powered higher, people couldn?t stand the thought of being
left behind.
Their overwhelming
desire for upward social mobility, and being seen as successful by
their peers, led them to aggressively buy stocks. And this went far
beyond normal investing to pathologic extremes of herd behavior.
Captivated by the intoxicating dream of fast wealth, many millions
of Chinese who had never before invested in stocks rushed to
open brokerage accounts. But they were in over their heads.
Just like in the
States, these new Chinese investors had to disclose their level of
education when they opened their trading accounts. And even back in
early spring before this mania really got crazy, fully 2/3rds
of all the new investors reported only having a junior-high-level
education or less! 1/4th only completed some elementary school,
while 1/17th were considered ?not literate? with no formal education
at all.
So literally ?dumb
money? fueled the popular speculative mania in Chinese stocks. This
isn?t pejorative, as the lower someone?s education level the greater
the odds they won?t really understand what drives stock markets and
how risky they are. This amazing degree of unsophistication was
evident in the way these new Chinese investors bought stocks. Many
opened margin accounts to borrow money to do it!
Legally stock
margin in China is limited to 2 to 1 just like in the US, and the
official levels of margin debt were astounding. They had hit a
record equivalent to $194b by mid-April, and kept rocketing even
higher to $322b by late May. This compared to a record $507b of
NYSE margin debt in US stock markets at the end of April. Relative
to China?s smaller stock markets and lower per-capita income, this
was incredible.
And the real level
of using debt to finance speculative stock purchases was much
greater. Another one of China?s many cultural peculiarities is the
widespread practice of ignoring all laws and regulations
until caught. The legions of Chinese investors were borrowing all
the money they could get their hands on from any source they could
find to buy stocks, not limiting that to formal margin borrowing
from brokerages.
Some of this
alternative financing was questionable, gray-market and even
black-market venues created specifically to circumvent margin
rules. And this extra borrowing certainly wasn?t reflected in the
official margin numbers. So many Chinese investors? leverage in
stocks exceeded 2 to 1. This double-edged sword not only amplifies
gains, but losses. And most Chinese investors believed
stocks couldn?t fall.
This dangerous
notion was actively fostered by China?s government. It encouraged
the Chinese to invest in stocks for patriotic reasons, to support
their nation. Its official media outlets ran endless stories about
the fortunes being won in the stock markets. This really resonated
with the Chinese need for social status and upward mobility. And if
the government was fully behind the stock markets, what was there to
lose?
Western
contrarians scoff at such a silly notion, but Chinese investors grew
up totally indoctrinated to trust their immensely-powerful
central-planning government. There is no other major government in
the world that comes anywhere close to having the absolute internal
power of China?s, both actual and perceived, to manipulate the
markets and economy. And Beijing was pushing hard for the Chinese
to buy stocks.
It was actually
China?s government, via its central bank, that ignited this
stock bubble. Beijing was very worried about the weakening Chinese
economy last year. So in Late November, the People?s Bank of China
made a surprise rate cut. It slashed its main interest rate by 40
basis points to 5.6%. This was a big deal, the PBoC?s first rate
cut since July 2012. Chinese investors figured a new easing cycle
was starting.
And just like all
over the world these days in this era of epic central-bank money
printing, that was seen as a green light to buy stocks. So capital
flooded in, and in less than 3 weeks the Shanghai Comp had blasted
23.2% higher! The Chinese central bank provided the initial spark
that ignited that popular stock mania, and continued to nurture it
whenever it faltered. Beijing really wanted local stock prices to
climb.
I suspect there
were two primary motivations. First with China?s economy slowing,
the wealth effect of higher stock markets would bolster consumer
spending. China is trying to transition from an export-dependent
economy to one largely supported by domestic consumption. Second,
Beijing wanted to improve the international prestige and standing
for Chinese stock markets. So it convinced countless Chinese to
buy.
After the SSEC
soared by nearly a quarter in a matter of weeks thanks to the
PBoC, the Chinese people really took notice. The Chinese
real-estate market was flagging along with the national economy, and
gold languished down in the dumps. So many millions opened
brokerage accounts, borrowed money, and rushed to buy stocks.
Visions of fast gains clouded their judgment, the greed for quick
wealth creation.
After this rally
stalled in early 2015, the PBoC sought to rekindle the euphoria with
another surprise rate cut at the end of February. And soon the
Chinese were buying aggressively again, and the Shanghai Comp
skyrocketed in March and April. As a speculator and student of the
markets, I had been closely watching the Chinese developments with
great interest. By late April, the SSEC looked like a classic
bubble.
I wrote an essay
warning about the extreme downside risk in the
parabolic Chinese
stock markets then. That was a hardcore contrarian position to
take, very unpopular at the time. Even the vast majority of the
Western analysts believed that the Chinese stock gains would
continue indefinitely. The most common reason advanced was the
ability of China?s powerful central-planning government to steer the
markets.
But while
governments can amplify market cycles, they can never eliminate
them. History is chock full of examples of government-inflated
markets collapsing. It?s ultimately popular greed and fear
that drive market cycles! No amount of government jawboning or
money printing can strike these overpowering emotions from human
hearts. And not even the most-powerful governments can corral herd
behavior.
So right at the
end of April as the popular speculative mania in stocks looked on
the verge of burning itself out and rolling over, we started
actively betting against it. There are some US ETFs that track the
leading Chinese stocks, led by Deutsche?s China A-Shares ETF (ASHR).
I recommended that our newsletter subscribers buy ASHR put options,
because parabolic stock surges roll over to symmetric collapses.
Indeed the Chinese
stock markets dropped hard in early May, with the SSEC plunging 9.2%
in 7 trading days! With the Chinese populace so heavily invested in
the red-hot stock markets at Beijing?s bidding, it was terrified of
the looming correction. So the People?s Bank of China made another
surprise rate cut in early May, its third in 6 months.
Convinced the PBoC would keep easing, Chinese investors stampeded
back in.
As is always the
case in popular speculative manias, people were far more worried
about missing out on the next big upleg than any potential downside
risk. So the social-status-conscious and wealth-loving Chinese
continued aggressively borrowing to buy stocks. Within just 5 weeks
by mid-June, they had succeeded in forcing the Shanghai Comp another
25.6% higher! Bullishness and euphoria were universal.
But that?s exactly
when prices peak. Once all investors willing to buy Chinese stocks
had deployed their capital, there were no buyers left. So in
mid-June with little fanfare and no meaningful news, the SSEC
finally peaked. And once that selling started, the unbridled greed
of Chinese investors quickly turned to naked fear. Greed and fear
are asymmetrical emotions, the former builds slowly while the
latter flares suddenly.
After skyrocketing
an astounding 110.8% higher in just 6.7 months thanks to 3 surprise
rate cuts by the People?s Bank of China, the red-hot Chinese stock
markets collapsed. The SSEC plummeted 13.3% in a single week,
its worst since the 2008 stock panic. And there still wasn?t any
significant news to drive this, it was purely emotional. Herd
sentiment can turn on a dime at extremes, which is why they?re so
dangerous.
With its stock
bubble popping, the Chinese government entered full-on panic mode.
It was terrified of the social implications of the wealth
destruction from plummeting stock markets, fearing civil unrest
in particular. So on the final weekend in June after the Shanghai
Comp had cratered 18.8% in just two weeks, the People?s Bank of
China tried to work its market-manipulating magic again with another
rate cut.
And that fourth
surprise rate cut since November was extraordinary. Not only did
the PBoC again cut its benchmark lending rate, but it slashed banks?
and finance companies? reserve-requirement ratios. The PBoC hadn?t
done a dual rate and triple-R cut since late 2008 in the dark
heart of the stock panic, which reflected the panicking in Beijing.
The Chinese government was throwing the kitchen sink at the stock
markets.
But it didn?t work,
as heavy selling resumed in the week straddling June and July! This
shocked traders all over the world, who had come to assume that
central banks can control market cycles. All around the globe,
extreme easing by central banks has levitated stock markets to lofty
levels. The belief that central banks are omnipotent has led to
unnaturally-low volatility, and thus epic complacency, in
recent years.
No major
government in the world has more control over its stock markets than
China?s. And if not even the all-powerful PBoC could arrest a
stock-market plunge, what hope is there for the Federal Reserve or
European Central Bank or Bank of Japan? As the Shanghai Composite
kept on plunging despite that panicked dual cut, the Chinese
government got even more aggressive and desperate. It was amazing.
In just this past
week, the Chinese government tried to reignite margin buying by
allowing brokerages to accept real estate as margin-loan
collateral. Chinese investors were being encouraged to literally
bet their houses on plummeting stock markets! This was such an
asinine idea that the brokerages balked, risking Beijing?s
displeasure. Losing houses along with stock wealth would greatly
exacerbate civil unrest.
After that, the
Chinese government convinced major brokerages to collectively buy
$19b worth of stocks. But that was a drop in the bucket compared to
the $3000b or so lost as the SSEC plummeted by 32.1% in less than
a month! These brokerages also pledged to not sell any shares
as long as the Shanghai Comp remained below 4500. And the Chinese
financial industry fought the bursting in other ways too.
Like in the US,
Chinese companies can request halts in their stocks? trading for
news pending. But it?s being rampantly abused in China, with
companies halting trading indefinitely to sit out this extreme
selling. As of this week, about 1400 of the 2800 listed
companies on China?s stock exchanges had their trading halted! So
around 50% of the Chinese stock markets were effectively closed,
yet the selling continued.
China?s government
continues to get more desperate, entering the realm of the absurd.
This week, major shareholders, corporate executives, and directors
were banned from selling any stocks for 6 months. All new
IPOs and share offerings have been suspended to reduce supply
pressure. And the latest is the Chinese government is promising
to arrest short sellers. Beijing is panicked beyond belief
about this bubble burst!
Chinese investors
are starting to realize that neither their government nor central
bank is omnipotent, that stock-market cycles can?t be nullified.
They are finding out that manipulated stock markets are like a
roach motel, you can check in but you can?t check out! While
Chinese were encouraged to take their lives? savings and borrow way
beyond that to buy stocks, they aren?t being allowed to sell when
they want to.
This is
horrifying, and extremely dishonorable on the part of Chinese
government and market officials. The surest way to fan the flames
of panic is to make investors feel trapped, unable to
liquidate any of their positions whenever they want. That breeds
the bearish sentiment that drives long declines after popular
speculative manias. And as China?s last one in 2007 showed, today?s
bust is only getting started.
After that 2007
mania peak, the Shanghai Comp plummeted 72.0% in just over a
year! And the Chinese stock markets have never fully recovered
since. I suspect they?d still be languishing near lows if the
People?s Bank of China hadn?t ignited and nurtured this latest
bubble. And all that manipulation got was a 7-month mania with
illusionary gains that are rapidly vanishing, at the terrible cost
of devastating private wealth.
With the Chinese
stock markets half frozen, we liquidated one of our ASHR puts
trades for a 151% gain for our subscribers this week. We?re holding
another tranche, currently with a 207% unrealized gain, for lower
Shanghai Comp levels. While this popular speculative mania and
resulting Chinese stock bubble were
blindingly
obvious to contrarian students of the markets in late April, I?m
really sad for the Chinese people.
They had faith
that their all-powerful government wouldn?t lead them astray, that
it could keep the stock markets climbing indefinitely. They
believed their mighty central bank could cut rates enough, and print
enough money, to eliminate stock-market cycles. Even the
vast majority of Western analysts fervently believed this. Boy were
they all dead wrong! The biggest global implication of this is
psychological.
The US Federal
Reserve?s extreme easing of recent years has
radically
levitated the US stock markets, while a similar thing happened
in European stock markets recently thanks to the European Central
Bank?s Fed-style debt monetization. Once these
overvalued
and greatly
overextended US and European stock markets inevitably roll over
decisively, traders are going to remember what happened in China.
If the PBoC with
its extreme power, control, and measures couldn?t short-circuit
Chinese stock-market cycles, how on earth can the Fed and ECB hope
to? Today?s lofty global stock markets are nearly totally the
result of excessive confidence in the ability of central banks and
their easing to prevent material stock-market selloffs.
While history mocks that foolish notion, China?s stock bubble burst
vividly proves it false again.
There?s no doubt
China?s popular stock mania failing so catastrophically is going to
seriously erode traders? recent total faith in central banks. Yes,
their machinations can certainly amplify uplegs. But once herd
mentality inevitably shifts from greed to fear, central banks are
powerless to eliminate the normal stock-market cycles and
truncate selloffs. The hard example of China will really exacerbate
coming Western selling.
With US and
European stock markets artificially inflated by central banks much
like China?s was, it?s never been more important to cultivate great
sources of contrarian market intelligence. That?s what we have long
specialized in at Zeal. We buy low when sectors are deeply out
of favor, then later sell high when sentiment inevitably shifts
and investors return. This prudent contrarian strategy has led to
big gains.
Since 2001, all
700 newsletter stock trades recommended to our subscribers have
averaged annualized realized gains of +21.3%! That?s a lot of
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alike. We share our latest stock trades in our acclaimed
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The bottom line is
China?s red-hot stock bubble has burst. Chinese investors have lost
nearly a third of their wealth, much more for the margin traders, in
less than a month. And the same mighty government that fomented
this popular speculative mania has been powerless to stop its
failure. Beijing is panicking and trying ridiculous measures to
halt the selling, but the fear-driven herd is still stampeding out
anyway.
As Chinese
investors are bitterly realizing far too late, central banks are
ultimately impotent to eliminate normal stock-market cycles. While
central-bank manipulations through jawboning and money printing can
extend uplegs and delay selloffs, they will still always come
eventually. Western investors? blind faith in central banks?
abilities to levitate stock markets indefinitely is misplaced and
dangerous, a reckoning is inevitable.
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